Tax Incentives

by Jay Johansen

Our government attempts to encourage behavior that it considers beneficial to society as a whole, and discourage behavior which is destructive. In extreme cases this is done through criminal law: murderers are sent to prison, etc. But a far more pervasive system of rewards and penalties has been established through the tax code. Tax laws are carefully crafted to provide incentives for socially-beneficial behavior.

For example, consider two hypothetical people, we'll call them Al and Bill.

Al's dream is to own a small business. He gets married, and for many years Al and his wife live very frugally while they save their money. Finally, they have enough to buy or start a small business. The business is successful, and they slowly expand. They provide jobs to many people. They finally reach a point where they have outgrown their original location, and so they sell the building and much of the equipment and move to a new, bigger facility. After a time they decide to turn the business into a corporation to attract investors to fund further expansion. They also carefully save to put their children through college. Finally, they die at a ripe old age, and leave the business to their children.

Bill has about the same income, but he spends it very differently. He likes the fast life. He never marries, but goes through a series of live-in girlfriends, throwing them out when he meets someone who strikes his fancy more this month. He goes deeply into debt, and squanders most of his income (and his borrowed money) on gambling and alcohol. He regularly goes through rehab programs but soon after he is pronounced "cured" he goes back on the binge. He fathers many children by a variety of women, though he has little idea where most of them are or even how many there are. As most are the result of one-night stands, the mothers themselves are not sure who the father is so Bill escapes any legal responsibility for child support. Bill finally dies of a drug overdose.

Now let's look at the tax consequences of each of these lifestyles.

Of course both men will pay income taxes. But because Al gets married, he and his wife pay higher tax rates than do Bill and his girlfriends.
As Al is saving to buy his business, he pays taxes on the interest his money is earning while it waits in the bank, even when the interest is less than the inflation rate. As Bill piles up debts, he gets a tax deduction for the interest he is paying.
When Al buys his business, from then on he pays property taxes. Bill drinks most of his income so he never pays property taxes.
Al pays sales taxes on his business expenses. There is no sales tax on Bill's gambling.
When Al hires employees, he must pay social security and unemployment taxes for them. Bill, of course, pays no such taxes.
When Al sells his original location to move to an expanded facility, he must pay capital gains tax on the profit from the sale, even though most of the "profit" is actually inflation.
Bill may take a dededuction for some of his gambling losses.
Bill can deduct the cost of his rehab programs as a medical expense. (Unless, of course, they are provided to him for free by the government.)
Al receives deductions for his children. As Bill is not supporting his children, he probably receives on such deduction. (Of course, he does not have the expense of supporting them, either.) While Al saves to put his children through college, he again pays taxes on the interest income.
When Al incorporates the business, all income is now taxed twice: once as income to the corporation, and again as income to himself and the other shareholders. Bill's income is all taxed only once, of course.
When Al dies, his estate must pay a hefty inheritance tax on the value of the business. As Bill leaves only debts, his estate pays no inheritance tax.

And so we can see that our government's tax policies have been carefully crafted to punish behavior that is considered anti-social: like marriage, saving, investment, providing employment, fueling economic growth, and passing something on to the next generation. Our taxes reward behavior the government considers desirable: like promiscuity, living beyond one's means, gambling, substance abuse, and leaving one's children to become wards of the state.

Notes:

1. The above discussion assumes that both men generally obey the law. If Bill were to derive his income from selling drugs, for example, he might well hide his income and pay no income tax. But it would be inaccurate to say that the government is therefore encouraging drug dealing, as the government cannot accept credit for incentives created in spite of the law rather than because of it.

2. Bill probably also receives a number of government benefits that Al does not qualify for. For example, his children may be supported by welfare while Al supports his children himself. But the above discussion is deliberately limited to tax policy: opening it up to a whole range of government incentives would have made for a much longer and more complex article.

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