Efficiency effects of tax deductions for work-related expenses

Wolfram F. Richter
C Springer Science+Business Media, LLC 2006
Abstract This paper studies the efficiency effects of granting deductions for work-related
expenses.Itisshownthatmuchdependsonwhethertheexpensesarerequiredforincreasing taxable
income and on whether the expenses are social costs. Among the noteworthy results are the
following. Expenses for commuting should be taxed rather than granted deduction, as the
increasing effect of commuting on taxable income is doubtful. Deductions for private
costssuchasexpensesforhouseworkandchildcaremayturnouttobeallocationallyneutral. If they are
not neutral, however, the efficient degree of deduction depends on relative labor supply
elasticities.
JEL Classification H21·H24
Keywords Income tax deductions . Commuting . Housework . Child care . Educational expenses
. Efficient taxation . Production efficiency
1 Introduction
The principle that income should only be taxed to the extent that it exceeds the expenses incurred
by earning the income—in other words, that earnings-related expenses should be taxdeductible—
seemstobesoself-evidentthatitishardlyeverquestioned.Theprincipleis well founded when applied
to business expenses. On deducting all costs of business activity from revenues, the net income
obtained equals the profit. A tax on pure profit is ideal in so
farasitgeneratesrevenuewithoutdeadweightlossandasitisconsideredtoservetheequity
objective.Thecaseislessclear,however,withwork-relatedexpenses.Thedisutilityoflabor
W. F. Richter () University of Dortmund, Department of Economics, CESifo, Munich, and IZA,
Bonn e-mail: Wolfram.Richter@uni-dortmund.de
Springer
686 W. F. Richter
not being deductible, the questions naturally arise which other costs should be deductible and
why. This paper tries to shed light on this basic question of income taxation. It does so in an
optimal-taxation framework. The question of optimal deductibility strongly suggests itself when
studying the practice of allowing the deduction of specific expenses. Even if consideration is
restricted to the practice of a single country, peculiarities and inconsistencies can be striking.
Baldry (1998, p. 48) reports about Australia that expenses for education are deductible if they
can lead to promotion and increased salary in the taxpayer’s existing employment but that they
are not deductibleiftheyallowthetaxpayertoenteranewandevenahigher-payingoccupation.He
findssuchapracticearbitraryandcontradictory,andhementionsotherprovisionsofsimilar
dubiousness.1 Evengreaterpeculiaritiesandinconsistenciescanbeidentifiedincross-country
comparisonsoftaxation.Themoststrikingexampleisthetreatmentofcommutingexpenses. For some
countries they are considered to be deductible expenses, while for others they are not (Wrede,
2001, p. 80). The United States and the United Kingdom are prominent examples treating
traveling expenses as nondeductible. Other countries, notably Germany
andtheScandinaviancountries,allowtaxpayerstodeductcommutingexpensesfromearned income.
Such opposing practice provokes the question of which rule is optimal in any welldefined sense.2
Although there exist interesting attempts to derive rigorous answers to this question, the
stateofdiscussionisanythingbutsatisfactory.Thisbecomesapparentjustbycomparingthe
contributions of Baldry (1998) and Wrede (2001). The former concludes that “on balance, there
is a strong case against employee tax-deductibility of wage-related expenses on both
efficiencyandequitygrounds,”whereasthelatterderivestheresultthatcommutingexpenses
shouldbedeductiblebymorethanonehundredpercent,givencertainassumptionsconcerning mobility
and taxation. This striking contradiction raises the question less of who is right or wrong than of
when wage-related expenses qualify for deductibility and when they do not.
Thispaperaimsatsheddinglightonthisquestion.Itisshownthatallowingthedeductionof work-related
expenses has a strictly positive effect on tax efficiency only if two conditions hold jointly: (i) The
expenses should be interpretable as social cost, and (ii) the expenses should be required for
increasing taxable income. As the latter is being disputed in the casetandard Deductions vs.
Itemized Deductions
In the United States, a standard deduction is given on federal taxes for most individuals. The
amount of the federal standard deduction varies by year and is based on the taxpayer's filing
characteristics. Each state sets its own tax law on standard deductions, with most states also
offering a standard deduction at the state tax level. Taxpayers have the option to take a standard
deduction or to itemize deductions. If a taxpayer chooses to itemize deductions, then deductions
are only taken for any amount above the standard deduction limit.
Standard deductions are often the easiest route to choose because there is no need to make a
calculation — the amount is already set and determined. Itemized deductions require some
calculation and work on the part of the tax filer. If you're married and are filing jointly, have
several major expenses like a home, major medical expenses and put money into a retirement
fund, then you may benefit from going through the itemized deductions route. According to the
Internal Revenue Service (IRS), the following expenses qualify under the itemized deductions
category:

 Healthcare costs including medical and dental bills, prescription drugs

 Property taxes
 Mortgage interest
 Union fees
 Home office and other job-related expenses

There are a number of common tax deductions and also many overlooked tax deductions at the
federal and state tax level that taxpayers can utilize to lower their taxable income. Common tax
deductions include charitable donations and fees related to tax preparation.

Some uncommon tax deductions include sales tax on personal property purchases and annual tax
on personal property, such as a vehicle. Many expenses incurred throughout the year for personal
and business reasons may also be eligible for itemized deductions, such as networking expenses,
travel expenses, and some transportation expenses.

Things to Consider When Itemizing Deductions

It’s important to keep in mind that there may be certain limitations on what you can deduct each
year to reduce your tax obligation to Uncle Sam. The IRS sets a threshold amount for many
deductions that you should research before filing.

For example, if you’re itemizing healthcare deductions, the threshold for any costs that were not
reimbursed during the tax year (and that were paid for yourself, your spouse and dependents) has
to exceed 10 percent of your adjusted gross income or they cannot be deducted. The threshold
was changed for medical expenses in 2017 going forward for all taxpayers. Your accountant will
be aware of these and any other thresholds, so if you’re using a tax professional, there should
be no need to worry.

Tax Loss Carryforward

One additional type of deduction not included in standard or itemized tax deductions is the
deduction for capital losses. A tax loss carryforward is a legal means of rearranging earnings to
the benefit of the taxpayer. Individual or business capital losses can be carried forward from
previous years. Capital losses of $3,000 are allowed per year.