5-11-07
Justifying Your Spending
People like spending money. We all enjoy buying our new toys, and look for ways to justify doing so.
I’m as guilty of this as anyone else. I went to the Art Chicago show a couple of weeks ago with an acquisition budget of zero, and spent—oh, let’s just say “more than zero” on a couple of great photographs. My justifications were that I really loved them (and I do), and it’s not like I could go back to the gallery next week because they’re from Munich, and both my friend-the-art-collector and her gallery-owning friends from London were also buying this photographer’s images.
So that’s desire, time pressure and peer pressure: three classic rationalizations.
The one I did not use was “and it’s tax deductible.” First, fine art purchases are not tax deductible.
More important, I know how lame that one is, because I hear it all the time from my clients.
Lost in Translation
A funny thing happens when people speak vaguely enough about an expenditure being tax deductible: in their minds, that somehow translates to “free.”
Or maybe even better than free. “He just put money into that awful show for the tax write-off,” implies that the tax saving is more than the money lost. That is simply not true. He may have invested because he was starstruck, or stupid, or conned, or sleeping with someone in the cast. Maybe he was living out the old joke, about the man who wanted to get into show business in the worst way, and that’s exactly what he did.
The economic irrationality of this becomes instantly evident when I turn the concept around to ask, “Would you spend $1 just to save 25¢ in taxes?”
Yet that is what people do when they buy something merely because it is deductible.
Warning: Math Content
A tax deduction indirectly reduces your tax by reducing your taxable income. Income tax (as I certainly hope you know) is calculated by applying one or more percentages to your taxable income.
So long as the tax rate is less than 100 percent, paying a dollar in tax-deductible expenses will reduce your taxes by less than a dollar. Federal income tax rates currently range from 10 percent to 35 percent, meaning a savings of 10¢ to 35¢ for each dollar spent. If you are self-employed, that $1 tax deduction also saves you about 14.1¢ in Social Security (“self-employment”) taxes.
Yes, that means rich people’s business expenses carry a higher income-tax subsidy than yours. You can find solace, I hope, in knowing that their Social Security tax savings eventually drop to roughly 2.7¢ per dollar spent.
Taking Credit Where It Is (Perhaps) Due
Dollar-for-dollar offsets do exist in the form of tax credits, usually up to a maximum amount for any particular credit. Take hybrid cars as an example. Buy a Prius, and cut your taxes by the amount of a $3,150 credit.
Maybe.
Most credits are only useful when you have actual income tax, and then only to the extent of the tax. Refundable credits, where they will pay you the difference, are excruciatingly rare. That is among the reasons that many (myself included) found the Bush administration’s recent proposal for health care reform laughable. The plan would have given a tax credit to those without health insurance who went out and bought it. Unfortunately, those most in need of health-care subsidy are the people least likely to have any tax to offset with the credit.
Some credits are not dollar-for-dollar, but use a percentage. These effectively act as deductions, but without the rich person’s higher subsidy that I discussed earlier. The best, and probably most popular, such credit is the lifetime learning credit. One can claim a credit equal to 20 percent of what you spend on tuition and related expenses at pretty much any post-secondary educational institution.
Credits are great if and when they actually apply. Unfortunately, they’re also often tiny and cosmetic, and meant only to sound good on the television news. You can, for example, get a credit for 10 percent of what you spend installing energy-efficient windows in your home. The maximum credit is a gigantic $200, and that’s per person—lifetime—not per year. Big whoop.
Gentle Guidance
Most credits do not relate to business expenditures at all. Rather, they are really a matter of social policy, of encouraging certain types of behavior by offering an economic incentive.
Much the same is true of itemized deductions. The mortgage interest and property tax deductions are explicitly designed to encourage home ownership. Casualty losses and medical expenses, to the extent each exceeds a percentage of your income, are deductible as partial protection against catastrophic costs. State and local income taxes have historically been deductible as a means of equalizing the burden between residents in high-tax states and those in low-tax states (though this has been somewhat undercut by the alternative minimum tax). And I certainly hope I don’t need to explain why encouraging charitable giving is a good idea.
Illusions Can Occur
Tax-deductibility does not always equate to tax savings. Self-employed people who show a loss from that can offset the loss against other inflows for income tax purposes, but the Social Security tax savings stop when the profit from the activity disappears. As with credits, deductions that drive your taxable income below zero produce no further tax savings. And the much-touted tax savings from home ownership can be illusory. A married couple buying a $120,000 condominium (yes, they do exist—just not near the lake) may find that their mortgage interest and property taxes are low enough that their total itemized deductions barely exceed the 2007 standard deduction of $10,700.
Don’t misunderstand me. Take advantage of the subsidy if it is something you legitimately want or need, and can afford. Just do not let the tax deduction completely drive the decision-making.
Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.
Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.