In this chapter, we take up exclusions from gross income. Congress has chosen – for various reasons – to permit taxpayers not to “count” certain accessions to wealth in their gross income. An exclusion is not the same as a deduction. A deduction is a reduction (subtraction) from what would otherwise be “taxable income.” An exclusion does not even count as “gross income,” and so cannot become “taxable income” – even though it usually is quite clearly an “accession to wealth.” We are still focusing on the first line of the “tax formula” – only now we are examining accessions to wealth that are not included in gross income as opposed to those that are. Deductions come later.
The Tax Formula
➔ (gross income)
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
- Taxpayers may feel encouragement to seek wealth in forms that the Code excludes from their gross income. They will do this at the expense (opportunity cost) of procuring wealth in a form subject to income tax.
- The fact that a taxpayer may acquire a particular form of wealth without bearing any tax burden does not mean that the taxpayer necessarily enjoys the full benefit of the exclusion. Others may “capture” some or all of the benefit.
- The fact that many taxpayers find a particular benefit to be attractive will most certainly affect the market for that benefit, e.g., health care. Taxpayers acting as consumers will bid up the price of the benefit and so must spend more to acquire such forms of wealth (benefits) than they would if all taxpayers had to purchase the benefit with after-tax dollars. The price of acquiring the tax-favored benefit will change. Entrepreneurs may be encouraged to enter fields in which their customers can purchase their goods and services with untaxed dollars. Such entrepreneurs might have created more societal value by selling other goods and services.
- The Treasury obviously must forego tax revenues simply because these accessions to wealth are not subject to income tax.
In light of these points, you should consider the net effectiveness of exclusions from gross income as a means of congressional pursuit of policy. Consider also whether there are better ways to accomplish these objectives. We will consider the parameters of some exclusions and note others. This text groups excluded benefits very roughly into three overlapping categories: those that encourage the development of the society and government that we want, those that encourage the creation of social benefits – perhaps of a sort that the government might otherwise feel obliged to provide, and those that are employment-based.