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Tax Consequences of Borrowing Money

30 July, 2015 - 12:10

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)

In this chapter, we take up various tax consequences of borrowing money. The fact that a taxpayer has borrowed money means that he/she/it has more money to spend. However, it also means that he/she/it has incurred an obligation to repay. One precisely offsets the other. Hence, there are no tax consequences to taking out a loan. Furthermore, taxpayer is entitled to spend this addition to his/her/its “store of property rights” on investment or consumption – and we treat such a taxpayer the same as we would if he/she/it had made such a purchase or investment with after-tax income. There is no income tax upon taking funds from the taxpayer’s “store of property rights” (minus) and spending them (plus), as such removal and spending precisely offset. Moreover, taxpayer’s expenditure entitles him/her/it to basis in whatever asset he/she/it may have purchased.

The Tax Code and Economic Growth

A taxpayer’s opportunity to invest borrowed funds prior to the time that he/she/it has paid income tax on the income necessary to invest an equivalent amount has tremendous growth implications for the nation’s economy. Imagine how much more slowly the economy would grow if borrowed funds were subject to income tax immediately upon receipt. No doubt, there would still be markets for credit, but the higher cost of borrowing would mean that there would be less borrowing – and slower growth.

This does not mean that taxpayer is entitled to income that is not subject to income tax. Consider how taxpayer will meet his/her/its obligation to repay the loan. Taxpayer will have to earn income that is subject to income tax to repay the loan – perhaps by working at a job, paying income tax on wages, and using what remains after payment of taxes to pay down the loan. By taking out a loan, taxpayer has in fact exercised certain future consumption choices: he/she/it has committed future taxable consumption choices to the repayment of that loan. Consistent with the principle that borrowing money is not income to the taxpayer is the rule that repayment of loan principal is not deductible.