What is the purpose of tax deductions? A common view among tax law scholars is that tax deductions are required to properly measure income. I present an alternative theory of tax deductions, relying on standard economic efficiency grounds. I develop a model which highlights the fact that economic activities have costs and benefits, but an income tax system taxes only some of those benefits. The efficient deduction rule allows the deduction of a share of the cost equal to the share of the benefit that is taxed. I also show that the deadweight loss due to a departure from the efficient deduction rule increases quadratically with the departure, making larger departures from the rule much more costly than smaller ones. I then review various tax deduction rules in the Internal Revenue Code, analyzing each rule under the two theories of tax deductions, and demonstrating that the efficiency theory is useful both for teaching tax deductions and as a guide to optimal tax policy.
Theories of Tax Deductions: Income Measurement versus Efficiency
I am grateful to Bernard Black and an anonymous referee for their helpful comments. I am also grateful to Ilan Benshalom, Jacob Goldin, Andrew Hayashi, Daniel Hemel, Marcel Kahan, Yoram Margalioth, Jacob Nussim, Alex Raskolnikov, Steven Shavell, Dan Shaviro, Steven Sheffrin, and to participants in the Law and Economics Seminar at Harvard Law School, the 2017 National Tax Association Annual Conference, the Boston College-Tulane Tax Roundtable, and the Columbia Law School Tax Workshop for helpful comments.
Givati Y (2020), "Theories of Tax Deductions: Income Measurement versus Efficiency". Journal of Law, Finance and Accounting, Vol. 5 No. 1 pp. 107–136, doi: https://doi.org/10.1561/108.00000042
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