Wednesday, February 11, 2009

Don't let the tax tail wag the economic dog


We've all heard the clever expression "don't let the tail wag the dog". It describes a mindset where an item of minor importance dominates a situation; like when income taxes are given more emphasis than economics when making financial decisions. Here are some examples I've heard over the years with my accompanying comments:

"Do you think I should work less so I won't have to pay so much income tax?"

No I do not. Nobody is in the 100% tax bracket so a dollar earned will not cost you a dollar of income tax. Let's say your marginal federal and state income tax rate is 35%, the tax rate you pay on the next dollar of income or the percentage benefit of an additional dollar of deduction.

So if you work less and have $10,000 less income, your income tax savings would be $3,500. In other words, working less and making $10,000 less means $6,500 less in your piggy bank after the taxman is paid.

Work less because you want to have more time to do other things besides work.

"Do you think I should buy new equipment for my business to save income taxes?"

No I do not, again for the same line of reasoning discussed above.

Buy equipment for your business because it's needed for your business to operate efficiently, provide better service to customers, and to be more profitable.

"I own my home free and clear so I don't have home mortgage interest to write off as an income tax deduction. I'm paying too much tax. Do you think I should take out a mortgage so I can have something to write off?"

No I do not, again for the same line of reasoning discussed above. I believe home ownership free and clear of any debt should be the goal for all homeowners as the cash you aren't using to make a monthly loan payment is cash available for investment or some other purpose.

There are many good reasons to take out a home loan such as to make home improvements, finance a new business venture, or make an investment. Take out a home loan for these purposes and not to save income tax.

I remind my clients to be primarily guided by economics when making financial decisions. Once those decisions are made, then look at taxes to see if there is a preferred way to structure a financial transaction to obtain a better income tax result. An example involves real estate. Let's say you have a rental property you own and want to sell to purchase another rental property. A direct sale of this property will result in income tax if sold at a profit. You could sell the property using a delayed exchange provision of the tax law, use the proceeds to acquire the new property and defer (postpone) the income tax until a later date.

Remember, don't let the tax tail wag the economic dog.

Pax Domini sit semper vobiscum

4 comments:

Anonymous said...

Thank you! Now I can say an accountant said so. I have never understood the logic of some people, and I know their math isn't that bad. I wish I paid a hundred grand in taxes last year. I wish I lost ten million in stock last week. I would like to have two mansions, a boat, and a Leer Jet go into foreclosure next year. My goal has always been to be in the highest tax bracket.

We'll have a party before I hand the boat keys over to the bank.

Tom

pierini said...

Hi Tom, sorry it took so long to acknowledge your visit. I was busy watching my tail wag.

Bob Reselman said...

Usually I find that when I am paying a bunch of tax, I am making a bunch of money.

My issues are not about paying taxes. Mostly I don't like my piece of taxpayer money going to blow stuff up.

pierini said...

Hi Bob and thanks for the visit.

Agree with your comment. I don't like to when my taxpayer dollars are used to buy low-quality pork.

I accept that there are such things as public goods and services, best provided by government. I just wish they had a spartan shopping mindset like a thrifty person scoring on deals at a thrift store.

Have a great day!