Capricious and Arbitrary

When I worked for one of the Big Eight accounting firms* in the ‘70’s, I spent two years in the Tax Department. For most problems I could generally figure out what to do without looking it up, because our income tax system was based on certain principles.

For instance, there’s the tax benefit rule, which taxes income if the taxpayer had received a benefit for deducting that item previously. The example most often cited is the treatment of State income taxes on the Federal return: if the filer had itemized deductions in the previous year, and had enjoyed a benefit from the deduction of State income taxes, then he must report the refund of those taxes on next year’s return. However, the refund should not be declared if the filer had used the standard deduction last year and therefore had not claimed a specific deduction for State income taxes.

We see the tax benefit rule applied to the host of education, medical, and retirement accounts that the government, in its wisdom, has established to encourage activities it deems worthwhile. Contributions to these accounts are either exempt from income or deductible while withdrawals are declared as income.

On the other hand, if items have already been taxed, such as the Social Security contributions which are deducted from an employee’s paycheck, the old rule was that it wouldn’t be taxed when the payment was made back to him. But now if a retiree’s other income is sufficiently high, Social Security receipts count as taxable income.

Developments like these I regard as disturbing because basic, long-standing definitions in finance and economics are being thrown out the window. In the arrangement of their personal affairs people accept that tax rates can change but not a fundamental principle such as, for example, the prohibition against taxing the same income more than once.

Returning to the example of the income taxability of Social Security, transactions are taxed when everyone makes their deposits into the Trust Fund and again on the “rich” when they receive it. (It’s no different from imposing a tax when you put money into your savings account and again when you take it out.) Furthermore, it is possible that many Social Security recipients who are not blessed with longevity will get back less than they put in, yet their losses will be magnified by the “income” taxes they pay on both ends of the transaction.

Today I don’t believe it is possible to prepare a tax return without consulting a reference guide for nearly every line. Why items are included or excluded is impossible to determine through the application of logic, leading to the conclusion that our income tax system is capricious and arbitrary. I’m glad I’m no longer in the business.

* Arthur Andersen, Arthur Young, Ernst & Ernst, Coopers & Lybrand, Deloitte Haskins & Sells, Touche Ross, Peat Marwick Mitchell, Price Waterhouse
© 2005 Stephen Yuen