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In general, it's an accepted principle that businesses should be allowed to deduct expenses. How did this principle come about? And why doesn't it appear to apply to individuals to the same extent?

Now I understand that businesses can't willy-nilly deduct every single expense they incur. I also understand that individuals are able to take certain expense deductions (like mortgage interest and a standard deduction in the U.S.) Despite that, it seems like businesses are able to deduct far more expenses than individuals can. Examples:

  1. Businesses are allowed to deduct salaries, but individuals can't deduct what they pay their gardener or housekeeper (at least in the U.S.)
  2. Businesses are allowed to deduct utility expenses as overhead, while individuals cannot.
  3. Food, shelter, clothing, and medical care are fundamental human needs, but we still pay for them with after-tax money, and pay additional sales tax. Only interest (and not principal) on a mortgage is deductible in the U.S., which is great for people who take out mortgages (and helps banks get more business), but you're out of luck if you pay cash for your house, or are renting.

Why is this?

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This question may be a better fit at since this relates to the why behind government tax policy, as opposed to the how. – Chris W. Rea Jun 23 '14 at 1:28
@ChrisW.Rea I was hoping it wouldn't become political. I was on the fence about whether to put it in or here, since I was also interested to know whether where there were historical reasons for this generally accepted idea – Jay Jun 23 '14 at 2:30
I note also that "what are the consequences of the mortgage interest deduction?" would be a fine question on its own. Canada, which does not have a mortgage interest deduction, has roughly the same rate of home ownership as comparable areas in the United States. It's function appears to be to increase the effective price of houses by allowing banks to charge higher interest rates. – Eric Lippert Jun 23 '14 at 15:58
@TylerH I bet rappers do. Like literally hard currency in a briefcase. – coburne Jun 23 '14 at 18:53
@TylerH "Who pays cash for a house?" - Some guesses: People who have cash on hand and want a house quickly in a hot market (like post-IPO employees in the SF Bay area, maybe?). People who believe debt or usury is immoral or against their religious beliefs? Lottery winners who haven't received good financial advice? I know that there do exist people who pay cash for houses, for whatever reason – Jay Jun 23 '14 at 19:20
up vote 48 down vote accepted

In the US there's no significant difference between what a business can deduct and what an individual can deduct. However, you can only deduct what is an expense to produce income.

Businesses are allowed to write off salaries, but individuals can't write off what they pay their gardener or maid (at least in the US)

If you're a sole proprietor in the business of managing properties - you can definitely deduct payments to gardeners or maids. Business paying for a gardener on a private property not related to producing the income (like CEO's daughter's house) cannot deduct that expense for tax purposes (although it is still recorded in the business accounting books as an expense - with no tax benefit).

Businesses are allowed to deduct utility expenses as overhead, individuals cannot

Same thing exactly. I can deduct utility expenses for my rental property, but not for my primary residence.

Food, shelter, clothing and medical care are fundamental human needs, but we still pay for them with after-tax money, and pay additional sales tax. Only interest (and not principal) on a mortgage is deductible in the US, which is great for people who take out mortgages (and helps banks get more business, I'm sure), but you're out of luck if you pay cash for your house, or are renting.

Sales taxes are deductible. You can deduct sales taxes you paid during the year if you itemize your deduction. You can chose - you either deduct the sales taxes or the State income taxes, whatever is more beneficial for you.

BTW in many states food and medicine are exempt from sales tax.

Medical expenses are deductible if they're significant compared to your total income. You can deduct medical expenses in excess of 10% of your AGI. With the ACA kicking in - I don't see how would people even get to that. If your AGI is low you get subsidies for insurance, and the insurance keeps your expenses capped. For self-employed and employed, insurance premiums are pre-tax (i.e.: not even added to your AGI).

Principle for mortgage is not deductible because it is not an expense - it is equity. You own an asset, don't you?

You do get the standard deduction, even if your itemized (real) deductions are less - business don't get that. You also get an exemption amount (for your basic living needs), which businesses don't get. You can argue about the amounts - but it is there.

In some States (like California) renters get tax breaks for renting, depending on the AGI. CA renters credit is phasing out at AGI of about $60K, which is pretty high.

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Great answer. As soon as I posted this question, I was worried about it turning into a political debate. This explains, what is considered a deductible expense, with a consistent rule of thumb that can be applied. – Jay Jun 23 '14 at 2:26
Nice explanation. " an expense to produce income" is a great way to put complex logic into simple one. – Dheer Jun 23 '14 at 4:14
Thanks. Another key phrase is "social policy", so don't forget to +1 @Victor who remembered to mention it while I forgot:-) – littleadv Jun 23 '14 at 4:32
You can hit the 10% of AGI in medical if you have costs that aren't covered by insurance. People who need special formulas--since they're available over the counter insurance normally doesn't pay. I suspect nursing homes can also push you into this realm. – Loren Pechtel Jun 23 '14 at 5:21
@Jayraj same reason mortgage principle isn't: it is not an expense. You're exchanging assets - you give money and get stocks. – littleadv Jun 24 '14 at 21:00

The answer is simple. You can generally claim a deduction for an expense if that expense was used to derive an income. Most business expenses are used to derive profits and income, most individual expenses are not.

Of course social policy sometimes gets in the way and allows for deductions where they usually wouldn't be allowed.

Regarding the interest on a mortgage being deductible whilst the principal isn't, that is because it is the interest which is the annual expense. By the way deductions for mortgage interest in the USA for a house you live in is only allowed due to social policy, as there is no income (rent) being produced here, unlike with an investment property.

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This one's a good answer too. +1 – Jay Jun 23 '14 at 5:02
My living expenses are definitely used to derive my salary! – Michael Borgwardt Jun 23 '14 at 5:45
@MichaelBorgwardt Are you saying that had you not being deriving income you would not have living expenses? People who don't work - don't eat? Don't go places? Don't need a place to sleep? That's a ridiculous claim. – littleadv Jun 23 '14 at 9:19
@littleadv: quite the other way round: people who don't eat and have no place to sleep can't work. So why do those expenses not count as "used to derive an income"? – Michael Borgwardt Jun 23 '14 at 9:51
@MichaelBorgwardt I'd argue against such a claim. I know plenty of people who have no living expenses yet they work. I also know plenty of people who have plenty of living expenses, yet they do not work. There's no causation relationship - you will eat with or without working. The fact that you will not work without eating doesn't mean that eating is needed for work only. – littleadv Jun 23 '14 at 9:56

I can think of a several reasons:

  • If businesses could not write off expenses, only those businesses could exist whose profit margins are higher than the tax rate. Profit margins vary wildly between industries, and many large and very important industries (such as grocery retail) have comparatively low profit margins. Those would have to disappear or massively raise prices if they could not deduct expenses.
  • You'd be double-, triple- and quintuple-taxating the heck out of industries with long supply chains and effectively rewarding maximal vertical integration, strongly favoring huge multinational corporations over small, specialized firms. Doesn't sound necessary or desirable to me. This is probably the main reason.
  • People and businesses have fundamentally different goals: businesses want to make profits, expenses are a means to an end. Expenses being deductible is not an incentive to maximize expenses because the business owners want profits (and profits are therefore what is taxed). People, on the other hand, want to enjoy their life and generally have no difficulty increasing their expenses towards their goal. Maximizing expenses is our nature and needs no further incentives (quite the contrary, actually).
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I agree that the surface explanation is that expenses used to generate income are deducted, however there clearly is a double standard in how is applied. For example I cannot deduct my car even though I use it primarily for commuting to work (I would consider that income generation), yet companies are allowed to deduct corporate jets. I can't deduct meals when I ate out with professional acquainted where much of the conversations are related to my profession and so directly relevant to my income, yet businesses can claim sending their executives to a country club because business was discussed or it was a team building excise. Etc etc.

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What a coincidence! This was an exam question for my business law class. The main reason why individuals are not allowed to deduct expenses is because income tax revenue would be zero. The reason being, if an individual is allowed to deduct expenses he/she would spend 100% of their income and deduct it all on their tax returns, which would mean he/she would pay virtually no income tax.

This is bad for the gov't and the economy. It's bad for the gov't because they loose tax revenue, and it's bad for the economy because people would not have any savings for tough times, which can send the economy into a negative spiral.

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Is there any data to back up this theory that people would save nothing if everything was deducible? This is not borne out in the US, where savings rates are spectacularly low, even though non-income-producing expenses are not deductible. And in a hypothetical, everything's deductible country, people would still need to save for retirement, education and medical expenses, especially since the government, with lower tax revenues, won't be able to help them out. – Jay Jun 24 '14 at 17:21
I do not have data to back it up, but you can safely assume that majority of the population would spend quite a bit more to pay less taxes. – user16369 Jun 24 '14 at 19:16
How well did you do in the exam, not too well going by this answer. I have rental properties for which I can deduct my expenses on them. When it comes to repairs I look for the cheapest way to properly do the repairs so my net income from the properties is maximized. Tax is only a fraction of your income, so why would you spend it all just to get a fraction of it back? – Victor Jun 24 '14 at 21:28
I did really well on my exam. My answer talks about individuals deducting expenses, where as you are talking about deducting business expenses. – user16369 Jun 25 '14 at 17:52
No I am an individual not a business. And whether a business or individual why would the concept be different? Like I said if you are paying 30c in the dollar in tax why would you spend every dollar you earn just to get the 30c back? Deductions in general are ownly allowed on income producing expenses, whether you are a business or an individual. Ask any accountant. – Victor Jun 25 '14 at 21:18

Almost any kind of tax will cause market distortions; if market distortions discourage activities which would have produced wealth, society will lose out not only on the money which was taken by the tax, but also on the wealth which could have been, but wasn't, produced.

If those setting tax policy seek to maximize the amount of revenue that is made available for each dollar that the tax costs society, taxing money which is being used to produce more wealth will go against that goal. Further, most of the things that companies do with their money to produce wealth end up generating taxable income for someone. If a company deducts from its taxes the money it pays to an employee who then has to pay taxes on that money, the government ends up collecting about the same taxes as it would collect if the company didn't hire the employee (and thus didn't take the deduction).

The effects of taxes on markets should be one of the most important factors considered when setting tax policy; if one tax would cost society $1.05 for every dollar raised, and another would cost society $5.00 for every dollar raised, a wise policy would favor the first over the second. Unfortunately, politics often dominates over economic rationality.

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