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THE CHENEY RETURN: AN INTRODUCTION TO DEDUCTIONS

April 20, 2006

The TaxProf on Monday noted that Vice-President Cheney took an extra-large charitable contribution deduction on his 2005 return. The big deduction was made possible by Hurricane Katrina relief legislation. Normally charitable deductions are limited to 50% of your adjusted gross income; the Katrina legislation boosted this to 100% of AGI for 2005 only. The Vice-President's contributions reached 77% of his AGI.

Commenters on the Tax Prof's blog, as well as some left-side bloggers, politely expressed their disapproval of the Vice-Presidential return:

"Why is this man not in jail?" intones "Beverly Hill"

"REPREHENSIBLE, totally devoid of any moral values, ...a true, dyed-in-the-wool Robber Baron," notes "tony"

"So, it really has been about money afterall. All the greed, selfishness, vainty, hubris, and cold-hearted egomaniacal, theivery is a wicked game of King-of-the-hill. War sold as democracy, theft disguised as charity, writing laws that benefit oneself and hurt most everyone else, all are putrid mutations of market-based economy run amok. What a shining example of reprehensible human charactistics Mr. Dick Cheney is," coos "Vanna"

And so on through dozens of comments and links from other blogs.

All right, then.

WHAT A "DEDUCTION" DOES

These commenters all have a common misconception: that Mr. Cheney made money by making donations to charity. It actually doesn't work that way.

The income tax is computed as a percentage of taxable income. A deduction reduces the taxable income upon which the tax is computed. The way the arithmetic works, the value of the deduction is simply the deduction amount multiplied by the tax rate.

Assume a taxpayer who has $1000 of taxable income subject to a 35% rate. His tax with and without the deduction:

deduction.JPG

So this taxpayer gave $100 to charity. He reduced his taxes by $35. This means that bottom line, he is $65 poorer than he was before he made the contribution, net of the $35 tax savings.

Now lets see what this means to Mr. Cheney. His charitable gifts in 2005 totaled $6,869,655. At the top 35% federal rate, this lowered his taxes by $2,404,379. That means he ended up $4,475,276 poorer for his donations, net of tax savings.

BUT HE GOT A BIG REFUND!

Some of the outrage over the Cheney return seems to be because the return resulted in a tax refund. Unless your refund exceeds the amount of tax you pay through estimated tax and withholding, refunds are not a particularly good thing. They mean the government had use of your money interest-free. In Mr. Cheney's case, the government had almost $2 million of his cash interest free. Assuming that the average balance of the "interest free loan" was $900,000, this means the government earned $36,000 on his money before refunding it, at a 4% interest rate.

AND IT'S PROBABLY ALL TIMING

The benefit of the Katrina relief is the ability to deduct contributions in excess of 50% AGI currently. If your deduction exceeds that amount, the excess carries over for the next five years.

Lifting the 50% AGI limit for 2005 allowed Mr. Cheney to deduct an extra $2,460,152 in 2005, reducing his 2005 taxes by about $861,000. Absent the Katrina break, the excess amount would have carried over to subsequent years; any unused amount would have expired after five years.

Based on his 2000-2004 income, it seems likely that Mr. Cheney would have had enough income in the carryover period to use up a $2.4 million contribution carryover. The advantage of the Katrina deduction, then, was timing - he got to use the deduction earlier.

BOTTOM LINE?

The Vice-President took advantage of an unexceptional tax break that got him his deduction a bit sooner than he would have gotten it anyway. It's hard to see why he should be criticized, just as I saw no reason to criticize John Edwards for structuring his law practice to reduce his employment tax costs. While we should expect our elected officials to comply with the tax law, we shouldn't expect them to fail to take tax breaks to which they are entitled. That would amount to expecting our elected officials to be stupid.

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