Note. What Is the True Value of a Tax Preference?

• Pages: 497-504
• Author: Marvin A. Chirelstein,Lawrence Zelenak

497

Note

WHAT IS THE TRUE VALUE

OF A TAX PREFERENCE?

1

Brief reference has been made at various po ints to so-called tax

preferences—the exemption for municipal bond interest, for example,

or the exclusion of imputed rents from owner-occupied residences, or

the p henomenon of acce lerated depre ciation. Qu ite obvi ously, such

preferences permit taxpayers who own “preferred” assets to receive

income free of tax, or subject to a lower-than-normal effective rate of

tax. Not wanting to complicate matters in the main text, we have

made little effort to show in detail how these preferences re late to a

progressive rate structure but have simply left the reader to infer

that the value of tax exemption for $1 dollar of income is equal to $1

times the taxpayer’s marginal tax rate. While this is true as far as it

goes, it probably doesn’t go far enough. Tax preferences exist in a

dynamic market, which means that they, like other valuable goods,

are the object of competitive bidding. An asset—say a munic ipal

bond—that y ields tax-exempt dollars is bound to b e wo rth mo re to

investors than an asset—say an ordinary corporate bond—that yields

the same number of taxable dollars. Because in the final analysis

investors are interested in after-tax income, they will certainly be

willing to pay more for a tax-exempt income-stream than a taxable

one, everything else being equal.

The vital question is, how much more? Paying a premium for a

tax advantage obviously reduces the value of the advantage to the

payor. The higher the cost of an exempt asset as compare d with the

cost of an equivale nt taxable asset, the less the value of the

exemption to the buyer. Indeed, if the premium were high eno ugh,

the v alue of the exemption would dwindle to the vanishing point.

2

Once again, therefore, the important que stion is: how much of a

premium do investors have to pay when they buy an asset that enjoys

a tax preference?

1

This Note—which is intended to be explanatory and illustrative—explains

and illustrates by reference to the pre-1986 rate schedule rather than the current rates

for two reasons. First, computations are simpler—50% is a handier number than 37%;

second, the outcomes and comparisons are more dramatic if the rate structure is

steeply progressive. The implication, of course, is that the “true value” of a tax-

preference would indeed tend towards zero if we had a single-rate tax system and gave

up the idea of progression altogether.

2

See Bittker, Tax Shelters and Tax Capitalization—or, Does the Early Bird Get

a Free Lunch?, 38 Nat’l.Tax J. 416 (1975).