Elective Efficiency

This thesis offers a new rationale that helps explain the phenomena of elective provisions in tax law. I analyze tax elections with reference to a particular election offered to individual taxpayers —the choice to itemize expenses or to take the standard deduction to determine taxable net income under section 63(e) of the Internal Revenue Code. I make three arguments concerning the section 63(e) election that are relevant to evaluating tax elections more generally. First, the ability to itemize deductions can be seen as having an efficiency rationale in addition to its more well-recognized horizontal equity rationale. For taxpayers with lower incomes, the election to itemize acts as a screen that reveals the taxpayer’s unobservable cost-type to the government and allows the income tax to be more optimally “tailored” in the direction of a first-best lump sum tax by lowering itemizers’ marginal tax rates. Second, I show that the elective standard deduction introduced in 1944 can be viewed as a mechanism that bolsters the separating function of the election by reducing the itemizing propensity of would-be tax avoiders and low-ability taxpayers on the boundary between itemizing and not itemizing, while saving government enforcement and taxpayer compliance costs. Third, I argue that one of the drawbacks of using elective provisions such as section 63(e) to optimally tailor the income tax—deliberation costs borne by lower-income taxpayers who are uncertain about whether they should make the election—can be mitigated by viewing elections as call options written by the government in favor of the taxpayer. By structuring the election within a real option framework, the taxpayer will have higher net utility with no loss in equity as compared to an election structured outside the real-option framework. The flexible election rules of section 63(e) comport with this utility-enhancing real option approach. Moreover, the real option analysis suggests that little-noticed details of tax elections more generally may have more important effects on their efficiency than previously recognized.MAS