Income Tax Deductions for Losses as Insurance

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Income Tax Deductions for Losses as Insurance

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Title: Income Tax Deductions for Losses as Insurance
Author: Kaplow, Louis
Citation: Louis Kaplow, Income Tax Deductions for Losses as Insurance, 82 Am. Econ. Rev. 1013 (1992).
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Abstract: The federal income tax allows deductions for some categories of personal losses, notably for casualty losses (such as destruction of one's home or car) and medical expenses above a threshold. The latter, even with lower marginal rates and further restrictions brought about by the 1986 tax reform, involves more than $3 billion annual revenue loss (Office of Management and Budget, 1990).(1) Deductions like these act as partial insurance: individuals receive a tax benefit equal to their marginal rate multiplied by the magnitude of their loss. However, this form of insurance is unnecessary when private insurance is available. Moreover, as will be emphasized here, these deductions have a perverse effect because they are allowed only for the uninsured portion of losses. This induces individuals to be less protected against risk in the aggregate than if the implicit insurance provided by the tax system were unavailable; if the tax rate is sufficiently high, individuals would forgo insurance coverage altogether.(2) It will be demonstrated that a tax system with no deductions for personal losses Pareto dominates the current system. These conclusions are demonstrated in Section I using a simple model in which risk-averse individuals may purchase actuarially fair insurance against loss and individual behavior does no affect the risk and loss (no moral hazard). Section II considers the applicability of the results when one allows for moral hazard, administrative costs, and other imperfections. It also discusses the applicability of traditional notions of tax equity.
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