Offsetting Loss Offset

• In Event: Tax and Finance

Abstract

The basis of an income tax is accretion to wealth. Income taxes are levied on profits. Since income taxes are applied annually, income tax is imposed on annual profits. How should, then, an income tax system apply to periodic erosions of wealth – to losses? Several tax treatments of losses may be suggested, such as tax refund, sale of losses, or even ignoring losses altogether. Yet, everywhere losses are treated for income tax purposes only through a loss offset scheme. The normative rationale for the choice of loss offset is income averaging. Indeed, the rationale for the income tax treatment of losses in general is income averaging.
This paper offers a new viewpoint for both the normative and positive analysis of tax losses: the applicable tax schedule for annual losses. The income averaging rationale as well as the actual tax treatments of losses can be evaluated in simpler and clearer terms of an applied tax schedule.
Using the new theoretical framework of analysis, the paper analyzes the positive effects of various tax treatments of losses as well as evaluates their normative implications. The analysis revolves around the prevalent loss offset mechanisms. It examines the capability of the offset method to average income over time, and accordingly considers its desirability. The paper shows that the averaging effect of loss offset as applied by law is quite different than imagined. In terms of applicable tax schedule, loss offset exhibits an haphazard rate, which is largely unrelated to the desirable flat tax rate. Thus, the paper adds support to a tax refund mechanism for the treatment of losses. It shows how a tax refund can apply a more desirable (general or individualized) tax rate to annual losses.

Author

• Jacob Nussim, Bar Ilan University