Museum of unintended consequences/A Paradigmatic tax dodge

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In Ill-Gotten Gains Leo Katz discusses this manipulations of both the law and morality. He distinguishes between consequentialist ethics (it's the results that matter) and deontological ethics (it's the rules that you follow that matter).

It is deontological ethics that lead to what from a consequentialist perspective appear to be manipulations of the system: if you can find a way to play by the rules yet still get the result you want—even though the rules apparently didn't intend that result—it's ok.

Katz claims that he shows why a deontological perspective is preferable. I was disappointed in that claim. It's not clear to me that he made much of an argument. As far as I can tell, all he did was give a lot of examples. (He is law-school profession and teaches by cases.) I was unable to see how his examples added up to an argument favoring deontological ethics. It's not that I am arguing either side here. It's just that I don't see that he argued the deontological side persuasively.

One of his paradigmatic examples is the case of the business owner who wants to give his son $1,000/year. As a gift, this is not tax deductible to the business owner. So instead, the business owner gives his son $10,000. The son then lends the $10,000 back to his father at 10% interest, which the father then uses in his business. The end result is that the father pays his son $1,000/year interest, which is now tax deductible to him.

Is that ok? Legally, it works. To see why it works, Katz suggests adding a third party, a bank. After giving the son $10,000, the father borrows the same amount from the bank, which he uses in his business. He can then deduct the interest he pays the bank. At the same time, the son deposits the $10,000 in the bank and receives interest on it. In effect, the father is paying $1,000/year to the son through the bank, which takes a commission for its laundering service.

Is this ethically questionable? On first glance it seems to be. But looking at the basic facts, the father has not only committed himself to paying the son $1,000/year, he has also committed himself to giving the son $10,000 in principal.

So why is this suspicious? The father gives the son $10,000. No matter what else happens, the father is out $10,000—for which he gets no tax advantage. In effect, instead of giving the son $1,000/year forever, the father gives the son $10,000 as a lump sum, which generates $1,000/year forever. It seems to me to be a wash. I'm not sure why this seems like a manipulation. In both cases, the father gets no tax advantage for his action.

It's only because the father takes a second step and borrows a like amount (from either his son or a bank) and then pays interest on it that he gets a tax advantage. But had he not borrowed that amount, he would be better off still. Not paying interest on $10,000 at all would be better than paying interest on $10,000 and then deducting that payment from his income. So I don't see why this seems like even a consequentialistically paradoxical result.

Russ Abbott 19:03, 21 December 2005 (PST)