Archive for the ‘Law and Economics’ Category

Gambling and Tax I

March 8, 2010

It is often said that income tax law subsidises gambling. Because there is no income tax on winnings from earnings, there is a “tax expenditure” which subsidises gambling. Philosophically the concept of tax expenditure is difficult – after all, what does it mean to say that an activity should otherwise be taxed? – but the point is pretty clear: not taxing certain activities which are comparable to other taxable activities has the same effect as a direct subsidy to the untaxed activities.

It has been found by the courts on numerous occasions that winnings from gambling “with the motive of making casual gains or merely for sport or amusement” is not taxable [Duggan v Commissioner of Inland Revenue [1973] 1 NZLR 682]. In that sense, the income tax system would seem to subsidise those who casually gamble. However, in a more important sense, a progressive income tax tends to punish those who take much larger and much more serious gambles.

Assume that there are 10 typists, all of whom earn $45,000 per annum. Any one who becomes a typist will earn that much. There are also ten actresses. Nine of those actresses earn $10,000 per annum, and one earns $360,000. Any one who becomes an actress faces the nine-tenths chance that she will earn $10,000, and a one-tenth chance that she will earn $360,000. To the careful observer, it is clear that the expected value of entering into either job – typing or acting – is equal, at $45,000. And yet, the progressive taxation system results in tax treatment that is quite different. The typists will on average pay $9,290 in tax. The actresses will on average pay $14,345.

So, the tax system may subsidise risk taking in one dimension, but in another massively penalises it. By changing the payoffs in this way, the income tax encourages a form of inefficient risk aversion. In Part II, I will consider whether profits from iPredict are taxable.