The Alimony Deduction and the Camp Proposal
As you go over your 1040 this year, you may wonder why the form has lines for alimony payments made and received. At first glance, this might seem like a puzzling intrusion into personal lives. Upon further examination, though, alimony is a sort of “gray area” in tax policy, and the current system handles the matter rather reasonably.
The issue deserves some examination, especially because Chairman Dave Camp’s tax reform proposal would change current tax law on alimony (Sec. 1411). Under current law, alimony payments are deducted from the income of the paying spouse, and then taxed as income of the receiving spouse. The Camp proposal would reverse this treatment, and make the income taxable when earned by the paying spouse, and then tax free as it is transferred to the receiving spouse.
You will notice that both of these designs make the income tax free for one of the spouses. Why do we do this? Well, not every financial transaction in the world should count as taxable income. It is unfair to legislate a goldfish-like memory for the IRS, in which it taxes income, sees it move from one bank account to the next, and say “Aha! Income!” and taxes it again without thought for where it came from. A neutral tax base would tax all economic production (such as wages) or all economic consumption (final purchases by households) – not just any transfer of income you can put a number on. A thousand dollars of alimony represents only a thousand dollars of production; to tax both spouses would be taxing it as if it were two thousand.
The “gray area” in tax policy with respect to alimony is the fact that we have a complex and progressive tax code, meaning that different payers face different marginal rates. Should alimony income be taxed at the rate of the paying spouse, or the rate of the receiving spouse? Current law opts for the latter, on the grounds that the receiving spouse is the one who actually gets the income in the end.
However, the Tax Reform Act of 2014 would reverse this for future alimony judgments. The Ways and Means summary on the issue raises an interesting point – given that the receiving spouse is usually poorer than the paying spouse, the receiving spouse usually faces a lower marginal rate in our progressive tax system. When we tax alimony money at the receiving spouse's rate, that can give divorced couples a lower tax bill for the alimony money than they would have paid on that same income if they had stayed together. In effect, current law can modestly subsidize divorce.
There is no perfectly optimal solution for the tax treatment of alimony. Current law is reasonable, as is Chairman Camp’s modification.