Tax allowances

What Are Tax Allowances?

Tax allowances are specified amounts of money that taxpayers can subtract from their gross income to reduce their taxable income. In essence, they represent portions of income that are not subject to taxation, thereby lowering an individual's or entity's overall tax liability. This concept falls under the broader financial category of taxation, which involves the compulsory financial charges levied by a government on its citizens and businesses to fund public services and government operations. Historically, tax allowances, such as personal exemptions in the U.S., were a fundamental component of income tax systems, designed to account for basic living expenses or family size.

History and Origin

The concept of tax allowances, particularly in the form of personal exemptions, has deep roots in modern income tax systems. In the United States, the modern federal income tax was established following the ratification of the Sixteenth Amendment in 1913. Initially, exemptions from the tax were quite high, meaning only high-income individuals were subject to taxation²³. This reflected an early intent to protect a "standard of living" against taxation²².

Over time, these allowances evolved. For instance, the Revenue Act of 1917 introduced an individual income tax deduction for charitable donations, further shaping what could be "allowed" as a reduction²¹. The personal exemption, an amount claimed for the taxpayer, spouse, and dependents, was a key feature of U.S. tax law for decades, intended to shield a minimal amount of income required for subsistence from taxation. The amount of the exemption varied, influenced by economic policy and the need for government revenue²⁰.

However, the landscape of tax allowances underwent a significant change with the Tax Cuts and Jobs Act (TCJA) of 2017. This legislation eliminated personal exemptions for tax years 2018 through 2025, fundamentally altering the mechanism by which individuals traditionally reduced their taxable income. This shift was accompanied by a substantial increase in the standard deduction and an expanded Child Tax Credit, designed to simplify tax filing and provide tax relief through different avenues. Globally, many countries continue to utilize various forms of tax allowances or "tax expenditures" as policy tools, which the Organisation for Economic Co-operation and Development (OECD) defines as deviations from a tax norm that reduce tax obligations to achieve certain social and economic goals¹⁹,¹⁸.

Key Takeaways

• Tax allowances reduce an individual's or entity's taxable income, thereby lowering their tax liability.
• In the U.S., the traditional personal exemptions and associated withholding allowances were eliminated from 2018 through 2025 by the Tax Cuts and Jobs Act of 2017.
• The elimination of personal exemptions was largely offset by an increased standard deduction and expanded tax credits for many taxpayers.
• Governments use tax allowances (or "tax expenditures") to achieve specific economic or social policy objectives.
• Understanding historical tax allowances is crucial for comprehending the evolution of modern tax codes and their impact on personal finance.

Interpreting Tax Allowances

In historical U.S. tax policy, interpreting tax allowances primarily involved understanding their direct impact on reducing adjusted gross income to arrive at taxable income. Each "allowance" claimed on a Form W-4 before 2018 essentially reduced the amount of federal income tax withheld from an employee's paycheck¹⁷,¹⁶. A higher number of allowances meant less tax withheld, leading to larger paychecks but potentially a smaller tax refund or even a tax due at year-end, if too many were claimed¹⁵. Conversely, claiming fewer allowances resulted in more tax withheld, potentially leading to a larger refund¹⁴.

While the concept of personal exemptions and withholding allowances has been suspended in the U.S. until 2026, the principle remains relevant in understanding how other deductions and exemptions function within a tax system. The intent behind such provisions is often to ensure that a certain baseline of income, deemed necessary for living expenses or supporting dependents, is not subject to tax. This approach can contribute to a system of progressive taxation, where those with lower incomes bear a proportionately smaller tax burden.

Hypothetical Example

Consider a hypothetical scenario before the Tax Cuts and Jobs Act of 2017, when personal exemptions and withholding allowances were still in effect.

Assume a single individual, Alex, earned a gross income of $60,000 in 2017. In that year, the personal exemption amount was $4,050 for each qualifying individual.

1. Alex's Gross Income: $60,000
2. Personal Exemption: $4,050 (for Alex)

To calculate Alex's taxable income:

• Alex would subtract the personal exemption from their adjusted gross income. If Alex had no other deductions, their adjusted gross income would be equal to their gross income.
• Taxable Income = Gross Income - Personal Exemption
• Taxable Income = $60,000 - $4,050 = $55,950

In this example, the tax allowance (personal exemption) directly reduced the amount of income on which Alex's federal income tax was calculated, resulting in a lower tax bill than if their entire gross income had been taxable. This reduction would also influence the amount of tax withholding from Alex's paychecks throughout the year, as determined by their choices on Form W-4.

Practical Applications

While the term "tax allowance" in the context of U.S. personal exemptions has changed, the underlying principle of reducing taxable income through specific provisions remains central to tax planning and personal finance. Governments worldwide use various forms of tax allowances, often referred to as "tax expenditures," to incentivize certain behaviors or provide relief to particular groups¹³,¹².

For individuals, understanding tax allowances involves:

• Tax Withholding Adjustments: Although the old "allowances" on Form W-4 are gone, the form still allows taxpayers to adjust their withholding based on factors like dependents, multiple jobs, or anticipated itemized deductions and tax credits¹¹. This allows individuals to manage the amount of tax taken from each paycheck, influencing their take-home pay and potential refund or balance due at tax time.
• Targeted Relief: Governments implement various allowances (or equivalent provisions) to encourage specific activities. For example, allowances for educational expenses, medical costs, or contributions to retirement accounts aim to reduce the tax burden for individuals engaging in these activities, aligning with broader fiscal policy goals¹⁰.
• Economic Stimulus: Tax allowances can serve as a tool for economic growth. By reducing the tax burden on certain incomes or activities, governments can stimulate spending, investment, or specific sectors of the economy⁹. For instance, certain business allowances might encourage capital investment or research and development.

The Internal Revenue Service (IRS) provides comprehensive guidance in publications like IRS Publication 17, "Your Federal Income Tax for Individuals," which explains how taxpayers can navigate the current tax laws to reduce their taxable income and determine their tax obligations⁸.

Limitations and Criticisms

The primary limitation of "tax allowances" in the U.S. context, specifically personal exemptions, is their current elimination from 2018 through 2025 under the Tax Cuts and Jobs Act (TCJA) of 2017. This means individuals can no longer directly claim an allowance for themselves, their spouse, or dependents in the same manner as before. While the TCJA increased the standard deduction and enhanced the Child Tax Credit, critics argue that the removal of personal exemptions disproportionately affected larger families or those who historically benefited more from the exemption structure, even if their overall tax burden might have been reduced by other provisions.

More broadly, tax allowances, often referred to as "tax expenditures," face criticisms regarding their transparency, efficiency, and fairness:

• Hidden Costs: Unlike direct government spending, the cost of tax allowances (revenue forgone) can be less visible, making it harder to scrutinize their effectiveness or compare them with direct expenditure programs⁷.
• Inefficiency: Tax allowances may not always be the most efficient way to achieve policy goals. For example, a tax allowance designed to encourage saving might disproportionately benefit higher-income individuals who already have the capacity to save, rather than effectively stimulating new saving across all income levels.
• Complexity and Distortions: A complex system of various allowances can lead to convoluted tax codes, making compliance difficult for taxpayers and potentially creating unintended distortions in economic behavior. Economists have debated the overall impact of tax rate changes and allowances on economic growth, with some studies suggesting the net impact can be small or even negative if not properly financed⁶. The Brookings Institution, for instance, has published research challenging the idea that tax cuts, which include the effects of allowances, automatically generate enough economic activity to offset their cost⁵.

Tax Allowances vs. Tax Deductions

While both tax allowances and tax deductions serve to reduce a taxpayer's taxable income, their historical application and current terminology in the U.S. tax code differ.

The confusion often arises because both mechanisms ultimately lead to a lower taxable income. However, with the TCJA, the U.S. tax system shifted away from personal exemptions and towards a larger standard deduction and expanded tax credits for many taxpayers.

FAQs

What happened to tax allowances in the U.S.?

In the U.S., the concept of personal exemptions, which functioned as a primary form of tax allowance for individuals, was effectively eliminated for tax years 2018 through 2025 by the Tax Cuts and Jobs Act (TCJA) of 2017,. This change also removed the old "withholding allowances" system on Form W-4.

How do I reduce my taxable income now that allowances are gone?

You can still reduce your taxable income through various means, primarily by claiming either the standard deduction or itemized deductions, if your itemized expenses are greater. Additionally, various tax credits directly reduce your tax liability dollar-for-dollar, and certain adjustments to income (e.g., for IRA contributions or student loan interest) also lower your adjusted gross income.

Are tax allowances the same as tax credits?

No, tax allowances and tax credits are different. Historically, tax allowances (like personal exemptions) reduced your taxable income, meaning they lowered the amount of income subject to tax. Tax credits, on the other hand, directly reduce the actual amount of tax you owe, dollar-for-dollar². A $1,000 tax credit is generally more valuable than a $1,000 tax allowance or deduction because the credit directly offsets your tax bill, while the allowance/deduction only reduces the income on which your tax is calculated¹.

Why did the U.S. eliminate personal exemptions?

The elimination of personal exemptions was part of a broader tax reform effort under the Tax Cuts and Jobs Act (TCJA) of 2017. The aim was to simplify the tax code for many Americans by increasing the standard deduction significantly, which was intended to provide a similar or greater tax benefit for many taxpayers than they would have received from personal exemptions. The law also expanded other benefits, such as the Child Tax Credit.