Fringe benefits, income tax exemptions, and implicit subsides

Abstract

Tax exemptions for fringe benefits implicitly subsidize employment and consumption. This paper presents a partial equilibrium model of optimal compensation which permits exact measures of subsidy magnitudes and distributions. Under proportional taxation, tax exemptions represent savings of approximately 5–10 percent of compensation costs to individual employers or employees. As much as 80 percent of this saving represents reduced income tax payments. Alternative income tax schemes might achieve specific policy goals with fewer distortions. If government raises tax rates to insure that exemptions for benefits do not reduce tax revenue in the economy as a whole, the net gain is much smaller, approximately 1.5 percent of compensation.