The Case for Taxing Frequent Flier Miles

Robert Hahn is director of economics at Oxford's Smith School, chief economist at the Legatum Institute, and a senior fellow at the Georgetown Center for Business and Public Policy. Peter Passell is a senior fellow at the Milken Institute in Santa Monica and the editor of its quarterly economic policy journal, The Milken Institute Review. They cofounded Regulation2point0.org, a web portal on economic regulation.

Road warriors arise! You have nothing to lose but the tax deductibility of your frequent flier miles.

Or something like that … When the airlines started doling out benefits linked to miles flown, in the late 1970s, the Internal Revenue Service took its cue from public opinion and chose not to define them as taxable, in-kind income. But as FrequentFlier.com reports, the issue isn't quite dead. Nor, frankly, should it be. (No hate mail please; we already hate ourselves for being honest.)

Miles given as prizes in sweepstakes are definitely taxable—get lucky, and you'll get a Form 1099 in the mail along with the chance to fly business class to Tahiti free (or, more realistically, to Cleveland at the back of the Airbus). But a recent piece in the Los Angeles Times suggests that other mileage awards may also be taxable. Citicorp, it seems, has been sending out 1099s to customers who earn miles for opening bank accounts. And if those miles are taxable, why aren't miles for granted for opening credit card accounts—or, for that matter, for traveling on airplanes?

[Read Thomas C. Lawton: What to Expect of the American Airlines Bankruptcy]

Why not, indeed? When pressed (and pressed and pressed) by a dogged Los Angeles Times reporter, an IRS spokesperson reluctantly acknowledged that all miles awarded as new-account bonuses are, indeed, taxable—but didn't say anything about the responsibility of the vendors to report the transactions.

End of story? Not quite. Like Eve (and most economists), curiosity got the better of us. Why aren't all miles earned a form of taxable in-kind income?

The IRS has a pretty good answer: miles granted for flying or using credit cards are really just consumer rebates. Seen from this perspective, it's none of the IRS's business whether you got a $90 rebate in the mail after you bought that $900 PC, or simply paid $810 in the first place.

Well, it isn't quite that simple. If you bought the computer for business purposes and deducted the cost from your taxable income, you're supposed to report the net cost—here, $810—however you paid for it. And an awful lot of airline tickets (especially the expensive ones) are bought for business use.

[See a collection of political cartoons on the economy.]

Don't worry; nobody—certainly nobody in a position to change the IRS rules—listens to us. But set aside self-interest for a moment: Might not the world (or at least the air travel market) be a slightly better place if business-earned miles were, in fact, taxed?

To see why, consider the reasons mileage programs were invented. The very first program was set up in 1979 by little Texas International, just after air travel was deregulated; the idea was to give travelers a reason to switch from the brand name incumbents to a carrier derisively nicknamed "Tree Top Airlines." But more than one could play the game. And, ironically, in matching Texas International Airline's initiative with its own program, American found it could exploit economies of scale unavailable to the little guys.

The big airlines soon discovered that their own programs were worth more to travelers because they flew more places and could thus offer free travel to neater destinations. Who wants free seats to Philadelphia on NoNameExpress, when United and Delta were giving away first-class to Paris? Probably more important, the biggies also discovered that the programs could also help sustain brand loyalty by offering upgrades to the most frequent customers.

The consequence: frequent flier programs tended to increase concentration in the airline market and to make it more difficult for new carriers to enter the fray. Start-ups can still stay aloft—think Spirit, Sun Country, and Allegiant—but typically by exploiting a niche too small to interest the megacarriers. Jet Blue is an exception, a little carrier that lived to reach middle size. But it managed that feat by using some very clever marketing techniques, including adding then-unprecedented amenities to coach class, and staying under the radar screens of the large carriers until it had achieved viable scale.

[Read Rick Newman: 11 Business Leaders Who Profited After Failure]

So the failure to tax miles earned through business travel delivers a double whammy. First, it reduces tax revenues at a time when we can ill-afford it. And it reduces taxes in a regressive way: The biggest beneficiaries, after all, are frequent business travelers on the high end of the income spectrum. Second, it subsidizes a marketing strategy that has increased concentration in the air travel market.

Not the biggest problem confronting modern capitalism. But the next time you find yourself grumbling about the high cost of flying on a route dominated by a single airline, remember those frequent flier programs you treasure helped make the display of market power possible. Yes (once again) we have met the enemy—and he is us.

• Read the U.S. News debate on the flat tax.
• See a collection of political cartoons on the budget and deficit
• Washington Whispers: Government is Taxing Your Valentine