As I write this, late last week, the U.S. Senate seemed poised to indeed pass a tax bill. This will no doubt be followed by reconciliation with the House version and a signature by President Donald Trump.
A tax plan it is, but to call it “reform” would be a travesty.
It will cut rates, particularly on businesses. Most of the benefits will flow to the upper percentiles of the income distribution. It is not likely to give much of a boost to an economy already running at full capacity. Nor is it likely to do much to foster long-term national savings or business investment in new plants and equipment. But cutting the top rates is a do-or-die goal that the GOP had set for itself before the 2018 elections. It seems that it will succeed.
I think it’s a bad mistake. But one must take the long view. Despite much talk of rate cuts being made “permanent,” meaning they are not nominally subject to a spurious 10-year end, nothing in the tax law is fixed. Whatever one Congress does, a subsequent one can undo or alter. One day we may return to the sort of pragmatic legislating based on compromise that prevailed for the first two centuries of our nation’s existence. If we do, we may, indeed, reform our tax system.
In a recent column, I explained what is meant by corporate tax rates. Let’s now consider what that true tax reform might include on the household side.
Reform advocates always argue for making the system fairer and more economically efficient. This is not a vain hope. Tax policy experts across the political spectrum agree that there are potential changes that would accomplish both. But these are not in the bills now moving through Congress nor were they in prior “reforms” from 1981 on.
One source of efficiency gains could come from simplification, reducing the number of household decisions throughout the year for which tax consequences must be considered, reducing the complexity and amount of records that much be kept and reducing the time and money spent on filling out actual tax returns. All this would reduce the “excess burden” of the individual income tax — the amount by which its total cost to society exceeds the net revenue it raises for the treasury.
Ironically, however, technology is already simplifying all this for households that are computer savvy. If you use a popular personal accounting platform like Quicken, link your financial accounts to that and then the results to tax preparation software, the annual drudgery of filling out one’s return is considerably reduced. But use of such software is much more common among higher-income and higher-education households than among those on the margin for whom a larger refund means more.
Improving efficiency by reducing complexity goes beyond household administration costs. Each special provision in the code brings with it the potential to motivate changes in behavior that are driven purely by tax considerations and not by factors inherent in market forces. Such distorted changes in behavior, taken across all taxpayers, can reduce the total of goods and services we get from a given set of resources.
All this brings us to “exemptions, deductions and credits” that complicate the tax code. The public tends to use these terms interchangeably, particularly the first two, but they are distinct.
Exemptions apply to incoming money. Deductions apply to outgoing.
An exemption, also often generically called an “exclusion” in public finance economics, is income to which no tax ever applies. For example, interest income from state and local bonds is exempt from federal taxation. So is interest from Series EE and most other savings bonds. Money received as a gift or bequest is not considered as “income” for the recipient and is thus exempt. However lottery winnings surely are considered income and are not excluded. Money put into a 401(k), IRA or other “tax-advantaged” retirement account is exempted until withdrawn.
Deductions are expenses paid by the household that the code allows to be subtracted from income before the tax is computed. These include charitable contributions, medical expenses above some threshold, home mortgage interest, some “casualty losses,” some employment expenses like union dues or tuition for mandatory continuing education and, historically, most state and local taxes.
Experienced taxpayers will note that the items just listed all come from Schedule A, “Itemized Deductions.” But there are other rubrics, such as educator expenses, certain expenses of reservists and performing artists, moving expenses, tuition and fees, and student loan interest, among others that clearly are deductions to economists but that are grouped with other items that are clearly exemptions, such as that for IRAs, in a section of Form 1040 that constitutes “adjustments to income.” Why two different places to enter deductions? Why are some rubrics on one form and some on another? That is an example of complexity that increases transaction costs and provides perverse incentives.
The categories listed on Schedule A are historic ones. But taking these deductions is an alternative to taking the “Standard Deduction,” which at times has been a lump sum and others a percentage of income. If one takes this standard deduction, then the amount given to charity or paid in union dues or mortgage interest is irrelevant in terms of tax paid.
Over time, Congress decided that to achieve some noble end, deductions should be allowed that would benefit everyone to whom they applied regardless of whether they itemized or took the standard deduction. So expenses of reservists were moved from employee expenses to a separate adjustment to income. Tight education budgets forced teachers to buy supplies for their classes with their own money so the federal government subsidized this. Sending kids to private schools was deemed good competition to public schools and going to college was good, so some tuition was deductible. Ditto for health savings accounts. But we wanted people to get this tax advantage even if they took the standard deduction. So we have two different categories of deductions, mostly by historical accident or the varying political clout of some special interest group.
And then there are credits. An exclusion or a deduction affects the amount of taxable income one has. We have a progressive tax rate system that applies a percentage varying from zero to 39.6 percent to this taxable income. The higher the income, the higher the rate paid. The effect is that if you are in a low tax bracket, say as a beginning grade school teacher in your mid-20s, and you spend $400 on classroom supplies, other taxpayers will pick up $60 of that. But if you are married to Ben Bernanke or Joe Biden, it will be $158.40 for the same supplies. If you are a single parent in a low-paying job, the treasury picks up $250 of the $2,500 mortgage interest on your double-wide, but if you are a cardiac surgeon, the implicit subsidy might be $19,800 if you have a 5 percent, million dollar mortgage on your McMansion..
With a credit, you compute a specified interest rate to the amount in question and subtract that amount from your actual taxes owed, regardless of what bracket you are in. With a 10 percent credit, the tax reductions would be $250 and $5,000. The absolute amount would still be higher for the higher-income taxpayer, but the percentage of the expense subsidized would be uniform. In general, most people find credits fairer, and many states have moved to convert deductions to credits, but the federal government lags.
For each credit, deduction or exclusion, there is some vocal group of beneficiaries. This results in there being a “credit for child and dependent care expenses” that is distinct from a “child tax credit” a few lines below. So the complication we face is the result of years of such interested groups securing special treatment from Congress. Many of these items have noble purposes, but the overall result is a highly complex and distortive system.
After this primer on exemptions, deductions and credits, much more could be said about the plusses and minuses of specific ones. But that is best left to a future column, perhaps after the GOP’s “reforms” are enacted or at least solidified. Then maybe we can look at them more specifically.