Restoring efficiency and reducing complexity must hurt all, at least a bit.
Both houses of Congress have passed tax bills. Exactly what reconciliation will bring is unknown, but some bill will be signed. It will include substantial corporate rate cuts and a lower tax burden on high-income individuals. The rest is still up in the air. But clearly there will be little true “reform” to make the tax code fairer or more economically efficient. It will go down in history as another missed opportunity. But other opportunities may arise. The next time, something approaching real reform may be possible.
Virtually every issue revolves around exemptions of certain categories of income from taxation, deductions of sundry household expenses, or credits that are directly subtracted from taxes due. Each of these special provisions has some rationale, or at least a historical explanation for its existence. Collectively, however, these special provisions distort incentives, increase the cost to society of the tax above the revenue it generates and cause unfairness. We need to work toward consensus on reducing these.
Recognize that the largest ones result from historical happenstance rather than reasoned policy making. These include the deductibility of mortgage interest and of state and local taxes. One often hears that at some time “the government decided it was good to encourage home ownership,” as if momentous policy debate had occurred.
The reality was that when instituted in 1913, the intent of the Democrats supporting it was that the income tax hit only the very rich. Less than 2 percent of households owed any tax, initially. The law was passed in haste and provisions incorporated administrative simplicity and common notions of fairness. It seemed sensible that those taxed should be able to deduct reasonable living expenses. These included interest paid, not just on mortgages, but on any debt owed. This remained true until 1986.
Moreover, there had long been a principle that one level of government not tax actions of another level. Allowing the deduction at the federal level of taxes paid at state and local levels seemed straightforward.
As long as 98 percent of households were below the threshold for paying tax, these policies were noncontroversial. The rate on taxable income for the elite 2 percent could be adjusted to keep revenue at desired levels. Allowing deductions increased the perceived fairness by those who did owe.
But as the percent of all households owing tax reached the 50 percent to 60 percent range, mortgage interest deduction became a hotter issue. Those who benefited tended to have higher incomes. Lower-income people who did not itemize got no similar effective subsidy. And renters have always gotten stiffed.
The disparity became starker when the 1986 Reagan tax bill ended the deductibility of any interest other than that on mortgages. One could no longer deduct interest on credit cards, auto, or student loans. Yet if you had a mortgage, you could refinance it, or take out a home-equity loan, and pay off non-eligible consumer credit. You could turn general interest into mortgage interest and get the Treasury to, in effect, pay part of it. But only those with mortgages could do this.
Moreover, as time went on, the effective cost to the Treasury mounted. The current annual cost is about $80 billion. This far outstrips all other federal subsidies to housing, yet the bulk of the dollars benefit the richest third of households. Economists across the political spectrum agree that this is absurd in terms of fairness and that it distorts household spending and reduces efficiency. But powerful forces oppose change including, ironically, key Democratic leaders.
It is always true that when you subsidize something, whether growing corn or building houses, you end up using more available resources on that product than is good for economic efficiency. The subsidy embodied in deductible mortgage interest causes us to spend too high a proportion of our income on too-big houses. And it skews the mix of owned versus rented housing.
Many deductions crept in gradually. Taxes were to be on spendable income. At a time when union membership was high, dues deducted from pay every month reduced spendable income for many. So let’s make that deductible. But if union dues can be deducted, what about a doctor’s annual AMA membership? Or the cost of a CPA or attorney or insurance agent getting professional credentials renewed?
Getting to work reduces spendable income from that job. Yet everyone was in the same boat and commuting costs were not deductible. But what if you had a second job? Or what if you were a careerist in the National Guard and drove 100 miles for weekend drills at a unit that had an appropriate slot? What if you were required to buy work uniforms or steel-toed boots?
Allowing the deduction of medical expenses was no big deal when an appendectomy cost $60; a normal pregnancy and delivery, including hospital, did not pass $500; and medical expenses as a fraction of GDP was under 4 percent. But as these rose, the effective cost to the U.S. Treasury mounted.
Everyone eats, yet we don’t allow the itemization of groceries. Everyone also needs some medical care. Why should we allow it to be deducted? So we imposed a somewhat arbitrary threshold, allowing deductibility only after outlays on health had passed a certain percentage of income.
The cost of health insurance coverage as a fringe benefit of employment was not taxable income. Shouldn’t we make some allowance for people who bought their own? But what if they only bought a major medical policy and then put money into a “medical savings account”? That needed its own provision to keep things fair.
Everyone got a personal exemption for each child. But day care costs were a major factor keeping women from achieving equal footings in job markets. A child care tax credit would correct for that. But if we are subsidizing child care, what about expenses for caring for an elderly household member? Keep them at home and you have less public expense than if put into a nursing home at the expense of Medicaid. So add a credit for that.
In all of these, there always was the problem that allowing the deductibility of some expense only benefited those who “itemized” their deductions. Yet in the interest of simplicity, there always had been an option of taking a “standard deduction.” At times this was a lump sum, $4,000 in 1914, and at times a flat fraction of income, often 10 percent. But as more and more possible deductions were added, it seemed unfair that only those with high mortgage interest or high state and local taxes should be in a position to benefit from something new.
It costs everyone something to move from one place to another, usually to get a job. Yet those doing so often were not in a position to benefit from itemizing. The response is to create a second category of deductions, dubbed “adjustments to income” that could be taken even if taking the standard deduction.
Each of these in its own way has some justification in terms of fairness. But each creates a special interest group for its preservation. Move to limit the mortgage deduction and the homebuilders and mortgage bankers associations will spend millions lobbying against you. Curb the child care credit and the day care operators’ association will rally the troops. Limit a deduction for teachers buying classroom supplies and the education associations will find someone else to endorse in the next primary.
It is the policy equivalent of death by a thousand cuts. Each provision, by itself, has an apparently cogent basis. But when one sums across hundreds of special treatments, the result is mind-boggling complexity and conflicting incentives.
Add in farm or small-business schedules and choices multiply. Is the sale of gravel to the county eligible for “percentage depletion”? Is a payment from the electric co-op for a power pole easement income or only an “adjustment to basis” that will up our taxes only 20 years from now?
Complexity leads some to call for a flat tax with no exemptions or deductions. That would be highly regressive. Adjust for that with a “prebate” and you have a Milton Friedman-esque “negative income tax” that would drive tea party folks rabid.
We need a return to the atmosphere of the 1960s when Republican Everett Dirksen could talk calmly to Democrat Hubert Humphrey and they, together with similar legislators of good will, could hash out a resolution that inflicted measured amounts of pain on myriad interest groups, but to the overall betterment of nearly everyone. Not likely to happen soon, but there’s always hope for the future.