Tax Deduction Reduction
Eighteen years ago, Congress and President Reagan enacted a tax reform that tidied up the mess quite a bit. Since then, Congress and presidents of both parties have made a new mess, and President Bush is right that it is time for another cleanup. He has called an economic conference this week to mull over some proposals.
The politics may require the lion’s share of the mulling. The mechanics of personal income tax reform are straightforward: You end deductions for this, that and the other. Then you can reduce overall tax rates and still raise the same amount of money. Everybody likes the idea of making the tax code simpler and reducing rates. In fact, everybody likes ending deductions too -- in the abstract. But when tax reform zeros in on a deduction they take, people suddenly discover the virtue of complications.
So before Bush reveals the specifics of his promised income tax reform, let’s talk about deductions and how they should be judged.
Tax deductions can serve two legitimate purposes. They can make the tax code itself fairer or they can use the tax code to achieve some other social goal.
Fairness, in turn, can mean two different things, which tax mavens call “horizontal equity” and “vertical equity.” Horizontal equity means that people in similar economic situations should have similar tax burdens. Vertical equity means that people who are better off should bear more of the tax burden.
Keep in mind, when you’re tempted to defend some treasured deduction, that almost every deduction reduces fairness. Bush has said, properly, that he wants reform to be “revenue neutral” -- that is, it should bring in as much money as the current system. So every deduction that survives reform raises the tax rate to ensure this “revenue neutrality.” In other words, the cost of saving your favorite deduction will be paid for by all other taxpayers.
When a deduction is supposed to serve some non-tax-related goal, two questions arise: Is this a legitimate goal? And is a tax deduction the most efficient way to serve it? Every deduction intended to serve some non-tax purpose is in effect a taxpayer subsidy of that activity. One problem is that tax subsidies don’t get anywhere near the scrutiny that a direct government payment would, though the effect is exactly the same.
Consider three popular deductions: contributions to charity; mortgage interest; and state and local income taxes. Bush has said he won’t mess with the first two. It’s hard to blame him for wanting to avoid these hornets’ nests. But the most popular deductions are also the most expensive. Leaving them untouched means that tax rates can’t be reduced as much. It also makes the advocates of other deductions feel like suckers. An ambitious tax reform that goes beyond the 1986 overhaul can happen only in a spirit of “I’ll give up my deductions if you’ll give up yours.”
The charitable deduction can be defended on either tax fairness or social policy grounds. You can say a person who earns $100,000 but gives $15,000 of that to charity should be treated like a person who earns $85,000 and keeps it all. Or you can simply say that encouraging private charity is a good thing. There are problems with both these arguments.
A taxpayer who chooses to give away $15,000 presumably gets some degree of satisfaction from having done so, much as other taxpayers earning $100,000 might like giving $15,000 to relatives. Plus, the deduction forces all taxpayers to subsidize every outfit that gets a deductible contribution, whether they approve of it or not. So Yale graduates have to subsidize Harvard, and dog lovers subsidize cat shelters. Of course the same can be said of direct government spending: You’re paying for it whether you like it or not. Doves help fund the Pentagon, conservatives subsidize the welfare state. But government spending is determined by a democratic process. Your neighbors’ charity is not.
The mortgage interest deduction is usually defended on social policy grounds: It helps people afford to buy a house -- and, rather absurdly, even a second vacation home -- and homeowners make better, more responsible citizens and community members. Even accepting that last rationale, does the mortgage interest deduction really make houses more affordable? Anyone who has sat with a real estate broker while she calculates the monthly after-tax carrying costs of your dream house can confirm from real life what economists report from the world of theory: The value of the deduction is absorbed into the price of the house. Your total after-tax cost is the same as if the deduction had never existed.
Eliminating the deduction would probably cause house prices to drop. In theory this wouldn’t help buyers, because the lower price and the lost interest deduction would roughly cancel each other out. But it would be an uncompensated loss to current homeowners -- unless the deduction were kept for preexisting mortgages. That would create a national situation like the one our own beloved Proposition 13 has caused in California, with the tax system locking people into their current houses.
It will be interesting to see what Bush proposes about the deduction for state and local income taxes because there is a dispute among conservative tax theologians. Some of them favor the deduction on federalism grounds: States should be able to set their own tax rates before the central government piles on. Others oppose the deduction on the grounds that it forces taxpayers in low-tax (mostly red) states to subsidize more public services in high-tax (mostly blue) states like California.
Not being conservative tax theologians, we look at this question through the lens of fairness. Is a person making $100,000 and paying $10,000 in state taxes more like a person in a no-income-tax state making $100,000, or one making $90,000? There is a reasonable argument to be made on either side, as presumably those state taxes enhance residents’ living standards.
In close calls, good tax policy would say these deductions should be dropped or curtailed. But politics says all these deductions will most likely be left untouched.
A president in his second term, who has bragged about the chips he has accumulated, might think about spending a few of them to allow good policy to trump politics for once.
