With April 15th rapidly approaching, and in the middle of an election season, taxes are on many peoples minds. There has been a lot of discussion recently (and not so recently) about the need to reform the tax code by eliminating loopholes and bringing rates down.That has been the core of many of the deficit reduction plans such as Bowles-Simpson, Domenici-Rivlen and the latest incarnation of the Ryan plan.However, as far as the individual side is concerned, there are really only five “tax expenditures” that could really move the needle enough to be able to bring down rates significantly without massively expanding the budget deficit.The change in the tax code would be structural change in the deficit picture, not simply a cyclical response to the current still too weak economy.The big tax expenditures are:
1)The ability of employers to deduct health insurance premiums for employees.Fewer and fewer Americans are being covered by employer provided health insurance each year.If the Supreme Court strikes down “Obamacare” the effort to provide health insurance to the one out of six Americans under the age of 65 with coverage will be severely compromised.If this provision of the tax code is taken away, it is likely that employer provided coverage will become about as common as employer provided defined benefit retirement plans are today.Is that the direction we really want to go?
2)The Mortgage Interest Deduction is the next big one.While it might be possible to argue that we could have a healthy housing market if we never had this to begin with (Canada for example does not allow its people to deduct interest payments from their taxes), it is impossible to see how getting from here to there would not have a big negative effect on housing.The lack of residential investment, which is normally the locomotive that pulls us out of recessions is the single biggest reason this recovery has been so sluggish.The mortgage deduction has been capitalized into the current price of houses.Take it away and the price of houses will fall, but the amount people owe on their mortgages will not.The result, more people underwater, and another huge wave of foreclosures and lost wealth from home equity.
3)The charitable giving deduction is the next biggest.If you think there has been a political firestorm over the idea that Church related employers have to provide health coverage that includes contraception, wait until the Federal government starts to tax what you put in the collection plate.Charities would start to get a lot less donations.If we had a much reduced Red Cross then FEMA would have to take a much larger role in responding to disasters than it does today.
4)The deductibility of State and Local taxes, and the tax free status of Muni bonds is another big one.This would put more political pressure on the lower levels of government to lower their tax rates, further starving them of revenues.It would be more expensive for them to borrow for infrastructure needs.Moving this direction would undermine Federalism and lead to more power being centralized in Washington and less in the 50 States.
5)The lower rate on Capital Income, such as capital gains and dividends, than on ordinary income.As a citizen I can see a strong case for equalizing the rates, and treating all income, regardless if it comes from clipping coupons or from a weekly paycheck, the same.As an investor, I’m not quite as keen on the idea. However, this is the one that results in people with eight figure incomes often having lower effective tax rates (especially when all Federal taxes, not just the income tax, are considered) than many people with five figure incomes.
Those five pretty much make up all of the “tax expenditures” on the individual side.On the corporate side there are many more.However, the individual income tax is a far more important source of revenue than the corporate income tax.While lower the rate and expand the base might make for a good slogan, and eventually might indeed make for better public policy, we really should think long and hard about what broadening the base really means and what effects it would have before we start down that road.
What do you think, which of these five would you be willing to see go away in return for a reduction in the tax rate?
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