Illogical Deductions

The tax credit trap

When the Republicans announced their Contract with America, Rep. Dick Armey attacked the old Democrat-dominated House for having "adopted as its central philosophy the belief that ordinary people cannot be trusted to spend their own money and make their own decisions."

The Republicans, he said, "propose to cede back power from the hallowed halls of Congress to the more hallowed kitchen tables of America, where night after night families bow their heads in thanks and make decisions about education, charity, jobs, spending, debt, and values with a wisdom and compassion that no number of agency heads, cabinet secretaries, or members of Congress could ever match."

Unfortunately, Armey was speaking mostly for himself. The Contract itself is proof positive that most Republicans still have a long intellectual journey to make before they really cede power to the kitchen tables of America.

Deep down, most Republicans are still in love with planning other people's lives, setting other people's priorities, making other people's decisions. But unlike the Democrats, with their alphabet soup of bureaus, Republicans rely primarily on a single government agency to manipulate public behavior: the Internal Revenue Service. And, oddly enough, letting the IRS enforce their vision of how Americans should live makes Republicans look like good guys, bearing gifts.

Consider the "American Dream Restoration Act," promise number five of the Contract. Among its provisions, this bill would exempt from income taxes the interest earned on "American Dream Savings Accounts"--money set aside for retirement, post-secondary education, medical care, or a first home. Republicans point to this provision, along with such "pro-family tax reforms" as a $500-per-child tax credit, when asked how their pledges will affect individual Americans.

"Our act," says the Contract, "is designed to deliver relief from the heavy burden of government and let families keep more of their hard-earned dollars to pursue their own version of the American dream." (Emphasis added.) Unfortunately, that talk about "their own version" is mostly boilerplate; Congress will determine which dreams are worthy of tax breaks. If you save to start a business, buy a car, send your kids to parochial school, pay for your daughter's wedding, or move to a larger house, you'll get hammered with the usual taxes.

The impulse to direct the financial choices of a quarter billion Americans is just too strong for most Republicans to resist. Even anti-income-tax Ways and Means Committee Chairman Bill Archer wants to bias the tax system in favor of saving money and against spending it.

And it's no accident that Newt Gingrich started nodding (not nodding off) during the State of the Union address when President Clinton plugged his own scheme to allow tax deductions for college tuition. Gingrich and Clinton agree that education is more important than other goods and services; both are, after all, former teachers. So Gingrich is at least intuitively attracted to Clinton's scheme.

Such schemes do sound appealing, and they can be an excellent way of buying votes. Who, after all, wouldn't like to keep more money from the tax man--especially to use it for such a worthy, and expensive, cause?

But tax credit schemes are snares. Their underlying premises are dangerous, their practical results often malign.

By lowering the apparent cost of tuition to students, for instance, the tuition deduction would simply let colleges raise their prices. The supply of college admissions slots is pretty much fixed, at least in the short run. And a fixed supply means that any increase in demand driven by the deduction will simply be reflected in higher prices. Knowing that they'll get a tax break, students (or their parents) will be willing to pay more for tuition--at least in nominal terms.

Distorting Americans' investment decisions through the tax code can have disturbing ripple effects, as several regions of the country discovered when housing prices collapsed in recent years. Luring people to take on six-figure mortgage debts by making the cost of owning equivalent to renting, after the mortgage-interest deduction, may promote bourgeois stability. But it also turns otherwise risk-leery average Americans into speculators. And if the local economy goes into recession, these speculators get stuck with mortgages they can't unload just when finding a job elsewhere means selling a house. American Dream accounts that favor first-time purchasers over other home buyers will only distort the real-estate market further.

And once such distortions exist, people come to count on them. When the 1986 tax reform eliminated tax benefits for commercial real estate, the value of office buildings plummeted, costing many people their businesses.

Dumping the mortgage-interest deduction would slash the market value of homes, which is artificially inflated because dollars spent on mortgage interest go farther than dollars spent on rent (or anything else). And that abrupt drop in national wealth, however unreal, could have devastating economic and psychological ramifications. Even people who were inarguably better off under a flat tax, as Armey likes to point out most homeowners would be, would feel poorer. The more trimmings the Republicans slap on the Internal Revenue Code, and the more people come to count on them, the harder it will be ever to get the IRS out of the behavior-modification business.

Any reform of government taxing and spending disrupts some people's plans, as subsidy-dependent farmers and public-radio station operators will be quick to point out. So the Republicans may never actually deliver a tax package that treats all American dreams equally. But they can avoid making things worse.

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