Taxes

Death to Deductions

More candidates should be making a serious effort to close tax loopholes.

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As Jeb Bush vies for the spotlight in a crowded presidential primary field, the former Florida governor is hoping his tax plan will help set him apart. Bush's proposal would lower rates on individuals and corporations-standard conservative fare-while limiting or killing many popular deductions and exemptions, something Republicans like to talk about but few actually seem willing to do.

Complying with tax laws shouldn't be complicated or punishing. But the process is anything but simple, and the price tag of that complexity can be enormous. According to a 2012 study from the Internal Revenue Service (IRS) and the Treasury Department, titled "Taxpayer Compliance Costs for Corporations and Partnerships: A New Look," corporations alone spent $104 billion complying with the tax code in 2012. That's a ton of money, especially considering that corporate tax revenues are only about $500 billion a year.

The cost to individuals may be even higher. According to a 2013 study by Jason Fichtner and Jacob Feldman of the Mercatus Center, Americans face nearly $1 trillion annually in hidden tax-compliance costs. Summarizing the study for U.S. News & World Report, they noted that "taxpayers spent more than six billion hours in 2011 complying with the tax code-that's enough to create an annual workforce of 3.4 million people. If that workforce was a city, it would be the third largest city in the United States. If that workforce was a company, it would employ more individuals than Walmart, IBM, and McDonalds, combined."

Why does tax compliance cost so much? The answer is largely that the Internal Revenue Code, which includes some 80,000 pages of regulations, is riddled with exclusions, exemptions, deductions, preferential rates, and credits.

The list includes the Child Tax Credit, the Earned Income Tax Credit, the Lifetime Learning Tax Credit, and the tax credit for "orphan" drug research (an incentive for pharmaceutical companies to develop treatments for very rare diseases). There is also an exemption for credit union income, an exclusion of interest on bonds for private nonprofit educational facilities, an exclusion for employer-provided transit passes, and a credit for residential solar panels and energy efficient appliances, among many others.

These all add up to more than $1 trillion in tax preferences, with two thirds benefiting individuals and the rest helping corporations. Navigating such a complex system generally requires expert help.

Genuine reform would cut out loopholes that tilt the playing field in favor of those with political connections. It would also aim to provide lower tax rates, fewer tax brackets, and less double taxation of income that is saved and invested. Such measures would be good for growth, but they would also mean taking on the interest groups that benefit from swapping tax preferences for campaign cash.

The worst and largest tax preference is the exclusion for employer-provided fringe benefits, such as health insurance. According to the Office of Management and Budget, this exemption will "cost" the federal government $216 billion next year.

I'm all in favor of people keeping more of their income, but this exemption is distortive, unfair, and, most importantly, a major contributing factor to the ever-growing cost of health care. Because it promotes overinsurance, more and more everyday health costs are laundered through insurers instead of being paid directly by individuals. As the Cato Institute economist Dan Mitchell notes, Americans today are expected to pay only 12 percent of their health care expenses out of pocket. This weakens normal market forces: Since consumers perceive that they're buying health care with someone else's money, they do very little shopping around for the best deal, and they don't hesitate to consume medical services even if they don't really need them.

Then there's the mortgage interest deduction, which will cost $75.2 billion in 2016 alone. This benefits just a quarter of taxpayers-mostly at the top of the income distribution, since most middle- and low-income taxpayers benefit more from taking a standard deduction than they would from itemization. It also encourages malinvestment by giving people an incentive to take on more debt to purchase bigger homes than they can really afford.

Finally, we should eliminate the federal deduction for state and local taxes, which makes it too easy for local lawmakers to raise taxes without political consequences. Similarly, the loophole that allows interest income on municipal bonds to go untaxed winds up pushing money into government projects that could be better used in the private sector.

The point of these reforms is not to finance bigger government. Every penny of additional revenue raised from closing loopholes should be used to lower marginal tax rates and/or to reduce the tax bias against saving and investment. The overall tax burden wouldn't be any higher; it just wouldn't be riddled with distortions.

Are any of the exemptions in the tax code worthwhile? Well, in 2011 Mitchell warned that "because of the capital gains tax, corporate income tax, personal income tax, and death tax, it's possible for some types of income to be taxed as many as three or four times." Luckily, the tax code contains provisions that allow people to avoid this, at least to a point.

On the corporate side, for example, there's the deferral of taxes on income earned overseas through foreign subsidiaries and affiliates. Because we have a "worldwide" taxation scheme, Americans are required to pay taxes to the U.S. government on foreign-source income even if it was already subjected to taxation in the other country. Moving to a territorial tax system, in which Americans are only expected to pay taxes to the country in which income is earned, would be ideal. Still, allowing companies to defer the tax burden until the money is repatriated to the U.S. is better than nothing.

There are similar provisions on the individual side. Most tax economists agree that income should be taxed either before it goes into a savings account or when it comes out, but not both. Vehicles such as the Roth-style IRA or the traditional 401(k) exist to prevent government from taxing our savings twice.

In addition, the best tax rate for capital gains and dividends is zero. Anything higher than that discourages private-sector investment and stalls economic growth. Currently, capital gains and dividends enjoy a lower rate than other types of income. While still higher than it could be, the reduced tax burden at least mitigates some of the bias against investment embedded in the tax code. The same is true of the estate tax.

There is some disagreement about whether such reduced rates should be considered "loopholes." But steps meant to alleviate the multiple taxation of savings and investment are more than mere handouts to special interests; without them the economy suffers, and that hurts everyone. Unfortunately, outfits like the Joint Committee on Taxation and the Congressional Budget Office fail to make this important distinction, instead slapping the "tax expenditure" label on all tax preferences.

As a result, you see progressive activists arguing for eliminating these anti-double-taxation provisions instead of undertaking real tax reform. Hence some of the attacks on Jeb Bush's plan, such as Jordan Weissmann's complaint at Slate that "he'd outright abolish the estate tax, which would be a boon to the Hilton family," which ignores the fact that this income was already taxed once or twice. Attacks like that can only work in a world where people don't understand the distortionary power of tax incentives.

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  1. It’d be nice but interests are so entrenched, I don’t see anyone getting rid of loopholes and deductions any time soon.

    1. I see them getting rid of deductions that help a lot of people a small amount but keeping deductions that help few people a large amount. Because that is how government works

      1. Palms will be greased.

      2. bassjoe|11.17.15 @ 12:53PM
        I came here to say this.
        Some *might* be eliminated, but they will be the ones with the least powerful interests behind them. A flat tax might wipe them all out at once, but good luck with that for the same reasons.

    2. I think the Romney plan of capping deductions might work. If there was some cap, say $20K, it allows most people to claim their favorite deductions, but prevents deductions from driving the tax code.

    3. Prohibition was really entrenched, but it too poisoned the economy and when that was understood, it went.

  2. So on whom would the taxes for health insurance premiums fall, the employer or the employee. Of it is the employee, you are going to give them a big surprise by taxing them on income they were not aware that they had. Of it is employers it will increase the cost of labor. Good luck getting the rates lowered as right now it is gospel to the Left that the higher brackets and corporations are not subject to high enough rates.

    This would be a massive and hugely complicated endeavor to balance out right and every aspect of it will be open to Left wing demagogeuery. Good luck.

    1. The easy, four-step process:
      A) Remove all business taxes.
      B) Eliminate all government service fees and taxes on anything else (e.g. the “luxury tax” on phones) as well as all rebates, “incentives” or other kick backs of any kind.
      C) Tax each individual at a single percentage necessary to continue operations as normal level, either through income tax or sales tax.
      D) The tax collection is restricted to the selected tax method (income or sales) selected at step C.

      There will be all sorts of push back from both parties because it means politicians can’t hide their taxes in every product and service that ever existed. On the other hand, if this managed to pass, watch as government is immensely scaled back over the following decade because people will suddenly understand how atrocious the government take is, and vote to improve their own station instead of seeking the feel good rush of voting “Yes” for the children.

    2. So on whom would the taxes for health insurance premiums fall, the employer or the employee.

      The special legal treatment of employer health plans should itself be abolished. A lot of the problems with our medical system are due to the simple fact that health plans are often linked to employment, rather than being a contract between an individual and an insurance company independent of employment.

      In fact, individual insurance would likely simply include a small premium for continued coverage in case of unemployment.

  3. How about we get rid of income tax altogether?

    1. This. get rid of it all and replace it with the fair tax, minus the prebate, and apply it to corporations too.

      1. Having businesses pay taxes is counter productive. All business taxes and fees are passed on to the consumer in two ways: Less employment spending and higher product costs.

        All people should be taxed at the same rate, but business should not be taxed.

        1. All businesses should be taxed and the people untaxed. Businesses pass the cost on to customers and have an incentive to keep prices low. They also can afford lawyers that can fight the IRS.

          1. and you get the rest of the world to help pay our taxes

            1. and you get the rest of the world to help pay our taxes

              Only in America do people think that businesses should pay US taxes on International earnings.

              That’s a patently ridiculous policy, and one that has likely cost us jerbs for years as income gets parked elsewhere instead of being brought home.

          2. Except that no business would survive. The taxes would amount to 50% or more. You can get a low rate if you spread it among 320 million people. Not so among a much smaller population of businesses.

    2. I’m for that. If we eliminate the individual income tax first, then see about whether corporations are worth the trouble of helping, nobody can say we’re in too bid a hurry, or that it’s difficult to understand. The first income tax prolonged the Civil War. The second caused the Panic of 1893 and had to be repealed to end the resulting depression. The third closed all stock markets for months and ushered in World War I and Prohibition. The idea came out of the communist manifesto, and is every bit as valuable and workable as the rest of the communist manifesto.

  4. Im making over $9k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do,

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    1. Yeah but how much of that do you get to keep after taxes?

  5. Mortgage interest and, in the past, all other interest, too, was a tax deduction because it was direct income to the entity that was charging for the use of the money. Thus it was an effort to avoid double taxation of the same money.
    The problem with all the ideas about reducing “loopholes”, otherwise known as deductions, is that the added money will go into the government and the desired reductions in personal income tax rates will never materialize.
    Every effort on taxes should be aimed at denying FEDGOV as much as possible. It is, after all, the biggest taxing agency, while producing the smallest, direct government benefits.
    The answer for businesses being able to write off employee medical insurance costs, while individuals can’t, would be to extend that write off to individuals, in a direct one-for-one reduction in taxable income.
    Denying money to the government would be like keeping addicts away from their substance of choice – a caring response to a troubled soul.

    1. retiredfire|11.17.15 @ 6:37PM
      At least in Virginia, you get the most bang for your buck reducing your federal income taxes since the state income tax is based on your federal return.

      1. That still holds state revenues hostage to federal revenues. If you want to break the power of the federal government, this is the wrong policy.

  6. What’s wrong with simply abolishing the individual income tax and let the corporations slug it out with the government that spawned them? Corporations are not individuals, and use the political state for unfair advantage against sole proprietorships. Anyone can see it is an illegal capitation tax, just as it’s clear to even the dumbest among us that conscription is involuntary servitude, corrupt Servile Court decisions to the contrary notwithstanding. Once they’ve felt it on their hides, corporations might come around to helping repeal the rest of that plank from the communist manifesto.

  7. You call them “loopholes”. I call them “remaining freedoms.”
    Why close down loopholes if they will make tax collections go up? I want the government to take in less money than it does now.

    1. Probably for the reasons mentioned at the start. Overcomplicated regulation is costing so much in compliance costs and tax prep fees that the benefit of the loopholes is somewhat reduced.

  8. How about an Alternative Maximum Tax instead? Once you’ve paid say 10K for the year, you don’t have to document anything, and you don’t pay any additional amounts. I wish it were less than 10K, but at the current federal spending rate of 10 billion dollars per day, you have to start somewhere.

  9. I sure wish tax reform would come, but there’s a lot working against it. You have one party that will resist any attempt to screw the rich, one party that will reject anything that could be perceived as helping the rich, and a thousand little interest groups that will scream bloody murder about how you hate the farmers or the single mothers or the churches or the homebuyers or the job creators if you touch their carve-outs. And then you have a whole nation of individuals who mostly want taxes reformed, but only if you do it without alarming any of the four interest groups that they trust (different four for each person).

    If it was me, I’d assign Congressional Dems to come up with four deductions or credits for individuals, and one for businesses, and then vice versa for Repubs (I am conceding the infeasibility of passing a zero corporate tax). Strict limit of five federal tax deductions and credits for each. Everyone gets what they most want, the tax code is five pages, and I can show my work to the spurned interest groups on why their favored party abandoned them.

  10. I’m sad to see reason use this made-up use of “loophole”. A loophole is something that’s there by accident. If the only two laws about alcohol on the books were the nobody under 21 could have alcohol and nobody over 21 could have alcohol, someone could come along and claim that you’re allowed to have alcohol on your 21st birthday since you’re neither under nor over 21. That’s a loophole because presumably the people who wrote the other two laws were trying to ban alcohol for everyone, not everyone unless it’s your 21st birthday.

    Whereas most if not all of these tax “loopholes” you hear about, were put there on purpose for some interest group’s benefit.

    1. Thank you. I get so sick of the word loophole. There is no such thing. There is tax law, or, at least, the tax code. That someone has found that a particular regulation works to their advantage is not a loophole.

    2. A loophole, in the original sense, was a (small) hole in a wall where a defender could fire projectile weapons out. They were intentionally built into walls, not by accident at all. The word applies.

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  12. “Finally, we should eliminate the federal deduction for state and local taxes, which makes it too easy for local lawmakers to raise taxes without political consequences.”

    I can’t agree, because the reverse is also true. Without the deduction, there is a natural bias toward federalizing more of the tax burden because local/state taxes are double-dipped while federal taxes are not. That’s bad: I prefer my taxes local where I have more say over them.

  13. I see no reason to treat the lower rate for capital gains as a sacred cow.

    “In addition, the best tax rate for capital gains and dividends is zero. Anything higher than that discourages private-sector investment and stalls economic growth.”

    Prove it. And while you are at it, prove that private sector investment has been a limiting factor and thus needs a special subsidy.

    Indexing gains for inflation has more merit, although from an equity standpoint, why should capital be the only sector protected from inflation?

    If you want tax reform, a dollar of income should be taxed as a dollar of income, whether it stems from return on capital or wages.

    1. Spot on. Any dollar of income should be treated as all others. Therefore, we should eliminate the corporate income tax, tax corporate owners on their share of corporate income (rather than tax them twice as under the current code) and then treat capital gains like any other income.

  14. Google pay 97$ per hour my last pay check was $8500 working 1o hours a week online. My younger brother friend has been averaging 12k for months now and he works about 22 hours a week. I cant believe how easy it was once I tried it out.
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