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.