The Independent Market Observer

3/19/13 – Taxes, as Simple as That

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Mar 19, 2013 1:14:01 PM

and tagged Economics Lessons

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I’m still in New Orleans, but I wanted to expand on a response I wrote to a question posed by Faye Casey as a comment on an earlier post. It addresses, directly and indirectly, many of the issues we now face in Washington, D.C. The question was, “If we were to eliminate many of the loopholes in our taxation system, would it not be possible to have lower rates? Seems to me that’s what I’ve been reading lately.”

First of all, thank you, Faye. This is a very good question, and it raises a number of issues that speak not only to the tax problem but to every problem we have in Washington.

The simplest answer is that, yes, if we eliminated loopholes, we could have lower rates. That’s the basis of the flat tax idea, which has been popular off and on: lowest possible rate, widest possible tax base.

The problem historically with the flat tax has been a lack of progressivity. That is, if the rate is, say, 10 percent, someone making $10,000 a year will pay $1,000 and someone making $1 million will pay $10,000. The argument has been that people who make more can afford to and should pay more. If, for instance, the $1 million earner instead pays 20 percent, his or her lifestyle will be relatively unaffected. Trying to address the progressivity issue brings us to income thresholds.

For example, the rate could be 10 percent over the first $20,000. While seemingly straightforward, this system immediately erodes the simplicity and equality of the flat tax. Who sets the limit? Why? As we move away from a simple, universal idea, judgment and value decisions move front and center. We do have these thresholds in our current system, and there are always big fights over them.

Along with introducing values-based decisions into the tax code comes the idea of incentives—provisions designed, like progressivity, to encourage a particular behavior or embody a certain value. Some would call these loopholes. The problem is that one person’s loophole is another’s vital social program, essential component of civic virtue, critical policy tool, and so on. Values-based decisions inevitably mean that any incentive will look like a loophole to someone.

Take the mortgage interest deduction, one of the largest “loopholes” in the tax system. For homeowners, it helps make a home more affordable. For real estate agents, it helps transactions happen. For politicians, it helps build a society of homeowners. Who could argue with all of that?

But, at the end of the day, it is a subsidy from renters to homeowners, and from people with smaller mortgages to people with larger mortgages. Why should real estate spending be advantaged over, say, education? The economic argument for eliminating it is irrefutable. The political argument, not so much.

How about tax-free interest on municipal bonds, which are owned largely by “the rich.” Not taxing the interest is a clear loophole that benefits those so-called rich people. On the other hand, it helps cities and states raise money more cheaply than they could otherwise, benefiting all of their citizens.

And let’s not even start on the charitable donation deduction.

You get the point. Eliminating incentives would broaden the tax base, but everything that would be eliminated has a good reason 3/19/13 – Taxes, as Simple as That—or, at any rate, a reason—for existing, as well as a group of beneficiaries. The benefit of eliminating an incentive is abstract, while the cost is immediate and concrete. The defenders of a loophole tend to be much more motivated than the people who want to eliminate it.

Which brings us to a larger problem in D.C.—the focused costs of any proposed solution and the diffuse benefits. If we eliminate the mortgage deduction, it will cost homebuilders and realtors, among others, lots of money. They will pay money to fight such a move. Who will pay money to support it?

All of this makes what would, in theory, be an obvious solution much more difficult in practice. The bigger issue is that taxes are only one example of a larger, systemic problem. How we resolve it will be the story of at least the next couple of Congresses.

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