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Fratto: Why Income Tax Reform Will Get Shelved


In his State of the Union address on Tuesdaynight, President Obama highlighted a welcome initiative to reform our corporate tax system. The President rightly noted that the system is a barrier standing in the way of economic success. Indeed.

But what about personal income taxes?

Any worker or sole proprietor would agree that the way we tax people in the U.S. is as inefficient and complicated as our system of corporate taxation. And beyond being inefficient and costly, it's equally fraught with loopholes, credits, exemptions, and the now notorious multiple definitions of a child. The President did offer to "join" members of Congress should they make the effort to simplify the tax code — while restating his call for higher rates on top earners.

But why no leadership on comprehensive income tax reform?

Those of us who advocate for wholesale income tax reform understand the quixotic nature of the fight. Our federal individual income tax system is so chock full of special beneficiaries that any action aligns an array of constituencies far too politically sympathetic to defeat.

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Taxes

This is most clear when you look at the biggest tax expenditures in the federal budget, like the mortgage interest deduction (MID).

This tax preference, favoring Americans who purchase shelter over Americans who rent shelter, accounts for such a sizable portion of tax relief in our current system that any revenue-neutral effort at tax reform would require it to be significantly capped, if not eliminated.

(Getting at that revenue is essential if you're going to adjust marginal rates in any meaningful way.)

Donald Goldstein, my old graduate school national security professor at the University of Pittsburgh, always said when analyzing any military or political fight, you have to look at the "order of battle."

Here's how the order of battle stacks up for the mortgage interest deduction:

In favor of MID elimination: most egghead economists, some fiscal hawks, and a disorganized and motley group of renters.

Opposed to MID elimination: Realtors; homebuilders; mortgage lenders; the building trade unions; home furniture and appliance manufacturers; oh…and about 50 million homeowners — and all of these groups are well represented and many politically active in every congressional district in the nation.

Reformers are armed with butter knives while the opponents have tanks.

The federal income tax system is inefficient, costly, cumbersome, and frustrating. But members of Congress and the President understand, until the order of battle is altered, we're stuck with it.

Tony Fratto, a CNBC contributor, is Managing Director of Hamilton Place Strategies – a strategic economic policy and communications firm based in Washington, DC. He is a former White House Deputy Press Secretary for the George W. Bush Administration and Assistant Secretary of the Treasury. You can follow him on Twitter at http://twitter.com/TonyFratto.

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