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Tackling the Holy Grail of Tax Reform: Loopholes

Barack Obama and Mitt Romney
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Barack Obama and Mitt Romney

The two political parties and their presidential standard bearers are moving inexorably toward an acrimonious public debate next month over how to pay for tax reform, which will be a major issue during the next session of Congress no matter who wins the White House or controls Congress after November.

They agree on only one principle: Lowering income tax rates, whether for individuals or corporations, will require eliminating some tax deductions and exemptions, the so-called tax expenditures (or in common parlance, loopholes) that reduce government tax collections by an estimated $1.1 trillion a year.

But the two sides are still bitterly divided over whether the goal should be fiscal neutrality or raising additional revenue for the government. Neither side wants to get too specific ahead of the election or the lame duck session Congress, which will have to deal with the so-called fiscal cliff of tax increases and budget cuts that could throw the economy into recession next year.

Assuming that the resolution of those issues will be some variation of kicking the can down the road – even if only for a few months – then tax reform will take center stage. Reform is key to any serious plan for reducing the nation’s budget deficit. And reducing tax expenditures is key to reforming the tax code.

COMPLICATED AND CONVOLUTED LOOPHOLES
The economists’ rap against the dozens of loopholes in the tax code is straightforward, non-controversial and generally ignored by the taxpayers and corporations whom they benefit. They’re unfair, they’re inefficient and the benefits are distributed unevenly.

They’re unfair because they treat similar taxpayers differently. Why do homeowners get their housing costs subsidized through the mortgage interest deduction while renters do not?

They’re inefficient because they influence economic behavior in ways that may be detrimental to the economy as a whole. Excluding health insurance from taxable income encourages employers to offer and employees to demand higher-cost plans.

And benefits are distributed unevenly because the tax code is progressive – it taxes higher income people at higher rates. Why should every dollar of charitable deductions by someone in the 35 percent tax bracket reduce his or her taxes more than twice as much as every dollar of charitable deductions by someone in the 15 percent tax bracket, even if the lower-income person is giving a higher proportion of their income to charity?

TOO MUCH RISK FOR TOO LITTLE REWARD?
Former Treasury Secretary Robert Rubin cautioned both parties Wednesday that a frontal assault on these long-standing tax breaks could have major adverse effects that most Americans don’t yet fully understand. “They are not a silver bullet, and realistic savings may be far less than many plans anticipate,” Rubin said during a seminar in Washington on the economic implications of U.S. debt.

Citing a study by the non partisan Congressional Research Service, Rubin said that barriers to eliminating or reducing most tax expenditures would make it difficult to raise more than $100 billion to $150 billion a year of additional tax revenues. “Tax expenditure proposals may seem like a politically attractive alternative to long standing debates about spending cuts, income tax rate increases, and the like. However, in my view, the tough choices in many ways have just been postponed.”

Republican candidate Mitt Romney signed onto the principle of closing loopholes during his appearance on Meet the Press last Sunday, which was widely panned for lacking details. President Obama has endorsed the goal of lowering corporate tax rates and included a specific approach for reducing tax expenditures in his last proposed budget, which went nowhere in Congress.

The two candidates’ reasons for pursuing tax reform remain very much at cross purposes. Romney and his economic surrogates want reform to be revenue neutral, that is, it should raise the same amount of money for the government that the income tax raises now. He would offset lower rates with a comparable amount of tax expenditure reductions.

ROMNEY’S PLAN
Romney said his plan to cut tax rates by 20 percent across-the-board would “keep revenue up.” But he never directly answered the follow-up question about which loopholes he’d close. “People at the high end – high income taxpayers – are going to have fewer deductions and exceptions,” he said. “I’m not reducing taxes on high income taxpayers.”

Are there enough high-end deductions and exceptions to cover the Romney’s promised tax cut? Under his plan, the 35 percent bracket would be reduced to 28 percent; the 33 percent bracket to 26.4 percent; and so on down the line. According to the Tax Policy Center, a tax cut of that magnitude would reduce income tax revenue by about $360 billion by 2015, part of the $456 billion in tax cuts they saw in his overall plan. The vast majority of its benefits would go to people in the upper income brackets.

Their review of the $1.1 trillion worth of deductions and exemptions in the code concluded that maintaining the same level of revenue would be impossible without sharply raising taxes on middle class families. Most of the deductions are broadly distributed to taxpayers in all brackets such as the exclusion of health insurance premiums from taxable income ($184 billion in 2011); the home mortgage interest rate deduction ($99 billion) and the exclusion for contributions to retirement savings ($68 billion).

Romney ruled out eliminating the preferential treatment for capital gains and dividends, which are taxed at a 15 percent rate and go disproportionately to high-income households. Three-fourths of the $77 billion in reduced taxes on capital gains and dividends went to the top 1 percent of U.S. households in 2011. “Making new high-end tax cuts revenue neutral would require raising tax rates on capital gains and dividends, which Republicans have taken off the table,” said Roberton Williams, a senior fellow at the Urban Institute and a member of the Tax Policy Center.

OBAMA’S PLAN
Democrats and President Obama see tax reform as part of their larger plans to increase government revenue from its current low level of less than 16 percent of gross domestic product. The federal government has averaged 18.5 percent of GDP in taxes for the past half century. They want additional revenue to reduce the nation’s long-term deficit while caring for a rapidly aging society and making investments in education and infrastructure.

To achieve those multiple goals, the president has called for allowing the Bush-era tax cuts to expire on households earning over $200,000 a year ($250,000 for families), which would return the top tax bracket to 39.6 percent from its current 35 percent. He also included in his last budget a 28 percent cap on tax expenditures for high-end wage earners. In other words, anyone in higher tax brackets would only receive 28 cents for every dollar deducted for, say, mortgage interest or charitable contributions.

The president’s proposed cap would raise $580 billion over the next decade, according to the TPC. The 2005 president’s advisory panel, the Bowles-Simpson deficit commission and a 2010 report from the Bipartisan Policy Center each recommended a cap on tax expenditures.

The advantage of capping tax expenditures rather than cherry-picking which ones to cut is that it mutes campaigns by special interests to protect their favored exclusions and deductions – whether it be home builders and realtors fighting to keep the mortgage interest deduction; non-profits fighting to keep the charitable deduction; or Wall Street and mutual funds fighting to protect the retirement savings exclusion.

The revenue raised and the number of households hit by limited deductions and exclusions would be determined by where legislators decided to draw the line in the tax code. Obama suggested the 28 percent marginal tax rate. It could be higher or lower depending on how much new revenue was needed to lower overall rates, raise additional funds for the government or a combination of the two.

“There’s no prospect for meaningful tax reform without that (capping tax expenditures) being a key step,” said Edward Kleinbard, a law professor at the University of Southern California and a former chief of staff for the Joint Committee on Taxation. “That way it’s impossible to pick favorites. The only way to get the job done is to keep all the itemized deductions shackled together and thrown into the sea together.”

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