Everything You Need to Know about Deductions, Loopholes, and Special-Interest Tax Provisions

Why does the tax code require more than 10,000,000 words and more than 75,000 pages?

There are several reasons and none of them are good. But if you had to pick one cause for all the mess, it would be the fact that politicians have worked with interest groups and lobbyists to create myriad deductions, credits, exclusions, preferences, exemptions, and other loopholes.

This is a great deal for the lobbyists, who get big fees. It’s a great scam for politicians, who get lots of contributions. And it’s a great outcome for interest groups, who benefit from back-door industrial policy that distorts the economy.

But it’s not great for the American people or the American economy.

Writing for Reason, Veronique de Rugy of the Mercatus Center explains that the net result is a Byzantine tax code that imposes very harsh compliance costs on the productive sector.

According to a 2012 study from the Internal Revenue Service (IRS) and the Treasury Department, …corporations alone spent $104 billion complying with the tax code in 2012. …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. …Why does tax compliance cost so much? The answer is largely that the Internal Revenue Code…is riddled with exclusions, exemptions, deductions, preferential rates, and credits.

And she also points to a solution.

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.

Since I want to rip up the tax code and replace it with a simple and fair flat tax, this is music to my ears.

Of course, achieving genuine tax reform won’t be easy.

There’s the obvious political obstacle since all the groups that benefit from the current system (politicians, lobbyists, bureaucrats, cronyists, interest groups, and other insiders) will fiercely resist reform.

There’s also a policy obstacle because many people oppose loopholes in theory but they haven’t paid sufficient attention to the nuts-and-bolts details.

With that in mind, let’s set out a set of guiding principles for the elimination of tax loopholes and the creation of a neutral tax system.

1. A loophole exists when income isn’t taxed – In libertarian Nirvana, the central government is so small that there’s no need for an income tax. Until we get to that point, though, we’re stuck with the internal revenue code and the goal should be to collect revenue (hopefully a modest amount) in a way that minimizes the economic damage per dollar collected. And that means a tax code that doesn’t have loopholes, which are best defined as provisions that enable people to avoid any tax based on how they earn income or how they spend income. In a neutral system, all income is taxed one time.

2. The economy performs better without a loophole-riddled tax code – Most people understand that high tax rates are bad for growth because they penalize people for earning income. They also generally understand that double taxation of saving and investment is bad for growth because it creates a bias against capital formation. But there’s not nearly enough appreciation of the fact that loopholes in the code are bad for growth since they are a back-door form of industrial policy that exist for the purpose of incentivizing people to make decisions on the basis of tax rather than on the basis of what makes economic sense. A neutral tax system means less economic damage.

3. It’s not a loophole to protect income from double taxation or to require income to be measured correctly – The bad news is that the current system forces taxpayers to overstate their income and it also imposes multiple layers of tax on income that is saved and invested. The good news is that there are provisions in the tax code – such as IRAs, 401(k)s, deferral, bonus depreciation – that seek to mitigate these biases. These parts of the system oftentimes are needlessly complex and they frequently will alleviate penalties in a discriminatory manner, but they are not loopholes. In a neutral system, all income is taxed only one time.

4. Loopholes should be eliminated as part of a plan to lower tax rates, not in order to give politicians more money – If loopholes are a corrupt and distorting dark cloud, the silver lining to that cloud is that all the special favors in the tax code deprive the government of tax revenue. Even the most egregious of loopholes, such as ethanol, have this redeeming feature. This is why loopholes should only be eliminated as part of an overall tax reform plan that also lowers tax rates and reduces double taxation. A neutral tax system shouldn’t enable bigger government.

There are some important implications that follow from these four guiding principles.

As a practical matter, we can now identify provisions in the tax code that are clearly loopholes, such as the healthcare exclusion, the municipal bond exemption, and the state and local tax deduction (the mortgage interest deduction is misguided, but isn’t technically a loophole since one of the goals of tax reform is to give business investment the same tax-income-only-one-time treatment now reserved for residential real estate).

We also know that the capital gains tax rate isn’t a “preferential” loophole, but instead is the mitigation of a penalty that shouldn’t exist. Similarly, it’s not a loophole when companies deduct expenses when calculating income. And you’re not getting some sort of handout simply because Uncle Sam isn’t imposing double taxation on your retirement account. At the risk of repeating myself, all income should be taxed in a neutral system, but only one time.

Let’s close by looking at a few secondary – but still important – implications of a neutral tax code.

First, getting rid of loopholes won’t put a burden on poor and middle-income taxpayers for the simple reason that an overwhelming share of the benefits of these provisions go to high-income taxpayers.

I’ve already shown how the vast majority of charitable deductions are taken by those making more than $200,000 per year.

The same is true for the state and local tax deduction and the healthcare exclusion.

And the Washington Post just editorialized that the home mortgage interest deduction is a boon for rich taxpayers as well.

The mortgage interest deduction is also a significant cause of after-tax income inequality: The top 20 percent of earners get 75 percent of the benefits; the top 1 percent get 15 percent, according to the Congressional Budget Office. …Specifically, 10 metropolitan “hot spot” counties (among them Los Angeles in California and Fairfax in Virginia) with the greatest number of mortgages larger than $500,000 accounted for 45.1 percent of all such mortgages nationally. Just eight California urban and suburban counties accounted for 40 percent of the national total. Outside of such tony coastal precincts, the only big-mortgage hot spots were resort destinations such as Martha’s Vineyard, Mass., and Vail, Colo. — where many homes are vacation places, not primary residences.

To be sure, the Post is misguided in that it wants to restrict tax preferences in order to finance a larger burden of government spending.

So I’m not expecting the editors to join a coalition for pro-growth tax reform.

The second implication is that a neutral tax system means less corruption.

To cite one example, consider the oleaginous way that politicians deal with so-called tax extenders. Marc Short and Andy Koenig explain in a column they wrote for the New York Times.

Congress will soon take up the so-called tax extenders package, which has more than 50 tax breaks affecting a variety of industries and issues. …this bill mostly helps the wealthy and the well connected.

The fact that rich insiders benefit is no surprise, but what makes “tax extenders” so odious is that what began in 1988 as a supposedly one-time fix now has become a regular part of the process, a scam that gives lobbyists and politicians a way of generating fees and contributions.

The first tax-extender package…opened a door that lobbyists and lawmakers were all too willing to run through. …A 2014 analysis by Americans for Tax Fairness found that more than one out of every 10 lobbyists in Washington focused specifically on the extenders package. Given that this bill comes up about every year or two, special interests constantly have the opportunity to demand new handouts.

By the way, some of the extenders actually are good policy. They’re in the mitigation-of-penalties category I discussed above.

But those good provisions should be made permanent and the bad provisions should be jettisoned.

Unfortunately, that’s not in the interests of the politicians and lobbyists who benefit from an annual extender package, so the problem doubtlessly will fester.

Last but not least, let’s consider the moral component.

For those of us who believe in justice, it is ethically offensive that some rich and powerful taxpayer get better treatment simply because they know how to manipulate the political process.

This violates the important principle that the law should treat everyone alike. Yet another reason to have a simple and fair flat tax.

P.S. At the risk of being a nit-picker about my own writing, I should confess that a flat tax is not a purely neutral tax system. There will still be a penalty on earning income. But the penalty presumably will be modest if there is a low rate and that penalty won’t be exacerbated by penalties and loopholes that distort how people earn income and spend income.

P.P.S. Here, in one image, is all you really need to know about the economics of taxation.

Read Full Post »

Since Leftists Don’t Like Corporate Loopholes, They Should Support the Flat Tax

I appeared on CNBC a couple of days ago to discuss a new report which claims that some big U.S. companies “only” paid 9 percent of their income to the government.

While I’m a bit skeptical of the numbers (did it include the taxes paid to foreign governments, for instance, which can be substantial for multinational firms?), I confess I didn’t read the report.

So I focused on the best way of getting rid of corrupt loopholes while simultaneously boosting the competitiveness of America companies.

In other words, I said we should rip up the wretched internal revenue code and implement a simple and fair flat tax.

As is my habit, allow me to emphasize a few points from the interview.

1. It’s good to keep money in the productive sector of the economy because we shouldn’t feed the spending addiction in DC.
2. If tax rates are low, there’s much less incentive for companies to lobby for loopholes.
3. The only feasible and desirable tax reform is to simultaneously eliminate tax breaks while lowering tax rates.
4. The marginal tax rate is what determines incentives for new investment and job creation, which is why America’s highest-in-the-world 35 percent corporate tax rate is a major problem even if average tax rates are much lower.

Sadly, I’m not holding my breath expecting improvements.

Even though tax reform should appeal to well-meaning liberals, Obama seems committed to the class-warfare approach . Romney, meanwhile, mostly wants to tinker with the current system (when he’s not saying worrisome things about a value-added tax).

Read Full Post »

Obama’s Corporate Tax Refom: Rearranging the Deck Chairs on the Titanic?

American companies are hindered by what is arguably the world’s most punitive corporate tax system. The federal corporate rate is 35 percent, which climbs to more than 39 percent when you add state corporate taxes. Among developed nations, only Japan is in the same ballpark, and that country is hardly a role model of economic dynamism.

But the tax rate is just one piece of the puzzle. It’s also critically important to look at the government’s definition of taxable income. If there are lots of corrupt loopholes – such as ethanol – that enable some income to escape taxation, then the “effective” tax rate might be rather modest.

On the other hand, if the government forces companies to overstate their income with policies such as worldwide taxation and depreciation, then the statutory tax rate understates the actual tax burden.

The U.S. tax system, as the chart suggests, is riddled with both types of provisions.

This information is important because there are good and not-so-good ways of lowering tax rates as part of corporate tax reform. If politicians decide to “pay for” lower rates by eliminating loopholes, that creates a win-win situation for the economy since the penalty on productive behavior is reduced and a tax preference that distorts economic choices is removed.

But if politicians “pay for” the lower rates by expanding the second layer of tax on U.S. companies competing in foreign markets or by changing depreciation rules to make firms pretend that investment expenditures are actually net income, then the reform is nothing but a re-shuffling of the deck chairs on the Titanic.

Now let’s look at President Obama’s plan for corporate tax reform.

*The good news is that he reduces the tax rate on companies from 35 percent to 28 percent (still more than 32 percent when state corporate taxes are added to the mix).

*The bad news is that he exacerbates the tax burden on new investment and increases the second layer of taxation imposed on American companies competing for market share overseas.

In other words, to paraphrase the Bible, the President giveth and the President taketh away.

This doesn’t mean the proposal would be a step in the wrong direction. There are some loopholes, properly understood, that are scaled back.

But when you add up all the pieces, it is largely a kiss-your-sister package. Some companies would come out ahead and others would lose.

Unfortunately, that’s not enough to measurably improve incomes for American workers. In a competitive global economy, where even Europe’s welfare states recognize reality and have lowered their corporate tax rates, on average, to 23 percent, the President’s proposal at best is a tiny step in the right direction.

Read Full Post »

A Very Depressing Picture of Tax Complexity and Political Corruption

Read it and weep. Or maybe I should say look at it and weep.

I suppose this is a good time to recycle my flat tax video. I don’t mention this in the video, but Hong Kong’s flat tax system, which has been around for more than 60 years, requires less than 200 pages. Slovakia’s flat tax law is thinner than a magazine.

Read Full Post »

Beating the You-Know-What Out of Congress in the New York Post

I have a piece in this morning’s New York Post, and I did not try to be polite. Commenting on the end-of-year orgy on Capitol Hill, I slam corrupt deal making that leads to ever-bigger government. Here’s part of what I say about the “omnibus” spending bill.

The weeks since Election Day have provided nauseating confirmation of Mark Twain’s observation: “There is no distinctly native American criminal class except Congress.” Exhibit A is the “omnibus” spending bill Harry Reid is trying to push through the Senate. This monstrosity contains about 6,500 earmarks — special provisions inserted on behalf of lobbyists to benefit special interests. The lobbyists get big fees, the interest groups get handouts and the politicians get rewarded with contributions from both. It’s a win-win-win for everyone — except the taxpayers who finance this carousel of corruption. …earmarks and pork-barrel spending are the gateway drug that turns good legislators into big spenders.

And here’s some of my commentary on the tax deal.

Regardless of what you think of its core elements, it’s also packed with provisions — known as “extenders” — that reek of corruption and special-interest deal making. Extenders are the tax version of pork-barrel spending: special tax breaks put in the law by powerful politicians in exchange for campaign cash and other support. …There are strong policy arguments against these kinds of special tax breaks, especially since we could use the revenue to finance lower tax rates — but most people are even more upset by the dead-of-night process used to put these goodies into the tax bill. The behavior on Capitol Hill reminds me of the movie classic, “Animal House”: After their fraternity has been placed on “double-secret probation,” John Belushi and the rest of guys at the Delta House decide to go out in a blaze of glory with a toga party. Likewise, the politicians on Capitol Hill just got placed on the equivalent of probation by a Tea Party uprising. Yet rather than mend their crooked ways, they’re throwing a massive party with our money.

But after further thought, I feel compelled to apologize to the guys at Animal House. To paraphrase Ronald Reagan, at least they were partying with their own money.

Read Full Post »

The Barack Obama Tax Reform Plan?

In my fiscal policy speeches, I sometimes try to get a laugh out of audiences by including a Powerpoint slide with this image. Leading up to this slide, I talk about the Armey/Forbes flat tax and explain that it would eliminate the corrupt internal revenue code and replace it with a simple 10-line postcard. But I then warn that simplicity is not the same as low taxes and show the Obama slide.

But maybe jokes about Obama tax reform were a bit premature. According to the New York Times, the White House is giving serious consideration to a sweeping plan to streamline the tax system.

While administration officials cautioned on Thursday that no decisions have been made and that any debate in Congress could take years, Mr. Obama has directed his economic team and Treasury Department analysts to review options for closing loopholes and simplifying income taxes for corporations and individuals, though the study of the corporate tax system is farther along, officials said. The objective is to rid the code of its complex buildup of deductions, credits and exemptions, thereby broadening the base of taxes collected and allowing for lower rates — much like a bipartisan majority on Mr. Obama’s debt-reduction commission recommended last week in its final blueprint for reducing the debt through 2020. Doing so would offer not only an opportunity to begin confronting the growth in the national debt but also a way to address warnings by American business that corporate tax rates and the costs of complying with the tax code are cutting into their global competitiveness.

There’s actually much to like in the Administration’s potential plan. Lower tax rates will help the economy by improving incentives for productive behavior. And getting rid of distortions will further enhance growth since people no longer would have an incentive to make inefficient decisions just for tax purposes. And simplification could have a profound impact on cleaning up the horrible mess at the IRS. Moreover, a plan that trades lower tax rates for fewer tax distortions would be a welcome change from the poisonous soak-the-rich tax policy the White House has been pursuing.

This sounds like good news, but there’s a catch. The White House is looking at this exercise as a way to not only clean up the tax code, but also as a way of getting more money for politicians. This blog post explains why this is the wrong approach from an economic perspective, but politics will be an even bigger obstacle.

The American people want tax reform, but they don’t want more of their money going to Washington. And most Republican politicians have wisely pledged not to support legislation that increases the overall tax burden.

So the ball is in Obama’s court. If he genuinely wants to make America more prosperous and competitive, he should move forward with plans to lower tax rates and eliminate tax distortions, but he needs to tell his staff that tax reform should not a Trojan Horse for a tax increase.

Read Full Post »