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Posts Tagged ‘Municipal Bonds’

I strongly applauded the tax reform plan that was enacted in December, especially the lower corporate tax rate and the limit on the deduction for state and local taxes.

But I’m not satisfied. Our long-run goal should be fundamental tax reform. And that means replacing the current system with a simple and fair flat tax.

And the recent tax plan only took a small step in that direction. How small? Well, the Tax Foundation just calculated that it only improved the United States from #30 to #25 in their International Tax Competitiveness Ranking. In other words, we have a long way to go before we catch up to Estonia.

 

It’s possible, of course, to apply different weights and come up with a different list. I think the Tax Foundation’s numbers could be improved, for instance, by including a measure of the aggregate tax burden. And that presumably would boost the U.S. score.

But the fact would remain that the U.S. score would be depressingly low. In other words, the internal revenue code is still a self-imposed wound and huge improvements are still necessary.

That’s why we need another round of tax reform, based on the three core principles of good tax policy.

  1. Lower tax rates
  2. Less double taxation
  3. Fewer loopholes

But how is tax reform possible in a fiscal environment of big government and rising deficits?

This is a challenge. In an ideal world, there would be accompanying budget reforms to save money, thus creating leeway for tax reform to be a net tax cut.

But even in the current fiscal environment, tax reform is possible if policy makers finance pro-growth reforms by closing undesirable loopholes.

Indeed, that’s basically what happened in the recent tax plan. The lower corporate rate was financed by restricting the state and local tax deduction and a few other changes. The budget rules did allow for a modest short-run tax cut, but the overall package was revenue neutral in the long run (i.e., starting in 2027).

It’s now time to repeat this exercise.

The Congressional Budget Office periodically issues a report on Budget Options, which lists all sort of spending reforms and tax increases, along with numbers showing what those changes would mean to the budget over the next 10 years.

I’ve never been a huge fan of this report because it is too limited on the spending side. You won’t find fleshed-out options to shut down departments, for instance, which is unfortunate given the target-rich environment (including TransportationHousing and Urban DevelopmentEducationEnergy, and Agriculture).

And on the tax side, it has a lengthy list of tax hikes, generally presented as ways to finance an ever-expanding burden of government spending. The list must be akin to porn for statists like Bernie Sanders.

It includes new taxes.

And it includes increases in existing taxes.

But the CBO report also includes some tax preferences that could be used to finance good tax reforms.

Here are four provisions of the tax code that should be the “pay-fors” in a new tax reform plan.

We’ll start with two that are described in the CBO document.

Further reductions in itemized deductions – The limit on the state and local tax deduction should be the first step. The entire deduction could be repealed as part of a second wave of tax reform. And the same is true for the home mortgage interest deduction and the charitable contributions deduction.

Green-energy pork – The House version of tax reform gutted many of the corrupt tax preferences for green energy. Unfortunately, those changes were not included in the final bill. But the silver lining to that bad decision is that those provisions can be used to finance good reforms in a new bill.

Surprisingly, the CBO report overlooks or only gives cursory treatment to a couple of major tax preferences that each could finance $1 trillion or more of pro-growth changes over the next 10 years.

Municipal bond interest – Under current law, there is no federal tax on the interest paid to owners of bonds issued by state and local governments. This “muni-bond” loophole is very bad tax policy since it creates an incentive that diverts capital from private business investment to subsidizing the profligacy of cities like Chicago and states like California.

Healthcare exclusion – Current law also allows a giant tax break for fringe benefits. When companies purchase health insurance plans for employees, that compensation escapes both payroll taxes and income taxes. Repealing – or at least capping – this exclusion could raise a lot of money for pro-growth reforms (and it would be good healthcare policy as well).

What’s potentially interesting about the four loopholes listed above is that they all disproportionately benefit rich people. This means that if they are curtailed or repealed and the money as part of tax reform, the left won’t be able to argue that upper-income taxpayers are getting unfair benefits.

Actually, they’ll probably still make their usual class-warfare arguments, but they will be laughably wrong.

The bottom line is that we should have smaller government and less taxation. But even if that’s not immediately possible, we can at least figure out revenue-neutral reforms that will produce a tax system that does less damage to growth, jobs, and competitiveness.

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I’m a proponent of a pro-growth and non-corrupt tax code.

I mostly write and talk about the flat tax, though I’d be happy to instead accept a national sales tax if we could somehow get rid of the 16th Amendment and replace it with something so ironclad that even Justices such as John Roberts and Ruth Bader Ginsburg couldn’t rationalize that the income tax was constitutional.

But since there’s no chance of any good tax reform with Obama in the White House, there’s no need to squabble over the best plan. Instead, our short-term goal should be to educate voters so that we create a more favorable intellectual climate for genuine reform in 2017 and beyond.

That’s why I’ve argued in favor of lower tax rates and shared the latest academic research showing that tax policy has a significant impact on economic performance.

But tax reform also means getting rid of the rat’s nest of deductions, credits, exemptions, preferences, exclusions, shelters, loopholes, and other distortions in the tax code.

Why? Because people should make decisions on how to earn income and how to spend income on the basis of what makes economic sense, not because they’re being bribed or penalized by the tax code. That’s just central planning through the back door.

And if you don’t think this is a problem, I invite you to peruse three startling images, each of which measures rising complexity over time.

  1. The number of pages in the tax code.
  2. The number of special tax breaks.
  3. The number of pages in the 1040 instruction booklet.

Today’s Byzantine system is good for tax lawyers, accountants, and bureaucrats, but it’s bad news for America. We need to wipe the slate clean and get rid of this corrupt mess.

But as I explain in this appearance on Fox Business News, we won’t make progress until we control the burden of government spending and unless we make sure that deductions are eliminated only if we use every penny of revenue to lower tax rates.

I’ve previously explained why it’s okay to get rid of itemized deductions for mortgage interest, charitable contributions, and state and local tax payments.

Let’s now take a moment to explain why the internal revenue code shouldn’t be artificially steering capital toward state and local governments at the expense of private investment.

Under current law, there’s no federal income tax imposed on interest from municipal bonds. No matter how rich you are, Uncle Sam doesn’t tax a penny of the interest you receive if you use your wealth to lend money to state and local governments.

Should the tax code steer money to Detroit politicians?

This “muni-bond exemption” has two unfortunate effects.

  • It makes it easier and cheaper for state and local governments to incur debt, thus encouraging more wasteful spending by cities such as Detroit and states such as California.
  • By making the debt of state and local governments more attractive than private business investment, the loophole undermines long-term growth by diverting capital to unproductive uses.

The politicians at the state and local level certainly understand what’s at stake. They’re lobbying to preserve this destructive tax break. Here are some excerpts from a story in the New York Times.

Mr. Firestine [of Montgomery County, MD] is on the front lines of a lobbying campaign by local and state governments, bond dealers, insurers and underwriters that is trying to pre-empt any attempt to limit or even kill the tax exemption. …At present, the federal government forgoes about $32 billion a year in taxes by exempting the interest that investors earn from municipal bonds. …The National Commission on Fiscal Responsibility and Reform, known as the Simpson-Bowles commission, has suggested taxing all municipal bond interest, not just the interest paid to people in the top bracket. …Officials of some other government groups, like the New York City Housing Development Corporation, have formed a coalition with Wall Street groups like the Bond Dealers of America to lobby on the issue. But there is the sense of an uphill battle. …Capping the tax exemption would cause high-bracket taxpayers to look for higher-yielding investments, he said, and the county would have to offer more interest to lure them back.

Based on the last sentence in the excerpt, I gather we’re supposed to think it would be bad news if we got rid of this tax preference and taxpayers shifted more of their money to private-sector investments.

Needless to say, that’s misguided. Only in the upside-down world of Washington do people think it is smart to create tax preferences that lead to more wasteful spending by state and local governments, while simultaneously imposing punitive forms of double taxation on saving and investment in the private sector.

By the way, this shouldn’t be an ideological issue. If this amazing chart is any indication, leftists who want workers to enjoy more income should be clamoring the loudest for a tax system that doesn’t tilt the playing field against capital formation.

P.S. While simplicity is a good goal for tax policy, you will understand why it shouldn’t be the only goal if you check out this potential Barack Obama tax reform plan.

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