Using the Tax Code to Increase Rents and Enrich Landlords

There’s a problem in California. No, I’m not referring to the punitive tax laws. Nor am I talking about the massive unfunded liabilities for bureaucrat pension.

Those are big problems, to be sure, but today’s topic is the state’s government-created housing crisis. The population keeps expanding, but local governments use zoning laws to restrict development of new homes and apartments.

And guess what happens when supply is constrained and demand keeps climbing? Even a remedial student in Economics 101 will probably understand that this is a recipe for ever-rising prices.

The solution, of course, is to expand the housing stock. Build more homes, apartments, and condos.

But local governments don’t like that option because existing homeowners (who vote) benefit from scarcity-induced increases in home values. And environmentalists also don’t like any development because of ideology.

Moreover, why fix the problem when politicians in Washington are willing to promote crackpot ideas. And that’s a very apt description of Senator Kamala Harris’ scheme to subsidize rental payments.

Under the Rent Relief Act, anyone who spends more than 30% of their income on rent would be eligible for a federal tax credit. What would you do with that extra money in your pocket?

— Kamala Harris (@KamalaHarris) July 28, 2018

Why is this a crackpot idea? Because prices go up in every sector of the economy that is subsidized. This is why health care keeps getting more expensive. It’s why higher education keeps getting more expensive.

And if Washington politicians decide to subsidize rent, the same thing will happen.

Writing for National Review, Jibran Khan explains why Harris has the wrong solution for the wrong problem. He starts by explaining why there’s a housing shortage.

Harris’s subsidy won’t improve the situation, and could even make things worse by drawing attention away from actual solutions. The Bay Area’s rent crisis is driven by a drastic shortage in housing. Strict rent control in San Francisco and “NIMBY” (not in my backyard) zoning policies have ensured that the area constructs only a fraction of the housing it needs. The San Francisco metro area added 373,000 new jobs between 2012 and 2017, but it allowed the construction of only 58,000 new units of housing. …Per Lawrence Yun, an economist who studies housing trends, the norm is for one housing unit to be built for every two jobs created. In the San Francisco area, there is less than one unit built for every six jobs created. …under Harris’s proposal, the currently homeless would remain homeless, while renters would receive some very short-term relief at the cost of other taxpayers.

He then explains why a subsidy will lead to higher rents, and a windfall for landlords.

Why would the relief be short-term? Because as landlords become aware that renters are receiving a subsidy, they will simply raise rents by the amount of the subsidy. The cost will be the same for the renters — who today are lining up for a chance to rent, showing that they are willing to pay it. In the end, then, this would be an effective subsidy for landlords, not renters.

Which, as mentioned above, is exactly what’s happened in other sectors that have received subsidies.

It’s not just libertarians who understand that Harris will make a bad situation worse.

Matt Yglesias is hardly a small-government zealot. He’s accused me, for example, of being insane and irrational because of my libertarian views. But we both agree that the real problem in California is government rules that limit development.

https://twitter.com/mattyglesias/status/1024652902344941568

And I assume he also would agree that Harris’ plan will wind up enriching landlords rather than helping renters.

So why, then, is Harris proposing such a destructive policy?

There are three possible answers.

1. She’s ignorant, and her staff is ignorant. Simply stated, there’s no understanding of indirect effects. Bastiat would be very disappointed.
2. She’s malicious. In other words, she’s smart enough to realize the policy is bad, but she doesn’t care. Call this the Venezuela approach.
3. She’s ambitious. In this scenario, she has no intention of pushing a bad idea, but she thinks it’s a good way of getting votes from renters.

I assume #3 is the right answer.

Regardless of her motives, she’s doing the wrong thing.

I’ve shared this chart on many occasions because it does a great job of showing that subsidized sectors are characterized by rising prices.

Give politicians enough leeway and maybe the entire economy can be dysfunctional!

P.S. I’m not being partisan. Republicans are quite capable of supporting very stupid policies in exchange for votes or campaign contributions. Just look at the GOPers who support the Export-Import Bank, Fannie-Freddie subsidies, or ethanol handouts.

P.P.S. Needless to say, I also object to the Harris scheme because it would make the tax code an even bigger mess. I realize it’s unlikely that I’ll ever see a simple and fair flat tax, but is it too much to ask for politicians not to make the system even worse?

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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.

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It’s Wrong for Federal Tax Deductions to Encourage Bad Fiscal Policy by State and Local Governments

I have a handful of simple rules for good tax policy.

• Keep government small, since it’s impossible to have a reasonable tax system with a bloated welfare state.
• Keep tax rates low to minimize penalties against income, production, and wealth creation.
• Since capital formation is critical for long-run growth, don’t double-tax income that is saved and invested.
• Eliminate corrupt and distorting loopholes that encourage people to make decisions that are economically irrational.

Some of these principles are interrelated. I don’t like loopholes in part because of the reasons I just listed. But I also don’t like them because politicians often claim that they need to boost tax rates to make up for the fact that they lose revenue due to various deductions, credits, exemptions, and preferences.

And sometimes a deduction in the tax code even leads to bad policy by state and local government. Today, I want to discuss preferences in the internal revenue code for state and local taxes. And I’m motivated to address this issue because some of the politicians on Capitol Hill have pointed out an inequity, but they want to fix it in the wrong way.

Under current law, state and local income taxes are fully deductible, but state and local sales taxes are only temporarily deductible. The right policy is to get rid of any deductibility for any state and local tax. But since that would create a windfall of new tax revenue for the spendaholics in Washington, every penny of that revenue should be used to lower tax rates.

Not surprisingly, the crowd in Washington doesn’t take this approach. Instead, they want to extend deductibility for the sales tax. And they may even be amenable to raising other taxes to impose that policy.

Here are some excerpts from a story in The Hill.

More than five dozen House members are pressing leaders of a tax panel to preserve a deduction for state and local sales taxes. The bipartisan group of lawmakers say it would be unfair to voters in their states not to extend the sales tax deduction, given that taxpayers would still be able to deduct state and local income taxes. …Eight states in all — Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming — currently use a sales tax, but either don’t have or have a very limited state income tax. …The letter comes as many lawmakers hope to finish off an extenders package once Congress returns to Washington after November’s elections. Lawmakers will have to grapple with expiring Bush-era tax rates — just one part of the so-called fiscal cliff — when they return, and tax extenders could be tacked on to a broader package. The Senate Finance Committee has already passed an extenders package of its own, which included a two-year extension — at a cost of an estimated $4.4 billion over a decade — of the sales tax deduction.

I have some sympathy for these members of Congress. They represent states that have wisely decided not to impose income taxes, yet the federal tax system rewards profligate high-tax states such as New York and California with a permanent deduction for state and local income taxes.

This is a very misguided policy. It means that greedy politicians such as Governor Brown of California or Governor Cuomo of New York can raise tax rates and tell voters not to get too upset because they can deduct that additional burden. This means that a $1 tax hike results in a loss of take-home pay of as little as 65 cents.

This is what a fair tax code looks like

But you don’t cure one bad policy with another bad policy. A deduction for state and local sales taxes just augments the IRS-enforced preference for bigger government at the state and local level.

The right answer is the flat tax. Put in place the lowest-possible tax rate, which is feasible because all loopholes are wiped out.

In the case of state and local tax deductibility (or lack thereof, with any luck), that’s a win-win-win situation.

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Just in Case You Need another Reason to Support the Flat Tax

I’ve done thorough blog posts highlighting the economic benefits of the flat tax, but I find that most people are passionate about tax reform because they view the current system as being unfair and corrupt.

They also don’t like the IRS, in part because it has so much arbitrary power to ruin lives.

But it’s not just that is has the power to ruin lives. That can be said about the FBI, the DEA, the BATF, and all sorts of other enforcement agencies.

What irks people about the IRS is that it has so much power combined with the fact that the internal revenue code is a nightmare of complexity that can overwhelm even the most well-intentioned taxpayer. Just spend a couple of minutes watching this video if you don’t believe me.

I’ve already shown depressing charts on the number of pages in the tax code and the number of special breaks in the tax law. To make matters worse, not even the IRS understands how to interpret the law. According to a recent GAO report, the IRS gave the wrong answers on matters of tax law more than 530,000 times in 2010.

Yet if you use inaccurate information from the IRS when filing your taxes, you’re still liable. To add insult to injury (or perhaps injury to injury is the right phrase), you’re then guilty until you prove yourself innocent – notwithstanding the Constitution’s guarantee of presumption of innocence.

Now we have some new information showing the difficulty of complying with a bad tax system.

A new report from the Treasury Department reveals that volunteers (who presumably have the best of intentions) make mistakes in more than 50 percent of cases.

Here are some key excerpts from the report.

Of the 39 tax returns prepared for our auditors, 19 (49 percent) were prepared correctly and 20 (51 percent) were prepared incorrectly. The accuracy rate should not be projected to the entire population of tax returns prepared at the Volunteer Program sites. Nevertheless, if the 20 incorrect tax returns had been filed: 12 (60 percent) taxpayers would not have been refunded a total of $3,996 to which they were entitled, one (5 percent) taxpayer would have received a refund of $303 more than the amount to which he or she was entitled, one (5 percent) taxpayer would have owed $165 less than the amount that should have been owed, and six (30 percent) taxpayers would have owed an additional total of $1,483 in tax and/or penalties. …The IRS also conducted 53 anonymous shopping visits during the 2012 Filing Season. Volunteers prepared tax returns for SPEC function shoppers with a 60 percent accuracy rate.

So here’s the bottom line. We have a completely corrupt tax system that is impossibly complex. Yet every year politicians add new provisions to please their buddies from the lobbyist community.

Wouldn’t it be nice if we could rip up all 72,000 pages and instead have a simple and fair tax system?

Sadly, tax reform is an uphill battle for four very big reasons.

• Politicians don’t want tax reform since it reduces their power to micro-manage the economy and to exchange loopholes for campaign cash.
• The IRS doesn’t want tax reform since there are about 100,000 bureaucrats with comfy jobs overseeing the current system.
• Lobbyists obviously don’t want to reform since that would mean fewer clients paying big bucks to get special favors.
• And the interest groups oppose the flat tax because they want a tilted playing field in order to obtain unearned wealth.

But there are now about 30 nations around the world that have adopted this simple and fair system, so reform isn’t impossible. But it will only happen when voters can convince politicians that they will lose their jobs if they don’t adopt the flat tax.

P.S. I’ll also take a national sales tax, like the Fair Tax, as a replacement. But since I don’t trust politicians, that option requires that we first replace the 16th Amendment with something so ironclad that not even Chief Justice John Roberts would be able to rationalize that an income tax was permissible.

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New Academic Study Confirms Previous IMF Analysis, Shows that Lower Tax Rates Are the Best Way to Reduce Tax Evasion

Leftists want higher tax rates and they want greater tax compliance. But they have a hard time understanding that those goals are inconsistent.

Simply stated, people respond to incentives. When tax rates are punitive, folks earn and report less taxable income, and vice-versa.

• When tax rates increase, sometimes they engage in tax avoidance, lowering their tax liabilities legally.
• When tax rates change, sometimes they choose to alter their levels of work, saving, and investment.
• And when tax rates go up, sometimes they resort to illegal steps to protect themselves from the tax authority.

In a previous post, I quoted an article from the International Monetary Fund, which unambiguously concluded that high tax burdens are the main reason people don’t fully comply with tax regimes.

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy.

Indeed, it’s worth noting that international studies find that the jurisdictions with the highest rates of tax compliance are the ones with reasonable tax systems, such as Hong Kong, Switzerland, and Singapore.

Now there’s a new study confirming these findings. Authored by two economists, one from the University of Wisconsin and the other from Jacksonville University, the new research cites the impact of tax burdens as well as other key variables.

Here are some key findings from the study.

According to the results provided in Table 2, the coefficient on the average effective federal income tax variable (AET) is positive in all three estimates and statistically significant for the overall study periods (1960-2008) at beyond the five percent level and statistically significant at the one percent level for the two sub-periods (1970-2007 and 1980-2008). Thus, as expected, the higher the average effective federal income tax rate, the greater the expected benefits of tax evasion may be and hence the greater the extent of that income tax evasion. This finding is consistent with most previous studies of income tax evasion using official data… In all three estimates, [the audit variable] exhibits the expected negative sign; however, in all three estimates it fails to be statistically significant at the five percent level. Indeed, these three coefficients are statistically significant at barely the 10 percent level. Thus it appears the audit rate (AUDIT) variable, of an in itself, may not be viewed as a strong deterrent to federal personal income taxation [evasion].

Translating from economic jargon, the study concludes that higher tax burdens lead to more evasion. Statists usually claim that this can be addressed by giving the IRS more power, but the researchers found that audit rates have a very weak effect.

The obvious conclusion, as I’ve noted before, is that lower tax rates and tax reform are the best way to improve tax compliance – not more power for the IRS.

Incidentally, this new study also finds that evasion increases when the unemployment rate increases. Given his proposals for higher tax rates and his poor track record on jobs, it almost makes one think Obama is trying to set a record for tax evasion.

The study also finds that dissatisfaction with government is correlated with tax evasion. And since Obama’s White House has been wasting money on corrupt green energy programs and a failed stimulus, that also suggests that the Administration wants more tax evasion.

Indeed, this last finding is consistent with some research from the Bank of Italy that I cited in 2010.

…the coefficient of public spending inefficiency remains negative and highly significant. …We find that tax morale is higher when the taxpayer perceives and observes that the government is efficient; that is, it provides a fair output with respect to the revenues.

And I imagine that “tax morale” in the United States is further undermined by an internal revenue code that has metastasized into a 72,000-page monstrosity of corruption and sleaze.

On the other hand, tax evasion apparently is correlated with real per-capita gross domestic product. And since the economy has suffered from anemic performance over the past three years, that blows a hole in the conspiratorial theory that Obama wants more evasion.

All joking aside, I’m sure the President wants more tax compliance and more prosperity. And since I’m a nice guy, I’m going to help him out. Mr. President, this video outlines a plan that would achieve both of those goals.

Given his class-warfare rhetoric, I’m not holding my breath in anticipation that he will follow my sage advice.

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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.

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America’s Awful Tax System

Happy Tax Day! Or, if you’re like me, happy tax extension filing day.

In the past couple of days, I’ve posted about the benefits of a better tax system and the unfairness of the current system.

Those were compelling posts, at least I hope. But now let’s tie these themes together. Art Laffer has a column in the Wall Street Journal that explains the comprehensively awful burden of the internal revenue code – and also shows the promise of a better approach.

There is a lot more to taxes than simply paying the bill. Taxpayers must spend significantly more than $1 in order to provide $1 of income-tax revenue to the federal government. To start with, individuals and businesses must pay the government the $1 in revenue plus the costs of their own time spent filing and complying with the tax code; plus the tax collection costs of the IRS; plus the tax compliance outlays that individuals and businesses pay to help them file their taxes. In a study published last week by the Laffer Center, my colleagues Wayne Winegarden, John Childs and I estimate that these costs alone are a staggering $431 billion annually. This is a cost markup of 30 cents on every dollar paid in taxes. And this is not even a complete accounting of the costs of tax complexity. …David Keating of the National Taxpayers Union provides a useful perspective on how big the tax compliance industry is. According to his research, as of 2009 the income-tax industry employed “more workers than are employed at the five biggest employers among Fortune 500 companies—more than all the workers at Wal-Mart Stores, United Parcel Service, McDonald’s, International Business Machines, and Citigroup combined.” Without diminishing in any way the professionalism of tax attorneys, accountants and financial planners, all of these efforts produce nothing other than, well, tax compliance. …A tax reform to a simple flat-rate tax with no deductions would significantly reduce the current complexity inherent in our progressive tax system, which is full of loopholes, exemptions and special interest carve-outs. Based on the estimates from our new study, if a static, revenue-neutral flat-tax reform were to reduce the tax complexity in half, the long-term growth in our economy would increase by around one-half of 1% per year.

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Republicans Are Right to Cut the IRS Budget

One of my many frustrations of working in Washington is dealing with perpetual-motion-machine assertions. The classic example is Keynesian economics, which is based on the notion that you magically create additional economic activity by having the government spend money instead of allowing the private sector to decide how it gets spent (in an especially bizarre display of this thinking, Nancy Pelosi actually said that subsidizing unemployment was the best way to create jobs).

Another example of this backwards analysis can be found in the debate over the IRS budget. The President is resisting a GOP proposal to modestly trim the IRS’s gargantuan $12.5 billion budget and his argument is that we should actually boost funding for the tax collection bureaucracy since that will mean more IRS agents squeezing more money out of more taxpayers.

Here are some excerpts from an Associated Press report about the controversy.

Every dollar the Internal Revenue Service spends for audits, liens and seizing property from tax cheats brings in more than $10, a rate of return so good the Obama administration wants to boost the agency’s budget.House Republicans, seeing the heavy hand of a too-big government, beg to differ. They’ve already voted to cut the IRS budget by $600 million this year and want bigger cuts in 2012. …IRS Commissioner Doug Shulman told the committee Tuesday that the $600 million cut in this year’s budget would result in the IRS collecting $4 billion less through tax enforcement programs. The Democrat-controlled Senate is unlikely to pass a budget cut that big. But given the political climate on Capitol Hill, Obama’s plan to increase IRS spending is unlikely to pass, either. Obama has already increased the IRS budget by 10 percent since he took office, to nearly $12.5 billion. The president’s budget proposal for 2012 would increase IRS spending by an additional 9 percent — adding 5,100 employees. …Obama’s 2012 budget proposal for the IRS includes $473 million and 1,269 new positions to start implementing the health care law.

Unlike Keynesian economics, there actually is some truth to Obama’s position. The fantasy estimate of $10 of new revenue for every $1 spent on additional bureaucrats is clearly ludicrous, but it is equally obvious that many Americans would send less money to Washington if they didn’t have to worry about a coercive and powerful tax-collection bureaucracy that had the power to throw them in jail.

This is an empirical question, at least with regards to the narrow issue of whether more IRS agents “pay for themselves” by shaking down sufficient numbers of taxpayers. Reducing the number of IRS bureaucrats by 90 percent, from about 100,000 to 10,000, for instance, surely would be a net loss to the government since the money saved on IRS compensation would be trivial compared to the loss of tax revenue.

But that doesn’t mean that a reduction of 10,000 or 20,000 also would lead to a net loss. And it certainly does not mean that adding 10,000 or 20,000 more IRS agents will result in enough new revenue to compensate for the salaries and benefits of a bigger bureaucracy. Even left-wing economists presumably understand the concept of diminishing returns.

But let’s assume that the White House is correct and that more IRS agents would be a net plus from the government’s perspective. The Administration would like us to reflexively endorse a bigger and more aggressive IRS, but public policy should not be based on what is a “net plus” for the government.

There are two ways to promote better tax compliance. The Obama approach, as we’ve read above, is to expand the size and power of the IRS. Up to a point, this policy can be “successful” in extracting additional money from the productive sector of the economy.

The alternative approach, by contrast, seeks better compliance by lowering tax rates and reforming/simplifying tax systems. This course of action boosts compliance by making evasion and avoidance less attractive. People are much less likely to cheat if the government isn’t being too greedy, and they’re also more likely to comply if they think there is less waste, fraud, corruption, and favoritism in the tax code.

Let’s now put this discussion in context. Obama wants more IRS agents in large part to enforce his new scheme for government-run healthcare. Yet that’s a perfect example of what I modestly call Mitchell’s Law – politicians doing one bad thing (expanding the IRS) only because they did another bad thing (enacting a health care bill that made the tax code even more convoluted and punitive).

So instead of making the IRS bigger in response to a bad healthcare law, why not repeal that bad law and shrink the size of the IRS? Even better, why not junk the entire tax code so we can replace the IRS with a system that is honest and fair?

And if these big steps are not immediately feasible, at least cut the IRS budget so that awful laws are enforced in a less destructive manner.

This Center for Freedom and Prosperity video has additional details about the national nightmare we call the IRS.

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The IRS: Incompetence on Steroids

The IRS certainly deserves lots of condemnation for its rogue actions, including a $200 fine for a taxpayer who supposedly underpaid his tax bill by 4 pennies.

But the tax-collection agency also should be criticized for blundering incompetence. In the past, I’ve mocked the Internal Revenue Service for sending checks to convicts. Now it’s time to rip the bureaucracy for its stunning failure to guard against fraud in the so-called earned income credit program. And we’re talking big bucks. Here’s a blurb from an AP report.

More than $10 billion a year in tax credits for low-income families go to people who don’t qualify for them, and the Internal Revenue Service isn’t doing enough to stop them, a government investigator said Wednesday. Using the tax agency’s own numbers, the investigator said about quarter of all earned income tax credits go to families that don’t meet the requirements. The IRS has known about the improper payments for years but has not done enough to stop them, said J. Russell George, the Treasury inspector for tax administration. From 2003 to 2009, improper payments have totaled at least $70 billion, according to a report issued by George. In 2009, between $11.2 billion and $13.3 billion was improperly paid out.

Bush and Obama have dramatically increased the IRS’s budget in recent years, but that money obviously is not being put to good use. The time has come to downsize the IRS. This video provides plenty of evidence.

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Two More Reasons to Hate Taxes

When all you have is a hammer, everything begins to look like a nail. That old saying makes a lot of sense. As a tax economist, I’m sometimes guilty of looking at all sorts of issues based on their relationship with the tax code. In my defense, however, the tentacles of the IRS now reach into almost every nook and cranny of our society. And greedy tax collectors on the state and local level make a bad situation even worse. Two things from today’s inbox illustrate my point.

First, you may remember that the IRS is going to be a chief enforcer of Obamacare. Well, our friends at the tax collection agency have just released a draft form for the “credit for small employer health insurance premiums.” We already have a tax system that takes up 72,000 pages and requires more than 1,000 different forms and publications, but now we can add 25 more lines of mind-numbing, eye-glazing bureaucratese, all of which doubtlessly will lead to innocent mistakes that cause many more taxpayers to have nightmarish interactions with the IRS. (click here to see a full-size version of the form)

Second, here’s an article on telecommuting which largely focuses on the environmental and quality-of-live advantages of people working from home. What does this have to do with taxes, you ask? It turns out that greedy state politicians have an annoying tendency of trying to tax people who live elsewhere. This form of taxation without representation imposes both bureaucratic and economic barriers that hinder an otherwise desirable development.

Possibly the biggest barrier to telework are state tax laws. Many states implement some form of double taxation on out-of-state teleworkers. For example, New York applies a “convenience of the employer” doctrine on out-of-state teleworkers who work for a New York–based organization, which requires them to pay income tax to New York for telework days outside of the state. All work done outside of New York is subject to New York income tax, unless the work is done outside of New York out of necessity to the employer . In 2005, the New York State Court of Appeals upheld the “convenience of the employer” doctrine in Huckaby vs. New York State Division of Tax Appeals. Thomas Huckaby, a Tennessee resident, worked for a New York–based company, but teleworked 75 percent of the time. On his New York State nonresident tax returns, Huckaby allocated 25 percent of his income to New York, and 75 percent to Tennessee; however, the New York State tax department determined that Huckaby should have paid New York income tax on 100 percent of his income. The court sided with the New York State tax department, stating that the doctrine was constitutionally applied. As many as 35 states have some form of double taxation for teleworkers.

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Talking About IRS Incompetence on MSNBC

I did a post yesterday about the IRS screwing up and sending housing tax credits to prison inmates. Apparently, the 100,000 bureaucrats at the IRS were unable to put 2 and 2 together and realize that jailbirds – by definition – are not buying new homes. I also appeared on MSNBC to talk about the issue, and took the opportunity to explain that much of the blame belongs with politicians who created a tax code that nobody understands.

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New Video Exposes Nightmare of IRS Complexity

Here’s a new Economics 101 video about the cost of the tax code from the Center for Freedom and Prosperity. I won’t spoil the surprise by giving the details, but you if you’re not angry now, you will be after watching.

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Sex-Change Operations Are Deductible According to Tax Court

The internal revenue code is a monstrous nightmare of special-interest loopholes and class-warfare penalties, but at least is generates some interesting stories. Here’s a report from Bloomgberg about a court deciding that the costs of switching from a man to a woman are tax deductible. Since I’m not a leftist, I’m not going to make the absurd argument that taxpayers are subsidizing sex-change operations. After all, the case revolved around how much of his/her own money the taxpayer got to keep. But I am an economist, so I’m going to say that tax loopholes tilt the playing field and encourage all sorts of inefficient outcomes. Indeed, this tax court ruling should be seen as a symbol of why tax preferences for health care should be eliminated as part of the shift to a simple, fair, and neutral flat tax:

Costs incurred in sex-change operations and procedures are tax-deductible, the U.S. Tax Court ruled. The Washington-based court decided yesterday that hormone therapies and sex reassignment surgeries are necessary to treat gender identity disorder, a disease, in the case of a Boston- area man who became a woman named Rhiannon O’Donnabhain. “The Court is persuaded that petitioner’s sex reassignment surgery was medically necessary,” Judge Joseph Gale wrote in a 69-page decision for the majority. The decision is the first to rule that sex-change operations qualify as medical care and overturns a 2005 Internal Revenue Service policy denying medical expense deductions in such operations on the grounds they are ‘cosmetic.’’ The case involves a $5,679 tax bill assessed by the IRS, which denied medical deductions claimed by O’Donnabhain after she underwent sex reassignment-surgery in 2000. O’Donnabhain, a civil engineer who joined the U.S. Coast Guard during the Vietnam War, was diagnosed with gender identity disorder in 1997. O’Donnabhain sued the IRS after it denied her deduction of $25,000 in out-of-pocket medical costs associated with the surgeries and other care such as hormone treatments and counseling, according to Boston-based Gay & Lesbian Advocates & Defenders, which represented her in court.

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Political Alchemy, Part I: Turning Spending Increases into Tax Cuts

Politicians in Washington have come up with something far more impressive than turning lead into gold or water into wine. Using self-serving budget rules, they can increase the burden of government spending and say they are cutting taxes instead.

This bit of legerdemain is made possible, thanks to the convolutions of the personal income tax, by adopting or expanding refundable tax credits. But in this case, “refundable” does not mean the government is returning money to taxpayers. Instead, it means that money is being redistributed to people who do not earn enough to be subject to the income tax.

This is hardly a trivial issue. According to the Congressional Budget Office, the amount of income redistribution being laundered through the tax code is now so large that the bottom 40 percent of the population has a negative “effective” income tax rate. In simple terms (though perhaps with profound political implications), the income tax is a revenue generator for a big share of the population.

And the problem is going to get worse if the President’s budget is approved. Buried in the fine print, on pages 188-189 of the Analytical Perspective of the Budget, you will see that the President is proposing to increase this hidden form of spending by more than $152 billion over the next ten years.

It is worth noting that proponents argue that it is okay to classify this new spending as tax cuts because it somehow offsets other tax payments, especially the payroll tax. I’m sympathetic to lower taxes on everybody, including the poor, but surely it is better to be honest and simply cut the taxes that people pay. The current methodology, by contrast, is open to abuse. Heck, I’m surprised politicians don’t classify other forms of spending as tax cuts. Maybe corporate welfare can be reclassified as a corporate tax cut (I better stop lest I give the political class any ideas).

Defenders also assert that some so-called refundable tax credits, particularly the earned income tax credit, are designed to encourage work. That is partly true, but credits like the EITC are withdrawn as income climbs, and this means poor people face punitive marginal tax rates, so the overall effect on hours worked may be negligible.

The right approach, of course, is to get the federal government out of the racket of redistributing income.

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