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Posts Tagged ‘Tax Expenditure’

It’s fun to write about big-picture tax issues such as tax reform (for instance, should we have a flat tax or national sales tax?).

It’s also fun to write about contentious issues such as whether there should be tax increases or whether the tax code should be based on class warfare.

Many tax topics, however, are tedious and boring. But they nonetheless involve important issues.

  1. Depreciation vs. expensing for new business investment.
  2. International tax rules and the choice of worldwide taxation vs territorial taxation.
  3. The debate on consumption-base taxation vs. Haig-Simons taxation.
  4. Choosing the right way of treating prior-years business losses.
  5. The fight over whether border-adjustable taxation should be part of tax reform.

Building on that list, today we’re going to wade into the boring topic of “tax expenditures.”

For those unfamiliar with the term, tax expenditures are special preferences in the tax code. In other words, tax loopholes.

But here’s the challenge: In order to figure out what’s a loophole, you first need to define a neutral tax system. And that means the debate over tax expenditures is actually a fight over consumption-base taxation vs. Haig-Simons taxation (the third item in the above list).

At the risk of over-simplifying, here’s what both sides believe:

  • Proponents of consumption-base tax believe you get a neutral system by taxing all income one time, but only one time (i.e., there should be no discriminatory extra layers of taxation on income that is saved and invested).
  • Proponents of Haig-Simons taxation, by contrast, believe that a neutral tax system also requires double taxation of income that is saved and invested (for all intents and purposes, taxing income and changes in net worth).

I’m motivated to write about this topic because the Committee for a Responsible Federal Budget put out a report last year entitled, “Addressing Tax Expenditures Could Raise Substantial Revenue.”

Since I don’t think our fiscal problem of excessive spending can be solved by giving politicians more revenue, I obviously disagree with the folks at CRFB about whether it would be desirable to “raise substantial revenue.”

For what it’s worth, I want to get rid of tax loopholes, but only if we use the revenues to facilitate lower tax rates. Indeed, that’s the goal of reforms such as the flat tax.

But let’s set aside that fight over tax increases and instead look at CRFB’s list of supposed tax expenditures. They rely on the Haig-Simons approach and thus include items (circled in red) that are not actually loopholes.

In a neutral tax system with no double taxation, there is no capital gains tax, no death tax, and no double taxation of dividends. In a neutral tax system, all savings is treated like IRAs and 401(k)s, which means the provisions circled above should be viewed as mitigations of penalties rather than loopholes.

Adam Michel of the Heritage Foundation illustrated the differences between consumption-base and Haig-Smons taxation in a 2019 report.

Here’s his table looking at what’s a loophole under both systems and the bottom part of the visual is where you will see the stark difference in how both systems treat saving and investment.

I’ll close by observing that my friends on the left generally support double taxation because they view such policies as a way of getting rich people to pay more (or as a way of punishing success, regardless of whether more revenue is collected).

I try to remind them that saving and investment is what leads to higher productivity, which means it is the most effective way of boosting wages for those of us who are not rich.

Sadly, it’s not easy to get them to understand that labor and capital are complementary factors of production (apologies for the economic jargon).

P.S. While CRFB uses the wrong definition when measuring tax loopholes, they are not alone. The Joint Committee on Taxation,  the Government Accountability Office, and the Congressional Budget Office make the same mistake. Heck, you even see Republicans foolishly use this flawed benchmark.

P.P.S. Here’s my award for the strangest tax loophole.

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For both political and policy reasons, the left is desperately trying to maneuver Republicans into going along with a tax increase. And they are smart to make this their top goal. After all, it will be very difficult – if not impossible – to increase the burden of government spending without more revenue coming to Washington.

But how to make this happen? President Obama is mostly arguing in favor of class-warfare tax increases, but that’s a non-serious gambit driven by 2012 political considerations. Moreover, there’s presumably zero chance that Republicans would surrender to higher tax rates on work, saving, and investment.

The real threat is back-door hikes resulting from the elimination and/or reduction of so-called tax breaks. The big spenders on the left are being very clever about this effort, appealing to anti-spending and pro-tax reform sentiments by arguing that it is important to get rid of “tax expenditures” and “spending in the tax code.”

I recently warned, however, that GOPers shouldn’t fall for this sophistry, noting that “If legislation is enacted that results in more money coming into Washington, that is a tax increase.” I also explained that tax breaks are not spending, stating that “When politicians tax (or borrow) money from one person and give it to another, that’s government spending. But if politicians allow a person keep more of their own money, that’s a tax cut.”

To be sure, the tax code is riddled with inefficient and corrupt loopholes. But those provisions should be eliminated as part of fundamental tax reform, such as a flat tax. More specifically, every penny of revenue generated by shutting down tax preferences should be used to lower tax rates. This is a win-win situation that would make America more prosperous and competitive.

It’s also important to understand what’s a loophole and what isn’t. Ideally, you determine special tax breaks by first deciding on the right benchmark and then measuring how the current tax system deviates from that ideal. That presumably means all income should be taxed, but only one time.

So what can we say about the internal revenue code using this neutral benchmark? Well, there are lots of genuine loopholes. The government completely exempts compensation in the form of employer-provided health insurance, for instance, and everyone agrees that’s a special tax break. There’s also the standard deduction and personal exemptions, but most people think it’s appropriate to protect poor people from the income tax (though perhaps we’ve gone too far in that direction since only 49 percent of households now pay income tax).

Sometimes the tax code goes overboard in the other direction, however, subjecting some income to double taxation. Indeed, because of the capital gains tax, corporate income tax, personal income tax, and death tax, it’s possible for some types of income to be taxed as many of three or four times.

Double taxation is a special tax penalty, which is the opposite of a special tax break. The good news is that there are some provisions in the tax code, such as IRAs and 401(k)s, that reduce these tax penalties.

The bad news is that these provisions get added to “tax expenditure” lists, and therefore get mixed up with the provisions that provide special tax breaks. This may sound too strange to be true, but here’s a list of the biggest so-called tax expenditures from the Tax Policy Center (which is a left-leaning organization, but their numbers are basically the same as the ones found at the Joint Committee on Taxation).

Since this post already is too long, I’ll close by simply noting that items 2, 4, 7, 8, 11, and 12 are not loopholes. They are not “tax expenditures.” And they are not “spending in the tax code.” Every one of those provisions is designed to mitigate a penalty in the tax code.

So even if lawmakers have good motives (i.e., pursuing real tax reform such as the flat tax) when looking to get rid of special tax breaks, they need to understand what’s actually a loophole.

But since politicians rarely have good motives, there’s a real threat that they will take existing tax penalties and make them even worse. That’s another reason why tax increases should be a non-starter.

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