The mismatch between federal government revenues (taxes) and spending has resulted in $1 trillion+ deficits for the last four years. Left unaddressed, the US could become another Greece in the next 10 or 12 years; unable to sustain existing benefits and services for its citizens. Democrats favor balancing the equation by increasing taxes while Republicans have opposed most tax increases and demand spending reductions. This has led to an impasse and multiple calls for reform of the US Tax Code, which has become 73,000+ pages long and has not seen major revisions since 1986. The Simpson Bowles Commission and other would be reformers advocate a simplified structure with 3 tax brackets and a great reduction in deductions.
In order to see where such changes would need to come from, Diogenes examined the major deductions and credits taken by US taxpayers to discover which are the most unfair, or unjust. Below is a chart showing the magnitude of each of these “tax expenditures”.
Employer Paid Health Insurance
The largest single deduction, that taken for employer provided insurance plans, should be the first deduction to be eliminated. The amounts companies (or government) spend on these plans should become ordinary income for everyone. All Americans should be given a deduction of up to about $10,000 for direct health insurance spending. While this would cost revenue, there is no public policy benefit to forcing the 30% of Americans who are self employed or self insured to pay for their health insurance with after tax dollars.
Municipal Bond Interest & State and Local Income Taxes
Not shown on the chart are an estimated $120 billion in interest payments on about $3 trillion in municipal bonds, which are generally not subject to federal taxes. Many wealthy citizens avoid tax on substantial portions of their income with these deductions. The Alternative Minimum Tax (AMT) was originally enacted to force these few to pay their “fair share”, but because of the “Fiscal Cliff“, the number of Americans subject to the AMT absent Congressional action before January will rise from about 4 million to over 25 million.
This deduction should also be eliminated. There is simply no justification to reduce federal revenues to provide support for the local and state projects that these bonds finance. Similarly, the $54 billion in deductions for state and local income taxes should not be deductible from federal taxes. Why do all taxpayers have to subsidize the profligate states (California, Illinois, Massachusetts)? We could broaden the tax base and lower marginal tax rates. The real effect of this deduction is subsidize the high-tax-rate states at the expense of all other taxpayers. People deserve the governments they get. Those who don’t like the policies in Illinois and don’t live there don’t deserve to be forced to pay for a part of the results.
Mortgage Interest Deduction
“Subsidizing housing finance is especially problematic, as home building clearly over expanded in the early 2000s and needed to contract. If public policy subsidized a good into excess supply, further subsidies aren’t the cure. The Fed has merely delayed adjustment in the housing and financial sectors by continuing to direct credit to them.” (Gerald O’Driscoll, WSJ 8/31)
The mortgage interest deduction is also socially unjust, as it disadvantages minorities and the poor. Only 43% of minorities and 65% of whites are able to take advantage of it. Furthermore, it has failed to achieve it’s public policy purchase of increasing home ownership. The rate of home ownership in the US trails many other countries which provide no tax advantages to home owners. By subsidizing housing finance, the US government has also absorbed about $160 billion in losses at Fannie Mae and Freddie Mac (so far).
Deduction of Charitable Contributions
Americans have a long history of being among the most charitable people on Earth. But why does government need to support this generosity with over $50 billion in tax deductions? Wouldn’t we still give? And if I am an atheist, why do I need to taxably support contributions to your church?
How Do We Decide Which Deduction and Credits To Eliminate?
We have just identified over $325 billion in tax deductions that should be immediately eliminated in the tax code. However, one can only imagine the howls of protest from lobbying groups whose determined efforts have resulted in these distortions to an equitable tax code.
The AMT and various code reform attempts including Simpson Bowles suggested that deductions be phased out as income increases. However, this again results in continuing complexity within the tax code. A reform proposed last week by Republican Presidential candidate Mitt Romney is to enact tax simplification by limiting any taxpayer’s total deductions to an amount that would result in revenue neutrality after enactment of across the board rate cuts. He has suggested that the number would be between $17,000 and $50,000. The genius of this proposal is that it would protect the deductions of the middle class. It would limit benefits to high income earners even as it cuts their rates to spur investment activities.
The approach is also appealing because it would make more income subject to taxation—which boosts revenue—while reducing opposition from taxpayers who want to preserve specific deductions. One benefit for politicians is that capping deductions wouldn’t produce the same intense opposition they would get if they tried to eliminate just a few specific deductions. And Congress could continue to sell their fiscal favors to special interests secure in the knowledge that they wouldn’t be hurting the country (much).