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Sunday, November 25, 2012

Tax reform and base broadening

As I've noted in these posts in recent months, both political parties have mentioned base broadening as part of tax reform including how to keep the current low tax rates and other tax reductions that expire at the end of 2012. I think most people view base broadening as meaning:
  1. Cutting back on corporate tax perks.
  2. Eliminating deductions used by other people.
While the above can certainly be part of base broadening, it would be better to look at base broadening as meaning all of the following:
  1. Removal, reduction or revision of special tax rules that come in the form of deductions, exclusions, tax credits and lower tax rates.
  2. Something that affects all taxpayers.
  3. Something that will mostly affect individual taxpayers because today, they use the vast bulk of the special tax rules (they also pay the bulk of federal tax revenues; the corporate income tax contributes about 6 - 9% of total revenues).
  4. Addressing the largest of "tax expenditures" rather than only small ones that affect one a small number of taxpayers.
  5. Changes that can also simplify the federal tax system and make it more equitable among taxpayers (by eliminating or cutting back on special rules that only benefit certain groups of taxpayers).
  6. Changes that raise real dollars over the long-term rather than only timing changes (such as changing the depreciation rules). Since revenue neutrality (PAYGO) is viewed over a 10-year period, there is a risk of trying to pay for permanent tax reductions with temporary tax increases. That would not be good for long-term fiscal health.
Also, in defining a tax expenditure or special rule, the standard deduction and personal exemptions (or some combination of these into a personal deduction) should remain to reflect the fact that an individual income tax structure needs to exempt some amount of income from taxation because people need it to live on.

Bruce Bartlett has a wonderfully clear article on base broadening and what it means and possible obstacles to such broadening in this 10/31/12 New York Times article, "The Real Barrier to Tax Reform."  I highly encourage you to read it.  He lists the 10 largest tax expenditures and notes that while they are popular, that popularity can't allow them to remain completely intact as they operate today because you'll need those dollars to enable lower rates.  My analogy is to the famous quote by some bank robber when asked why he robs banks (because that is where the money is). Likewise, you have to look for funds for lower rates and deficit reduction in the larger expenditures - it is where the money is.

I have heard some lawmakers and news commentators say that the mortgage interest deduction has to be off the table.  I disagree. That is the largest tax expenditure that is a deduction.  It has many flaws that I and many others have pointed out. These include:
  • The mortgage interest deduction allows individuals who itemize deductions to deduct interest on mortgages on their principal residence and vacation home and a home equity loan. The maximum loan amounts are $1 million for acquisition and $100,000 for equity loans. This subsidy is way out of line with logical social and fiscal policy. Why should the tax system subsidize a debt on a vacation home or home equity loan?  Why the $1 million debt limit which is much higher than the average and median home price in all parts of the US?
  • The deduction is only available to the roughly 1/3 of individuals who itemize and not all of those filers have a mortgage. So this big deduction is used by a minority of individuals.
  • Studies show that the deduction primarily enables higher income to purchase a more expendixe home.
  • Home ownership rates in the US are comparable to those in countries without the mortgage interest deduction.
  • The favorable rules lead to overinvestment in housing (and underinvestment in other ventures).
I am not advocating for elimination of the home mortgage interest deduction. It should be pared back though with the freed up funds used to allow for lower tax rates, pay down the deficit and to help people who cannot afford to buy a home to buy one.  The $1 million should be gradually phased down to perhaps $350,000 or as suggested by President Bush's Tax Advisory Panel, based on the regional home price.  The home equity and second home deductions should be phased out for existing claimers and disallowed for new mortgages.

Also, while phase-outs can cause some complexity, perhaps they should be used more broadly as a possible base broadener. I only suggest this because they have been used for many provisions for years, such as for child credits, education credits, and more.  Why not use them for the exclusion for employer-provided health insurance and tax-exempt interest and a lower capital gains rate?

Base broadening will be a tough sell because, as Mr. Barlettt points out, people will step forward to argue for keeping the special rules. I think that is even true for deductions that are used only by a minority of filers, such as the home mortgage interest deduction. What will it take for the over 2/3 of individuals who do not claim a home mortgage interest deduction to argue that some of the funds to pay for it should instead be used for deficit reduction and/or a larger standard deduction?

Perhaps as part of upcoming tax reform, we need to see a "unified budget" that lists the tax expenditures right in the budget. For example, suppose the budget for the Department of Housing and Urban Development (HUD) had a line item for the following:

   Subsidy for middle-to-high income individuals to pay mortgage interest on their vacation home

 If that line was in the HUD budget, I feel quite confidant that the subsidy (deduction) for mortgage interest on a second home would be gone! 

So perhaps a different presentation is needed for tax expenditures so the public can see how they would look if instead of providing these special benefits via reduced tax bills, they were provided by checks written to the beneficiaries.

What do you think?


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