Closing Loopholes Better Fix Than Tax Hike

Republicans and Democrats disagree on how to lower the deficit rather than raising the debt ceiling; President Obama argues raising federal taxes is necessary and Republicans have promised …

Republicans and Democrats disagree on how to lower the deficit rather than raising the debt ceiling; President Obama argues raising federal taxes is necessary and Republicans have promised to block such a move. Some economists believe, however, that eliminating deductions would better increase tax revenue without pushing people to simply alter behavior to avoid higher federal taxes. Suggestions include eliminating the deduction for charitable contributions and deductions on home-mortgage interest. For more on this continue reading the following article from Money Morning.

As the debt-ceiling debate escalates, U.S President Barack Obama says federal tax increases are necessary to close the U.S. budget deficit.

Although Republicans then said that tax hikes were “off the table,” this statement is reminiscent of a toddler who threatens to hold his breath until he turns blue if you make him eat spinach.

Given that our elected leaders in Congress just can’t seem to curb their spending addiction, the unpleasant reality is that some types of tax hikes are essentially inevitable.

Truth be told, I can show you three tax increases that should be enacted.

As a taxpayer, that statement will probably make you wince in anticipated pain.

But once I’ve made my case, I’m betting that the investor in you will agree that these three federal tax increases could save the U.S. economic recovery.

Let’s take a look …

Federal Tax Increases We Don’t Want to See

If we ignore the debt-ceiling debate (and the Aug. 2 deadline for increasing the ceiling) for a minute, and just consider the health and welfare of the U.S. economy, we can see that there are a number of federal tax increases that would be highly counterproductive.

One example: boosting the corporate tax rate above 35%.

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Except for Japan, the United States already has the highest corporate tax rate in the Organisation for Economic Co-operation and Development (OECD). Corporations don’t pay much tax because they are able to keep profits overseas in tax-free jurisdictions and employ leasing and other tax breaks. It would make much more sense to lower the corporate tax rate – perhaps to 30% – and close many of the loopholes so that the “yield” (what’s actually collected) is the same or perhaps even a little higher.

Similarly, it makes no sense to increase the 15% tax on dividend income. Dividends are paid by corporations out of their after-tax income. The levy on dividends – paid by the company’s shareholders – means those companies actually suffer from a “double-taxation” rate of about 47%.

This encourages companies to fool around with stock options, repurchase agreements and with overpriced acquisitions, thus ripping off ordinary shareholders and reducing the economy’s efficiency.

The best system would be to make dividends fully tax-deductible at the corporate level – just like debt interest – and then tax them as ordinary income at the individual level. We would benefit as investors and shareholders, because it would put more money in our pocket. That would make us very hostile to tax shelters and other management gambits – which at the end of the day would very likely increase overall tax yields.

Increasing individual rates of income tax and capital gains tax is also economically inefficient, but less so.

Learning From the Laffer Curve

The Laffer Curve is a way of demonstrating the relationship between government tax revenue and tax rates. According to Arthur Laffer, tax-rate increases decrease the taxes’ yield below what you would expect.

That’s a very important truth. But there’s a bit of a catch.

In the Laffer Curve’s extreme form, where you actually get less money when you increase tax rates, it’s only true at very high rates.

At lower tax rates, the Laffer Curve is much less effective. The Laffer Curve effect for increasing capital-gains tax from 15% to 20% would be modest, reducing the additional revenue only slightly below that expected by simple proportionality arithmetic.

The Laffer Curve bends at lower rates for capital gains than it does for income tax: That’s why the 35% capital-gains-tax rate of the 1970s appears to have yielded less than the 28% rate that succeeded it.

We saw a similar effect in 2001, when the top income tax rate was reduced from 39.6% to 35%. The Laffer Curve offsetting revenue gain was modest.

Since 2001, however, Congress has added a Medicare surtax, and from 2014 onward there’s an additional 3.8% surtax on top investment incomes.

When you include state taxes (which have also risen in many cases), high-income taxpayers are now subject to a top rate of more than 50%. At that point, the Laffer Curve effect substantially reduces the additional income from tax rate increases, though it probably does not eliminate it altogether.

That means that restoring the pre-Bush administration (II) rates on top incomes will produce much less revenue than is being predicted by the computer models that Congress is using.

And it will mess up the economy, too.

The Three Federal Tax Increases We Need to See

There is no Laffer Curve effect from closing loopholes. As an extreme case, the Republicans would like to end $6 billion in annual subsidies for ethanol producers. That will produce substantial additional revenue, including revenue from gasoline taxes as oil refiners change the mix they sell to gas stations. It will also make the economy more efficient, not less, effectively reducing a wasteful farm subsidy.

The same applies to several “tax preferences” in the tax code for individuals. The largest of these are the tax deductions for state and local taxes, home-mortgage interest, charitable contributions, health-insurance premiums and pension contributions.

Of that group, the following three deductions could be eliminated – thereby serving as three tax increases that could help save the U.S. economy:

  • The tax deduction for home-mortgage interest cost $89 billion in the 12 months that end in September. It benefits mostly those living in high-cost areas: At today’s interest rates the deduction on a 4.5%, $300,000 mortgage is only $13,500, barely enough to make it worth “itemizing” for those with no other major deductions. Eliminating the deduction would reduce house prices in high-cost areas, and push the wealthy into investing in productive industry – instead of in vulgar “McMansions.” It should go.
  • The tax deduction for state and local taxes costs the government $38 billion. And the tax exemption on municipal-bond interest costs an additional $31 billion. I’m of two minds here: Eliminating these deductions would push people to move to lower-tax states, increasing the out-migration from California and New York – and as a New York resident, I object to this! On the other hand, the tax exemption for municipal-bond interest pushes municipal bonds into their own little market, separate from the corporate bond market. It’s thus very inefficient. The federal government would save money by abolishing the exemption and paying (preferably somewhat less) money directly to the states.
  • The tax deduction for charitable contributions costs $50 billion. And various other tax privileges for charities cost the federal government an additional $50 billion or more. These are the tax preferences I would eliminate first. The idea that some Wall Street trader can tax-deduct his $1,000 charitable dinner that boosts his flashy social life is deeply offensive. Members of the super-rich set take huge advantage of this deduction, while normal people are much less able to do so. There are many charities that do great work. Unfortunately, there are just enough “charities” that are actually either scams, huge pointless bureaucracies or leftist political activism thinly disguised to conclude that the economy would hugely benefit by shrinkage of this sector. At the very least, this deduction should be limited to the 28% tax rate, so that the millionaire’s charitable dinner is treated the same as the middle-class donation to his church.

The other two deductions, although even more expensive, are I think justified:

  • The health-insurance contributions deduction cost $174 billion in 2011. Eliminating it would “level the playing field” between employer-provided and self-provided health insurance, which is a good thing. However, increasing the net cost of everyone’s health insurance is highly unattractive – it’s not as if people incur healthcare expenses for fun. I’d be in favor of a tax credit – as opposed to a tax deduction – that would “level the playing field” without impoverishing those with poor health.
  • Last, but not least, are the pension, 401(K) and IRA deductions that cost the government $120 billion. No doubt here – I would keep these: They encourage saving, which God knows the U.S. economy needs.

So if you are frustrated by everything you’re reading about the debt-ceiling debate, write your congressional representative, and tell him or her: If you must increase taxes, do it by cutting out the home-mortgage and charitable deductions, other “corporate welfare” loopholes and the tax exemption for municipal-bond interest.

These increases would actually help the economy, or at worst be neutral; other federal tax increases would be damaging to this feeble recovery – some of them hugely so.

This article was republished with permission from Money Morning.

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