Tax Fantasies

Benjamin Franklin coined a popular idiom when he wrote “In this world, nothing can be said to be certain, except death and taxes.” While both are certainly inevitable in this modern world, the latter can be made a little more bearable. By passing a budget through the House, the GOP hopes to do just that. The goal is to make taxes simpler for more Americans, while also taking some actions that economists agree are much needed. However, these tax changes have serious consequences and will certainly face challenges going forward. So what exactly is the GOP trying to do?

First, a quick primer on tax deductions. A tax deduction is simply the government giving people a break by allowing them to subtract certain expenses from their taxable income. When American citizens file their taxes, they have two options. They can either go through their income and spending for the year and individually itemize their deduction, or just take the standard deduction and move on. Itemization takes more work and usually requires a tax accountant, but it can lead to a larger deduction than the standard amount if a person engages in certain spending, such as charitable donations. As of 2013, according to the Tax Foundation, 68.5% of households took the standard deduction, while 30.1% took the itemized. Interestingly, they also found that as incomes increased, so does the chance that a person itemized their deduction.

This is where the GOP tax bill comes in. The biggest difference between the current system and the one proposed is that the standard deductions for both individuals and married couples would nearly double, while also eliminating many itemized deductions that are inefficient and create perverse economic incentives that distort behavior. The bill also reduces the income tax brackets down from seven to four, with the highest bracket becoming a “millionaire rate.” The change would greatly simplify taxes for millions of Americans, as more take advantage of the higher standard deduction. However, the eliminated deductions have some serious supporters.

The most contentious deduction on the block is for state and local taxes. This is the reason 20 House Republicans voted against the budget. The idea behind the deduction originally was that the government should not tax a person’s income twice. Besides the fact that it is different governments imposing taxes for different ends, the deduction is further unfounded because of the incredible distortion it creates. By allowing people to write off the income they pay in state and local taxes, it provides incentive to move to high-tax states, for no other reason than a larger deduction. This effectively grants a subsidy to those living in high-tax states, especially the wealthy in those states, because they pay higher state and local taxes. Obviously, this deduction receives a lot of support from the people and governments of those states. The deduction significantly reduces the weight of state and local taxes, allowing governments to have high taxes in the first place.

A second category of deductions altered by the bill is interest on loans, specifically mortgages and student loans. The mortgage interest deduction is reduced to $500,000 from $1 million, while the student loan interest deduction is eliminated entirely. The purpose of these deductions was to help homeowners and students. But what they really do is encourage people to take out larger loans on houses or education, whether or not they need it, and then pay as little as possible. Again, they benefit the wealthy more as they tend to have larger mortgages and attend more expensive schools. They also have drastically increased the demand for those items, which has in turn increased prices much higher than they would be under normal conditions. If someone is willing to take a larger mortgage for their house, then why not charge a higher price? The same goes for college. Again, both deductions have staunch supporters from the people that benefit, but both have serious consequences for the rest of the country.

For that reason, all of these deductions are at or near the top of every economist’s list of things that need to change with our tax system. The associated problems are considerable and cause significant distortions in behavior. So why are they still around? That’s where something called the “transitional gains problem” comes in. When these deductions were passed into law, a select group of people immediately benefited by being able to write off a larger portion of their income. However, as time goes on, these “transitional gains” are mitigated by rising prices and shifting expectations. Meaning no one currently benefits from these tax  breaks. But removing them poses direct consequences on the interested group, while providing only a diffused, indirect benefit to the rest of society. So the group lobbies hard to keep their interests safe, then everyone else stays silent since they don’t realize what is going on, and the “protections” remain. The same thing happens with unions, trade restrictions, and other government programs. The shortsightedness of the past has trapped the present in an unbelievably inefficient system.

Is there any hope of getting these changes through? A little. Remember, the bill also doubles the standard deduction, so the number of people that itemized deductions even apply to would decrease significantly. In fact, the eliminations would hit the wealthy the hardest. But they will not go without a fight. The interests in support of the current system are loud and powerful, and they will bring everything they’ve got to keep their gains, even if it means dumping a larger burden on the rest of America. The GOP tax plan, while not perfect, is a huge step in the right direction from an economic perspective. Let’s hope it’s not all a fantasy.

A large portion of the information for this article came from “ECO 451: Economic Policy, FA-17,” Lecture on Taxation, with Dr. Jared Pincin at The King’s College, NY.


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