The Case for Removing Deductions to Increase Revenues

As it stands now, both John Boehner and Barack Obama agree that revenues need to increase as part of a deficit reduction package. How to go about increasing revenue appears to be the sticking point. Democrats would like to see the marginal tax rate for income made over $250,000 to go back to the Clinton-era level of 39%. Republicans would like to eliminate tax deductions instead. Both raise revenue, but aside from simply political bickering is there any reason to prefer one over the other?

David Frum has penned a convincing case for why reducing deductions is the better choice:

The biggest tax preference in the individual tax code is the treatment of employer-purchased health-care benefits. An employee who earns $60,000 and receives a health-insurance policy worth $8,000 pays income tax on the $60,000 but not on the $8,000. This exclusion has thrust employers into the role of main buyers of health insurance. It hides the costs of health coverage from employees and thereby makes it easier for health providers to raise fees.

The exclusion is such a bad policy that we should want to get rid of it, even if doing so wouldn’t raise a dime in extra revenue. But as it happens, the exclusion costs the Treasury an estimated $130 billion a year, only a little less than the entire cost of the U.S. Navy…

…Another large tax preference is the home-mortgage-interest deduction. This preference is justified by the claim that it promotes homeownership. Yet Canada, which doesn’t have the preference, has roughly the same home­ownership rate as the United States: a little over 60 percent.

Rather than put more people into homes, the deduction puts the same number of people into more home: before the Great Recession hit, new homes in the United States averaged 2,300 square feet; new homes in Canada, 1,800 square feet….

…Finally, there’s the deduction of state and local taxes against federal income tax. That costs $80 billion a year, or about the same as the federal Department of Education.

Why doesn’t it trigger a revolution when California raises its state income tax past 10 percent? Or when suburban communities around New York City hike property taxes to an astonishing 8 percent of median local annual income? The short answer: the people who pay the most local taxes also receive the biggest relief on their federal taxes. Ironically, as federal tax rates rise to 40 percent, the highest earners will receive an even bigger subsidy on their local taxes.

By cushioning the shock of local taxes, federal policy induces local governments to spend irresponsibly. New York state, for example, with almost exactly the same population as Florida, spends literally twice as much.

The main thrust of his argument is that deduction create distortions; healthcare inflation,  bigger houses, and less efficiencies in local and state government.

Later, I will cover the best reasons for increasing marginal rates.

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5 Responses to The Case for Removing Deductions to Increase Revenues

  1. Don’t forget the capital gains treatment, which has also crept into dividends and other forms of income. It distorts the financial markets with no evidence of any impact on economic growth, and exacerbates income disparities. Treating all income alike for tax purposes would not only raise revenue but improve the equity of the tax code, and it would be very simple to index the acquisition cost of capital assets for inflation, to prevent unfair taxation of phantom profits.

    • Thanks for your thoughtful comment. My only concern with that idea is whether or not it will discourage savings and investment. I personally feel we should tax income and savings less and consumption more. What are your thoughts on that?

      • Well, our economy is 90% domestic, so it’s mainly what we sell to each other. It might sound virtuous to discourage consumption and encourage savings, but a desire to save only translates into business investment when business forecasts demand, i.e. when consumption is healthy. Paradoxical, eh? I have a couple of posts on this. The key thing to remember is that what we commonly call ‘savings and investment’ is not business investment at all, but merely buying and selling assets.

  2. john zande says:

    I feel sorry for Frum. He seems to be a man without a Party.

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