Everyone supports tax reform in the abstract, but not the specifics

One of the issues that Washington pundits think the president and the Republican Congress might work together on is tax reform. Good luck.

Most people agree that tax reform should make the tax system simpler and fairer. Ideally, most people should be able to do their own tax returns without the help of tax lawyers and accountants. Today, with software like TurboTax, filing a return has become simpler for most people, but it can still takes days to gather all the paperwork and enter the numbers.

Making the tax system fairer involves seeking what economists call horizontal and vertical equity. Horizontal equity means that people with the same income pay the same amount in taxes. Vertical equity means that people with more income pay more taxes.

Conservatives argue that vertical equity can be fulfilled with a flat tax because the rich will still pay more, but liberals would want a progressive tax system where the rates are higher for the rich than for those with low incomes.

Tax reform gets high support in the polls that politicians watch, and as a result, members of Congress are eloquent in describing their commitment to it. Democrats want to use the revenue raised through closing loopholes to support social programs. Republicans will support closing loopholes only if the revenue is used to lower tax rates. Optimists think some compromise could be worked out here.

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But the real problem is that everyone supports tax reform in the abstract, but once you get specific, support vanishes. Any tax break that a taxpayer uses is not a loophole in his mind -- it is his God-given right: A loophole is a tax break used by someone else, not me. And even if I do not use a particular tax break, I might someday, so don't touch it.

Another reason closing loopholes is difficult is that those few supporting the loophole are very active while those indifferent or opposed to it are passive. It is simple economics. A loophole might mean thousands or millions of dollars to individual beneficiaries, but if it is closed and the money distributed to all taxpayers, it might mean only pennies or, at most, a few dollars. The result is that Congress hears from those who oppose closing particular loopholes but not from those who would benefit.

When it comes to the personal income tax, there are also sacred cows that no politician is brave enough to attack: the deduction for interest on home mortgages and the deduction for state and local taxes. Not only do homeowners want to keep these deductions, but bankers, developers, construction workers, real estate agents, and state and local politicians will also fight to protect them.

The possibility of going after the mortgage interest deduction today during a housing slump is near impossible. Even attempts to cut out the interest deduction on vacation homes ran into problems so that the tax code still allows interest deductions for two qualified homes.

While President Barack Obama has not gone after these deductions, he has gone after the other elephant in the tax code: reduced taxes on capital gains income. Capital gains -- the increased value of an asset (stock, land, etc.) -- is taxed only when an asset is sold, and then at a lower rate than ordinary income.

For example, if you invest $10,000 in a bond that pays 5 percent interest each year, you will pay taxes on this interest as ordinary income each year. However, if you invest $10,000 in an asset (land, art work, stock, etc.) that appreciates in value by 5 percent each year, you will not pay any taxes on that increased wealth until you sell it, and then the tax will be lower than the tax on ordinary income. If you die before you sell it, your heirs will not pay any taxes on that increase.

As a result, very wealthy people prefer capital gains to ordinary income because it allows them to avoid taxes. This leads them to tax shelters, whose primary purpose is to convert ordinary income into capital gains. Tax shelters are especially attractive to high-income movie stars, athletes, doctors, lawyers and CEOs.

The tax system can also lock investors into assets they don't really want because they don't want to pay taxes on capital gains when they sell. While conservatives trumpet the importance of the market, the capital gains loophole tells investors to pay attention to the tax code not the market.

There is zero likelihood that Republicans will support the president's proposal to increase taxes on capital gains. The truth is that it could not even have passed in last year's Democrat-controlled Senate. That is why he waited until the Republicans controlled the Senate before offering his proposal.

Reforming the capital gains taxation is anathema to major donors to both Republican and Democratic campaigns. They hate the idea. Obama can make this proposal now because he is not running for office again.

But the truth is that unless preferential treatment of capital gains, the mortgage deduction, and the state and local tax deduction are dealt with, there will not be any significant cut in tax rates if tax reform is going to be revenue neutral. The remaining tax loopholes simply don't offer enough money. This is why politicians only talk about tax reform in the abstract.

What about the corporate income tax? Here the tax system is tilted in favor of capital intensive industries, banks, oil companies, and companies with investments abroad. Labor intensive industries pay a higher percentage of their income in taxes. This of course makes no sense if we are trying to encourage employment. Getting rid of the loopholes and lowering the corporate tax rate would level the playing field, but while corporate America wants lower tax rates, no one steps forward to support closing loopholes, even those of another industry.

Currently, the tax system encourages corporations to replace workers with machines. Suppose the number-crunchers tell a CEO that it will cost him $1 million a year for the next 10 years to accomplish a task, and he can do it with either equipment or with workers at the same price. The corporate tax code with tax credits and rapid depreciation will encourage him to use equipment, while the employer share of the payroll tax (financing Social Security and Medicare) on salaries will make it more expensive to use workers. Plus machines do not complain or form unions. It's a no-brainer. The CEO will go for the machines rather than workers.

The negative impact of payroll taxes on employment is one reason why a number of economists would like to see the employee and employer payroll taxes replaced by a value-added tax like the one in Europe. The problem is that a VAT is too much like a federal sales tax to get political support in the U.S. 

One last tax proposal making the rounds in Washington is the idea of replacing the corporate tax with a carbon tax raising the same amount of money. Corporate America would be happy to see the corporate tax go away, while a carbon tax would reduce the amount of carbon going into the atmosphere and slow down global warming.

Would a coalition of environmentalists and corporate America support such a move? That would certainly be an unusual alliance for Washington. Corporate America would have to deliver the Republicans and the environmentalists would have to deliver the Democrats. It is a fascinating idea, but don't hold your breath. The more likely scenario in Washington is that nothing will happen. 

[Jesuit Fr. Thomas Reese is a senior analyst for NCR and author of Inside the Vatican: The Politics and Organization of the Catholic Church. His email address is treesesj@ncronline.org. Follow him on Twitter: @ThomasReeseSJ.]

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