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April 15, 1991
"Today's the Day to Figure how to Make Taxes Lower - Room for Reform"
San Jose Mercury News

By Timothy Taylor
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TAXES hinder the economy, like leeches hanging on a body.

Sorry if the analogy is a little gory. In keeping with a proud family tradition of suffering rather than hiring help, I fill out my own income tax forms, an activity that creates a certain amount of bitterness this time of year.

As an example, consider the case of a married Californian, filing separately. For every $100 that person earns over $40,000, he or she will pay $33 in federal income tax and $9.30 in state tax. That doesn't include Social Security and about $7 (depending on county of residence) in state sales taxes, if the money is spent. In total, less than half of the additional $100 can actually be spent for personal consumption.

To reduce the drag of taxes on incentives to work and buy, it's necessary to cut tax rates.

Let's assume we want to keep the same level of government spending. To cut tax rates, then, means finding a way to tax income currently excluded from taxation, so that the net revenue, even with a lower tax rate, stays the same.

From this viewpoint, the enemy is well-defined. When special breaks are available to some taxpayers, everyone else needs to pay higher rates to make up the difference.

Attacking tax breaks has an additional bonus of greater fairness, as well. It makes a person's income tax burden depend more on true economic income than on whether the income is mostly salary, or fringe benefits, or stock dividends or interest from municipal bonds.

Of course, fairness often resides in the eye of the beholder. Rather than loading the rhetorical dice by writing of "tax loopholes," the federal budget provides a chart of "tax expenditures," which are benefits or programs supported by tax breaks rather than by direct federal spending. There are 128 tax expenditure items for the individual income tax listed in the Bush administration's recently proposed budget. Fifty of them cost the government over $1 billion per year.

In total, tax expenditures will cost nearly $400 billion in 1991. To put that number in perspective, the entire individual income tax will collect only $493 billion this year. The largest tax expenditures, accounting for nearly three-fourths of the total cost, are listed in the table.

Clearly, there should be room to scale back or eliminate at least some tax expenditures and use the money for reducing overall tax rates. Each of us would regret losing particular tax breaks, of course, but the overall result will be greater fairness and lower tax rates for everyone.

This agenda for tax reform may sound familiar, because it was the approach taken by the Tax Reform Act of 1986. By eliminating tax breaks, that bill allowed the top federal income tax rate to be cut from 50 percent to 28 percent, thus making taxes less intrusive for the economy and giving taxpayers less incentive to play games on their returns.

In addition, Joseph Pechman of The Brookings Institution calculated that the 1986 Tax Reform Act also took 5 million poor people off the tax rolls, and moved a greater share of the tax burden to the wealthy.

Consider some of the arguments for reducing or removing some of the tax expenditures on the nearby table.

Employer contributions to pension plans and to medical care are excluded from income taxation, thus costing the government about $100 billion. But why should people lucky enough to work for a (usually large and stable) company that offers such fringe benefits pay less for medical care and retirement (because they don't pay taxes on the money used to buy them) than those who work in other jobs?

Why are only a part of Social Security benefits taxed as income, even when they are received by elderly people who are also wealthy?

Why should the (relatively prosperous) taxpayers who itemize deductions get a tax break for charitable contributions and for their state and local taxes, while the (relatively poor) taxpayers who don't itemize must contribute to charities and pay state and local taxes without any break?

Why should those who are wealthy enough to own homes be showered with tax breaks -- deducting interest on mortgages, deducting property taxes, using their capital gain from owning one home as an untaxed down payment on a next home -- while the relatively poor people who rent apartments get no such benefits?

Why should someone who inherits an item on which there has been a capital gain be able to avoid paying any tax on that capital gain?

Frankly, even if I were economic dictator for a day, I'm far from sure that I would rigorously follow these questions to their logical conclusions. But surely, some changes are in order.

If the government were to reduce tax expenditures by some tens of billions of dollars, it could then take millions more of the poor and near-poor off the tax rolls altogether, while cutting tax rates across the board. The point would not be to raise total tax collections -- remember, the Tax Reform Act of 1986 was explicitly revenue-neutral -- but instead to collect income taxes in a more fair and less economically disruptive way.

I can hear the complaints already, about how these tax breaks are essential. About how this whole concept of tax reform is politically impossible. And stupid. And pointless.

But remember, a reform that broadened the income tax base, cut tax rates, and moved the tax burden toward the rich was was carried out in 1986. It could be done again.

Here is a list of the largest tax expenditures in 1991, and how much each costs the government in lost revenue.

  • Exclusion of employer contributions to pension plans $64.0 billion
  • Deductibility of mortgage interest on owner-occupied homes $37.6 billion (box)Exclusion of employer contributions for medical insurance and care $36.3 billion
  • Step-up basis of capital gains at death $32.7 billion
  • Deductibility of state and local taxes $19.4 billion
  • Accelerated depreciation of machinery and equipment $18.2 billion
  • Exclusion of Social Security benefits for retired workers $17.0 billion
  • Exclusion of interest on public purpose state and local debt $15.9 billion (box)Deductibility of charitable contributions $15.7 billion
  • Deferral of capital gains on home sales $13.3 billion
  • Deductibility of state and local property tax on owner- occupied homes $10.5 billion

Source: Budget of the United States Government, Fiscal Year 1992, Table XI-1.

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