The so‐called Fiscal Cliff has triggered a debate over tax increases versus cuts. Yet the biggest problem remains over‐spending. Unfortunately, no one who proposes raising taxes to their Clinton‐era levels suggests lowering expenditures to their Clinton‐level levels. The political class wants more revenues to support more outlays.
In the coming decades taxes will remain at their historic percentage of GDP even if all of the Bush tax cuts survive. It is runaway spending which threatens to drown Americans in a tsunami of debt.
Whatever happens to spending, Americans would benefit from genuine tax reform. It is important not only to lower marginal tax rates, but to minimize government social engineering via the Internal Revenue Service.
The basic premise of tax reform is to trade off tax rates and revenue base. Reduce deductions and credits in return for dropping rates. That’s how the 1986 tax reform worked.
The most obvious benefit of this approach is to encourage economic growth. In a new study for the Tax Foundation William McBride reported that higher levies reduce growth. He reviewed 26 studies since 1983: “All but three of those studies, and every study in the last fifteen years, find a negative effect of taxes on growth.”
Marginal rates are particularly important because they affect decisions to work and invest. If the government takes 90 percent of any additional dollar earned, you are far more likely to go on a lengthy fishing trip, buy an expensive new toy, or create a bizarrely inefficient tax shelter. The incentive to consume more and spend more time enjoying that consumption as well as to engage in tax avoidance rises with income.
Of course, economic growth is not everything. But it makes little sense to impose confiscatory tax rates which would collect little revenue while discouraging economic activity. Alas, politicians are ever ready to satisfy people’s envy if they believe doing so will win a few votes in the next election, even if we all end up worse off.
However, tax reform should have another, equally important, objective: reduce government social engineering. Deductions, credits, and other preferences obviously have a political role. They act as expensive special interest pay‐offs, hidden subsidies which avoid the scrutiny usually applied to appropriations.
To be sure, tax reductions should not be treated like expenditures. Allowing you to keep more of your money is very different from taking someone else’s money and giving it to you. However, the narrower the deduction — a big write‐off available to only one industry, company, or person — looks a lot like a direct pay‐off.
But there is another negative impact of a tax code filled with a mix of obvious and obscure preferences. Washington is manipulating behavior just as surely as if it was imposing legal requirements.
There’s still a difference since you can say no. That’s why Obamacare’s insurance mandate could not be justified as an analog of a tax deduction for purchasing a health care policy. Mandating that you do something is different from cutting your taxes if you do something. Nevertheless, one reason politicians love today’s horrid tax code is because they can use it to get a lot of us, at least, to do what they want instead of what we would want, all other things being equal.
This tax manipulation has created some of our worst policy problems. Leaving fringe benefits, including health insurance, untaxed has encouraged companies to shift a greater share of compensation away from wages. So employers rather than employees control the latter’s health insurance. Moreover, insurance has gone from catastrophic to comprehensive, essentially becoming the prepayment of medical expenses. Today roughly 90 percent of medical expenses are paid in the first instance by someone else, government or insurer, fueling health care costs. It would be far better if all compensation was taxed equally at a lower rate, allowing workers to decide how much to spend on what kind of policy.
Realtors en masse would commit ritual seppuku if the mortgage interest deduction was eliminated. However, it was massive government support for the housing industry through the mortgage deduction, rules such as the Community Reinvestment Act, and a multitude of subsidy programs that created the property bubble which burst so disastrously in 2008. Houses are nice. I own one. But there is no public justification for effectively lowering the cost of home ownership via the tax code. Charge everyone less tax and let them decide how to spend their income — whether to buy or rent, and, more basically, whether to put their money into real estate or something else, such as automobiles, art, boats, wine, or travel.
There is no good argument for the state and local tax deduction, which effectively subsidizes other big‐spending, big‐taxing jurisdictions. Connecticut, New Jersey, New York, California, and similar wastrals should suffer the full consequences of their profligacy. There are several tax breaks for kids. As a bachelor, I suppose I’m biased, but why should politicians use the tax code to reduce the cost of child‐bearing?
Even the charitable deduction deserves to be tossed into the policy dustbin. The end, more money for churches, soup kitchens, and symphonies, is worthy. However, people should give because they believe in the cause, not because the government lessens the cost of giving.
Of course, nonprofit organizations react with near hysteria at the prospect of having to rely on people’s generosity alone. Diana Aviv, president of the Independent Sector, warned of “potentially catastrophic consequences for groups that do good.” She offered the oxymoron of “a government incentive to sacrifice on behalf of the commonweal,” which seems to miss the real meaning of sacrifice. Yale Professor Robert J. Shiller wrote of Americans’ “deep tradition of giving to others” — which actually began long before there was an income tax, let alone an income tax deduction for charitable contributions.
Ironically, evidence suggests that the write‐off does more to affect the timing than amount of charitable giving. My Cato Institute colleague Dan Mitchell recently pointed out that “charitable giving tends to hover around two percent of U.S. gross domestic product, no matter what the incentive.” Even the dramatic reduction in the top income tax rate under Ronald Reagan, which reduced the value of deductions, did not markedly lower contributions from the extremely wealthy. This counter‐intuitive result may reflect the strong cultural and religious pressure to give, and the fact that the Biblical tithe, against which many people measure their donations, says nothing of pre‐ or post‐tax dollars.
Another argument is that private contributions reduce the need for government welfare. However, whatever the logical connection between the two, there appears to be no political relationship. The welfare state expanded even as evidence grew that many public programs actually harmed the poor, creating dependency, discouraging work, destroying families, and disabling communities. Nor was there any government retrenchment no matter how much people gave privately.
Indeed, if charitable organizations want to preserve “their” deduction, they should propose letting taxpayers choose between private charity and government welfare. Make a deduction (or take a credit), and simultaneously reduce public spending by the same amount. In effect, the more people gave privately, the less would be taken from them coercively for the same purpose. Indeed, the biggest incentive to give then might not be the financial benefit but the satisfaction of shrinking government.
Of course, the fact that tax write‐offs are bad policy doesn’t reduce their political appeal. Ronald Reagan refused to take on most of them in 1986 for that reason (he tried but lost on state and local taxes). That doesn’t mean an effort shouldn’t be made, however. Bloomberg columnist Ramesh Ponnuru complained of the health insurance exclusion: “We have had this break for an awfully long time, though. It would be disruptive, as well as unpopular, to get rid of it.”
Yet any policy change would be disruptive — whether raising tax rates or expanding the revenue base. And any change would be unpopular, at least to those benefiting from it. That’s no reason not to push for better policy. And it might be possible to make far‐reaching changes politically palatable by lowering rates enough to convince taxpayers to give up their favorite deductions and credits. Most people would like to have more money to spend and to do so without being pushed and pulled by government in response to the latest political winds in Washington.
Taxes should be lower and simpler. That requires cutting spending. It also requires getting government out of the social engineering business. Neither will be easy. Both are necessary if we ever want to live in a truly free society.