Browsing the blog archives for October, 2017.

What is a legitimate tax deduction?

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With this week’s passing of a budget blueprint, it looks like several contentious tax deductions could be potential sticking points as things move forward. I favor a flat or fair (sales) tax at a lower rate for everyone without deductions, but there’s a rational way to assess deductions if you must have some. Most of them don’t pass muster.

The first thing to keep in mind is that every deduction must be coupled with higher tax rates to generate the same revenue. Therefore, supporting a deduction means that you are also supporting a higher rate for those who cannot claim it.

For example, the mortgage interest deduction allows taxpayers who purchase homes to pay less in taxes at the expense of their neighbors who purchase cheaper homes or rent instead. Proponents claim that it promoted home ownership, but politicians should not be crafting tax codes to reward one group at the expense of another. We’re addicted to this one, but it should be phased out.

Consider the state and local income tax deduction, which reduces taxable income by the amount paid in state and local taxes. With this deduction, a taxpayer in a 30% federal bracket reduces his or her taxes by 30% of the amount paid locally, favoring those in high-tax locations like New York, New Jersey, and California, at the expense of Americans in other states. Like the mortgage interest deduction, there’s no rational basis for this one either.

There are a few rational deductions, however. Consider charitable contributions. When you contribute a dollar to charity, you are assigning the income to that organization. You receive no direct benefit from the dollar, so it’s reasonable that are not taxed for it. Likewise, 401(k) contributions assign your income today to a future period. It’s rational that you should be able to defer the taxes you pay into the future as well.

There are exceptions, but if you apply basic logic and rationality, most deductions in the tax code fall short. Unfortunately, the current debates focus on who’s losing what instead of the legitimacy of the deduction. For example, proponents of the state and local income tax deduction argue that taxpayers in certain states won’t get much of a tax cut if this deduction is eliminated. This artificial standard assumes that tax reform would reduce everyone’s taxes proportionally, but the only way to do this is to retain all of the deductions. This is why a tax cut is likely to pass, real reform is not, and a tax cut without meaningful reform would continue the ongoing back-and-forth shift that increases the burden on the most productive and creates a growing percentage of non-payers.

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Tax Reform vs. Tax Cuts

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Several weeks ago, I argued for the importance of tax reform, not just tax cuts. Since then, I’ve been listening closely to various politicians opine on the subject. When asked by reporters about their position on tax reform, many refer only to tax cuts in their response. The conversation usually goes something like this:

Reporter: Senator XXX, President Trump is calling for major tax reform. What is your position on this issue, and how likely is it that Congress will pass reform legislation?

Senator X: The American people need a tax cut and we need to get to work to make that happen. The focus should be on the middle class…

Perhaps I the only one who notices that many politicians discuss tax cuts when asked about tax reform. Are they using the terms interchangeably or are they trying to change the subject? Am I paranoid, or is something going on behind the scenes?

There is a real difference between tax reform and tax cuts. Most politicians know the difference and would rather steer clear of reform. And yes, I think something is going on behind the scenes. When asked specifically about tax reform—such as eliminating deductions for state and local income taxes—most Republicans get weak-kneed and refer to “many ideas on the table.”

Tax reform is about how the government collect taxes. It involves simplification of the system and eliminating deductions in exchange for lower rates across the board. It means standing up to special interest groups that beg for subsidies through the tax code for their industries, whether it be manufacturers of solar panels “promoting green energy” or realtors “pursuing the American dream of home ownership.” Real tax reform would reduce Washington’s influence in our lives, but passing it requires backbone. Every provision in the tax code benefits one group at another’s expense. Net losers from real reform won’t go down without a fight.

A tax cut is about how much the government collects. A broad tax cut is needed, but beware. Discussions about tax cuts pit one group against another. In order to pass political muster, cuts usually favor lower to middle income groups. Consider that tax increases usually hit upper income earners for the same reason and the cycle becomes clear. With alternating cuts and increases over time, the tax burden has shifted so that half of Americans don’t even pay federal income taxes any more, and many of the non-payers actually receive money through tax programs like EITC. This is why a tax cut without real tax reform is a mixed bag at best, and could be a net negative when a future Democratic Congress undoes the cut in a way that further shifts the burden.

Perhaps I’m just paranoid, but we will find out in the next few weeks.

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