A Stitch in Haste

The President’s Advisory Panel on Federal Tax Reform is charged with presenting a report, by September 30, with proposals to simplify the federal income tax.

The panel’s work has led to debates over fancy-sounding alternatives such as “flat tax,” “fair tax” and “consumption tax.”

A huge problem with the federal income tax (besides of course the fact that it’s too high) is that it is too riddled with special provisions to special interests, groups that use their influence and resources to buy from politicians particular credits, exemptions and deductions. Some call this “rent seeking,” while others call it “corruption.” I call it the Politics of Pull.

But the real question, the one that most taxpayers care about, are not the individualized provisions of the tax code that unfairly benefit farmers or oil companies or auto manufacturers, but the broader provisions that affect large swaths of the taxpayer base. People may be annoyed about whatever tax breaks Halliburton may be getting, but they care far more about the tax breaks that they themselves have received in the past and hope to receive in the future. If the Advisory Panel recommends eliminating huge chunks of the Internal Revenue Code that only apply to small chunks of the economy, Main Street America won’t really care. But propose tinkering with their tax returns and the Panel’s work will occupy quite a few news cycles, op-eds and blogposts.

“Tax reform” and “middle class America” really only intersect at two points: the deductibility of state and local taxes, and the deductiblity of mortgage interest. In anticipation of the Panel’s report, here are some hasty stitches on those two major topics.

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The nonpartisan Urban Institute has analyzed the potential impact of eliminating the deductibility of state and local taxes from federal income taxes. Bottom line, there would likely be little impact: about $65-70 billion in tax receipts are lost from the deduction.

This is actually not surprising. Consider:

–The poor pay no income tax to begin with (the lower 50% of households by income pay no income tax at all).

–The lower middle class tend not to itemize their deductions and opt instead for the standard deduction, so their state and local taxes become moot.

–The rich already can’t deduct state and local taxes either, because of either the progressive reduction in deductions built into the tax code, or the Alternative Minimum Tax, which does not allow the deduction at all.

–Those who live in no-tax/low-tax states of course receive little benefit from the deduction as well.

Bottom line, only upper middle class taxpayers in high-tax states receive any benefit from the deduction. In fact, New York and California alone account for 20% of tax returns claiming the deduction.

Which, as the Urban Institute observes, invites a intriguing possibility: Eliminate the deduction of state and local taxes while also eliminating the Alternative Minimum Tax. Such an move would be relatively revenue-neutral (UI estimates that tax receipts would increase by a nominal $21.4 billion in 2006) and could be politically viable (e.g., all us rich New Yorkers wouldn’t care, since it would be essentially a wash). The increasing resentment toward the AMT, even just on grounds of the extra time and paperwork, could make such a proposal palatable, despite the likely knee-jerk reaction to the elimination of a “sacred cow” deduction.

Such a plan could be dismissed as a Hobson’s Choice, but with AMT liability set to explode starting in 2006, this reform could be successfully sold to taxpayers. On the other hand, this Administration has been especially pathetic at selling Social Security reform, so who knows.

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The other “sacred cow” tax deduction is the write-off for mortgage interest on a primary residence. The President imposed the following constraint on the Panel:

“Options should…share the burdens and benefits of the Federal tax structure in an appropriately progressive manner while recognizing the importance of homeownership and charity in American society…”

Some have interpreted this to mean that the mortgage interest deduction is off the table, but as the Tax Foundation, reports, others are not so sure:

Linda Goold, tax counsel for the National Association of Realtors, said it’s possible that the tax panel may recommend replacing the interest deduction with a tax credit that would be more beneficial to lower-income Americans. They usually don’t have enough deductions to justify itemizing, a prerequisite for taking advantage of the mortgage interest deduction.

The Tax Foundation is ambivalent:

Unfortunately, that would make a bad tax policy worse by likely carving even more out of the federal tax base, requiring higher overall tax rates, and further entrenching its political support, all of which make fundamental tax reform even more difficult than it already is.

They would rather see no tax benefits of any kind, with lower tax rates for all instead.

I can certainly sympathize — as I have blogged previously, “take care of tax rates and tax simplification will take care of itself.” But there’s another consideration, both economic and moral, that makes eliminating the existing deductibility of mortgage interest problematic.

Yes, tax policy distorts economic decisions, and subsidies (which tax deductions essentially are) result in overconsumption (housing bubble, anyone?). But even greater distortions and misallocations can result from breaking the promise of deductibility for those who have already financed homes.

There’s a analogy in the law that makes my point. All lawyers and many lay people know that a mere promise, without more, is not a contract and is not enforceable as a contract, with one important exception: the case of detrimental reliance.

Here’s an example of detrimental reliance. Let’s say an impoverished nephew earns a partial scholarship to attend a particular private university. His rich uncle promises instead to pay in full for the nephew to attend the uncle’s alma mater. The nephew turns down the partial scholarship and enrolls in the uncle’s college. There is no contract and the nephew is under no obligation to the uncle, who is merely making a promise. Halfway through the nephew’s education, the uncle changes his mind and cuts the nephew off. Can the nephew sue the uncle for the remaining tuition even though there was no contract? Yes! If the nephew reasonably relied, to his detriment, on the uncle’s promise, then that promise is legally binding even in the absence of a contract.

When it comes to the deductibility of mortgage interest, the law may be different from the nephew-uncle example, but the logic isn’t. It is fundamentally unfair to induce taxpayers to purchase and finance a home based in part on the current tax code, and then suddenly change the rules on them in the name of “tax reform.” Eliminating mortgage interest deductibility would be far more disruptive to many taxpayers than tweaking their marginal rates or removing some minor deduction. It must not be done lightly.

I don’t know what the answer is and I am not saying that mortgage interest should indeed be a “sacred cow” within the tax code. Grandfathering existing mortgages is probably unworkable and is arguably even more unfair than the detrimental reliance problem. Perhaps the “credit instead of deduction” idea could be structured in a fair way for existing mortgage payers. I don’t know.

But I do know that it is incomplete to lament only the macroeconomic effects of a tax policy going forward while ignoring the impact of changing that tax policy on those who have already made life-altering decisions in reliance on it. And to do so in the name of a “fair tax” is especially obnoxious. The Internal Revenue Code may not have to be permanently immutable, but neither should it be a crap-shoot.

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Finally, there are some who think the Panel may propose a national sales tax or consumption tax. I certainly hope not.

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UPDATE: In the aftermath of Katrina, the Commission has delayed the release of their report until the end of October.

Similar Posts:

• Tax Reform Panel: Lots of Bitter, Lots of Sweet
• More on the Tax Reform Panel Recommendations
• Tax Reform = Higher, More Complicated Taxes
• Tax Reform — The Example of the Blind
• More on the Deductibility of State & Local Taxes

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