The Corner

Economy & Business

Special Interests Are about to Score Big on Bipartisan Tax Breaks

It’s that time of year again: The time when we see commitments to fiscal responsibility in Congress go out the window. First, there is the horrible transportation conference bill, which will end up costing more than both the House and Senate versions. For more information, read this good summary by the Heritage Foundation’s Michael Sargent. Second, there is the renewal of the crony Ex-Im Bank, proving that the business lobby is still in charge in the Republican-controlled House and Senate.

Finally, there is the ridiculous $800 billion tax-extenders package going through Congress right now. Politico reports:

Congress is eyeing a year-end budget-busting tax cut blowout.

Lawmakers’ latest effort to renew a hodgepodge of temporary tax breaks is swelling into a catch-all measure that could cost more than $800 billion over 10 years. The money would go for everything from extending generous write-offs for business investments to renewing tax credits for poor families to repealing or delaying Obamacare’s much-loathed Cadillac tax. All of it would be unpaid for, which is giving budget hawks nightmares.

The bipartisan plan taking shape, a throwback to the George W. Bush era of big tax cuts that ballooned the deficit, has some wondering if it will collapse under its own weight. It could also run afoul of the budget that Republicans adopted in May, which promised to balance the government’s books within a decade. 

If you were wondering why tax compliance costs are going through the roof and why the tax code is over 75,000 pages long, well, this is why. This mess is mostly the product of the unhealthy marriage between lobbyists, special interests, and lawmakers. These guys are also the reasons why it is so hard to get rid of these loopholes and why we have the same debate year after year.

The simple solution to this problem is obviously fundamental tax reform and the adoption of a flat tax or a simple, low rate applied on as wide a base as possible. Interestingly, during this year’s presidential campaign, most Republican presidential candidates have released such plan. Though all the proposals are different, they share common characteristics: They would cut income-tax rates on households, lower the tax code’s bias against savings and investment, close some loopholes, and reform America’s anti-competitive corporate income-tax system.

Short of fundamental tax reforms lawmakers should go through each of the tax code’s deductions and sort them out based on their merits. That’s a political obstacle too because the debate around “tax-exemptions” are often completely misguided.

First, if you listen to most people on the left, all tax credits or deductions (except for the ones they like such as the child tax credit and the Earned Income Tax Credit) that allow people to keep more of their own money is a bad thing. In many cases the deductions are a bad thing, but not because people get to keep their hard earned dollars – because those loopholes and tax deductions tend to create economic distortions.

For that reason, I would like to make it clear that the point of the elimination of these deductions is not to finance bigger government. Every penny of additional revenue raised from closing loopholes should be used to lower marginal tax rates and/or to reduce the tax bias against saving and investment. The overall tax burden wouldn’t be any higher; it just wouldn’t be riddled with distortions.

Second, not all exemptions are created equal. Tax expenditures fall into one of three categories.

  1. Expenditures that are necessary to correct for double taxation and the timing of taxation (consumption/investment neutrality and temporary deferral of taxation). The death tax and capital-gains tax exclusion fall in that category.
  2. Expenditures that are not evenly applied to all firms or individuals, but if expanded without constraint would meet the criteria above. The child tax credit falls into this category.
  3. Expenditures that privilege certain categories of people, activities, or industries, while excluding others. These do not correct for economic distortions in the income tax. The wind-power “production tax credit,” the healthcare exclusion, and the municipal-bond exemption fall firmly in this category. For more exemptions falling into this category read this excellent piece by Freedom Partners’ Marc Short and Andy Koenig.

Exemptions falling in the first category are not loopholes. Think about it this way: Under the capital-gains tax, corporate income tax, personal income tax, and death tax some types of income are taxed as many as three or four times. Luckily, the tax code contains provisions that allow people to avoid this, at least to a point and at least to some degree. I gave a few examples of such exemptions in my recent Reason column:

On the corporate side, for example, there’s the deferral of taxes on income earned overseas through foreign subsidiaries and affiliates. Because we have a “worldwide” taxation scheme, Americans are required to pay taxes to the U.S. government on foreign-source income even if it was already subjected to taxation in the other country. Moving to a territorial tax system, in which Americans are only expected to pay taxes to the country in which income is earned, would be ideal. Still, allowing companies to defer the tax burden until the money is repatriated to the U.S. is better than nothing.

There are similar provisions on the individual side. Most tax economists agree that income should be taxed either before it goes into a savings account or when it comes out, but not both. Vehicles such as the Roth-style IRA or the traditional 401(k) exist to prevent government from taxing our savings twice.

In addition, the best tax rate for capital gains and dividends is zero. Anything higher than that discourages private-sector investment and stalls economic growth. Currently, capital gains and dividends enjoy a lower rate than other types of income. While still higher than it could be, the reduced tax burden at least mitigates some of the bias against investment embedded in the tax code. The same is true of the estate tax.

Steps meant to alleviate the multiple taxation of savings and investment are more than mere handouts to special interests; without them the economy suffers, and that hurts everyone. Unfortunately, outfits like the Joint Committee on Taxation and the Congressional Budget Office fail to make this important distinction between the three different categories, instead slapping the “tax expenditure” label on all tax preferences. As a result, you see progressive activists arguing for eliminating these anti-double-taxation provisions instead of undertaking real tax reform.

Unfortunately, this seems too complicated for Congress to take on. So instead, lawmakers are set agree to extend the few good exemptions in order to save the many terrible ones. That’s bipartisanship the Washington way.

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