I was on PBS the other night to talk about the House and Senate versions of the tax plan. At some point, we started talking about how the House reform plan treats graduate-student tuition waivers as taxable income. In response to the other guest on the show saying that it was malicious, I pointed out that a tuition waiver was indeed income. Based on the response I received from listeners, you would have believed that I had just endorsed torturing kittens.
Yet notwithstanding all the articles and commentaries about supposed cruelty to grad students, the House Republican plan is based on conventional tax analysis. Simply stated, tuition forgiveness in exchange for work is indeed a form of income even if no money technically changes hands. So the “exclusion” currently in the law is a loophole. Saying this doesn’t mean that grad students would feel no pain or wouldn’t have to pay higher taxes — even though with the doubling of the standard deduction and lower tax rates, it may not be as bad as what people fear. By the way, lost in the drama is the fact that outright scholarships would remain tax free. In other words, don’t be surprised if universities re-categorize tuition waivers as scholarships if that part of the House plan is in the final bill. Voila!
Now, let me say this upfront: In the search for a better tax base and genuine tax reform, getting rid of this tax preference is the right thing to do, especially if it is a way to pay for lower tax rates on corporations or individuals. I may not have started with that particular provision but that’s beside the point.
Yet this gives me an opportunity to highlight an issue that I and many others have complained about for a long time. The current tax code is based on a fundamental conceptual flaw (Warning: wonk alert!): As its base, our tax code uses the “Haig-Simons” definition of income: consumption plus the change in net worth.
In other words, it starts with a presumption that there should be double taxation of income that is saved and invested. As Dan Mitchell has explained, you see this approach from the Joint Committee on Taxation. You see it from the Government Accountability Office. You see it from the Congressional Budget Office. You even see Republicans mistakenly use this benchmark.
This is the wrong definition for the tax base. It introduces economic distortions to savings and investment by not accounting for the timing of economic profits. The Haig-Simons tax base prohibits an objective accounting of tax subsidies.
The best example is to look at so-called tax expenditures in Table 13-3 of the Office of Management and Budget’s Analytical Perspectives. The table lists all those tax breaks, exclusions, credits, and deductions as defined by a Haig-Simons tax base. But the result is that it fails to make a distinction between the preferences that are subsidies to special interests and those meant to mitigate some of the income tax’s bias against savings and investment and that attempt to move us towards a more neutral treatment of these activities.
Among the provisions meant to correct the frequent double-taxation imposed on investment and savings income, we find the deferral of taxes on income earned overseas through foreign subsidiaries and affiliates, the exclusions for IRAs and 401(k)s, and the supposedly preferential tax rate for capital gains and dividends.
Among the provisions meant to subsidize particular groups through the tax code, you find tuition-forgiveness deductions, the deduction for domestic production activities, the deduction for entertainment expenses, deduction for employer-provided transportation and parking, and the deduction for moving expenses. All of these and many others are repealed in the House version of the tax-reform plan.
Unfortunately, the House failed to repeal the biggest of them all: the deductions for employer contributions for medical-insurance premiums and medical care. As I have noted in a recent paper on tax preferences:
The exclusion for employer-provided fringe benefits, such as health insurance, is a prime example of a provision that should be repealed. It is distortionary, unfair, and — most importantly — a major contributing factor to the ever-growing cost of healthcare. Because it promotes overuse of insurance, it also dramatically decreases the amount of healthcare costs paid by consumers themselves as opposed to by a third party. Americans today pay only 12 percent of their healthcare expenses out of pocket, which weakens normal market forces. In addition, as Fichtner and Feldman have noted, it also results in profound horizontal inequity since “there is roughly a 30 percent price difference between employer-provided premiums and individual premiums.”
It’s a shame because it would have provided for a lot of revenue that could have been used to reduce the top marginal income tax rate and avoid the idiotic bubble tax.
Hopefully, the House’s effort to get rid of some genuine tax expenditures — and that includes the tuition-waiver exclusion — sets a precedent that could lead one day to the needed repeal of the health-care deductions.
One thing is sure: Fixing the tax code’s internal inconsistencies with tax preferences introduces a number of problems, if only because it complicates the tax code and people fail to differentiate between the good and the bad tax breaks. The U.S. economy would be better served by defining the tax base to eliminate the need for tax expenditures through a neutral “consumption tax.” It would certainly be more simple, efficient, equitable, predictable, and have a more neutral treatment of consumption and future consumption.