Scott Sumner  

Do the right thing

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My daughter is now taking her first college economics class. Occasionally I like to provide her with examples from everyday life.

For instance, my wife spends a lot of time on the phone with insurance companies, mostly dealing with complex and confusing rules and regulations. One day after a particularly frustrating set of calls trying to get coverage for the purchase of my daughter's contact lens, we discussed the root cause of all this distress. I pointed out that in a normal country you'd just go to the store and buy contacts, instead of working through a so-called "insurance" company. (I use scare quotes as this has nothing to do with "insurance" as an economic concept--it doesn't reduce risk.)

Our government uses the tax and regulatory system to push people towards buying more expensive contacts via employer insurance. (And let's not even talk about "prescriptions".) Without these provisions, my company would have no reason at all to provide contact lens insurance for my daughter. I'd buy catastrophic health insurance (which I'd probably go through my entire life never using), and then pay for health care out of pocket. Even if health care were a bit more expensive, my wife would be much happier. And in fact I'd probably spend far less on health care.

Recently I've been disturbed by some of the comments that I read about tax reform. One argument is that it's a mistake to repeal certain deductions, because that will allow the government to collect more revenue---in other words, the closing of loopholes will not be offset by tax cuts elsewhere. I see lots of problems with this argument:

1. The GOP clearly plans to offset the loophole closing with tax cuts elsewhere.

2. One counterargument is that the Democrats would later raise the tax rates back up again. Maybe so, but if the Democrats are determined to raise taxes, they will do so regardless of whether the GOP cuts out some loopholes or not.

But let's say I'm wrong in these claims. I'd still argue that we should close tax loopholes, regardless of the impact on later decisions regarding how much to tax. To see why, let's divide public policy questions up into what we know and what we don't know:

1. There is wide bipartisan agreement among experts on both the left and the right that tax complexity is harmful. Fixing the tax system is like picking up $100 bills lying on the sidewalk. It's a no-brainer.

2. There is no agreement among experts about the proper size of government. Some prefer a government that spends about 18% of GDP, like Singapore or Hong Kong. Some want to spend about 35% of GDP, like Switzerland or Australia. And some want to spend about 57% of GDP, like France or Denmark.

If we are to be a successful society then we need to come together on issues where there is broad agreement, and then agree to disagree on other issues, which will be fought out in the political arena. Given American culture and politics, the near-term outcome of that fight will probably be pretty similar to what we have now; we aren't going to suddenly drop government spending down below 20% of GDP, or raise it up above 55%. The votes aren't there.

If we become so tribal that we squash win-win reforms because it might, and I emphasize might, help the "other tribe" at some future date on some future issue, then we will almost all end up worse off. That's the mentality you see in failed tribal societies in the third world, say Afghanistan or Libya.

Similarly, a person's views on tax reform should not depend on how it affects their pocketbook. I favor eliminating state and local tax deductions even though I live in California and pay a lot of taxes. If you always support sensible reforms, then the net effect of all of these reforms will eventually benefit you as well. It's not a zero sum game!

If you support a bad policy in the hope that down the road it might lead to good policies elsewhere, then you are likely to be disappointed. It's like a four cushion shot in billiards, theoretically possible but difficult to pull off. We simply don't know enough about our highly complex world to make those sorts of calculations. Better to support sensible policy reforms as they come up and then let the chips fall where they may on other issues. And what makes you think that your opinion on the highly contentious issues is even correct?

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The focus of public policy should be on doing things that we know will make society better off.




COMMENTS (19 to date)
Mark writes:

Is there something extraordinarily difficult about eliminating a deduction and adjusting the rate so as to make the elimination (at least close to) revenue neutral? It doesn't seem like it should be that hard to do. Ideally, then, 'revenue neutral deduction elimination' should be the go to policy, and then we can haggle over tax rates later, effectively seperating the two issues. Then at least we'd see who precisely is holding tax reform hostage to ransom it for lower/higher tax rates.

John Thacker writes:
One argument is that it's a mistake to repeal certain deductions, because that will allow the government to collect more revenue---in other words, the closing of loopholes will not be offset by tax cuts elsewhere.

...

I'd still argue that we should close tax loopholes, regardless of the impact on later decisions regarding how much to tax.

...

I favor eliminating state and local tax deductions even though I live in California and pay a lot of taxes.

Scott, apologies, but I don't see how this is consistent with your post here. The entire complaint in that article, which you linked approvingly to and supported, is that SALT deductions were being eliminated to impose rate cuts. However because some families benefit from the SALT deduction more than others and the SALT deduction is particularly large, that, even with eliminating many other deductions, without an absolutely enormous overall tax cut it is difficult to avoid some upper middle class families from paying more.

I am sorry if I missed some kind of subtlety in your two posts that reconcile them. Were you perhaps wanting to emphasize that the upper middle class families that benefit disproportionately from SALT deductions don't feel all that rich, even as you still support eliminating it? You were feeling their pain even as you oppose what they want as policy?

You certainly gave the impression in that post of wanting to preserve the SALT deduction for their benefit. I suppose I missed your point?

Thomas Hutcheson writes:

@ Mark
Or substituting the tax deduction for a partial tax credit that is revenue neutral or cutting business tax rates but eliminating the features that let different businesses pay different tax rates.

Of course the big issues in this bill is not the reduction in deductions, but the massive shift in after tax income to the highest income tax payers and the large increase in the structural deficit.

BTW I still do not see the efficiency rational for eliminating SLG taxes. What distortion in consumer/investor behavior is created by the S&LG tax deduction? Whatever that rationale is, would it not apply to businesses deducting S&LG taxes from taxable income?

Justin D writes:

--"BTW I still do not see the efficiency rational for eliminating SLG taxes. What distortion in consumer/investor behavior is created by the S&LG tax deduction? Whatever that rationale is, would it not apply to businesses deducting S&LG taxes from taxable income?"--

The dead weight loss of taxation rises with the square of the rate. Deductions require a higher tax rate, leading to significantly more dead weight loss.

It also subsidizes state and local government spending. If program X costs $100 per taxpayer, it only has a net cost of $65 or $75 for taxpayers who itemize, and so there will a tendency to spend more than an efficient amount on state and local government programs.

I remember reading an analysis from 2005 that if you got rid of all deductions and credits, the income tax rate would only have to be 9%. Now there's something to be said for allowing some deduction for lower incomes, but it shows how much the tax base is narrowed by myriad deductions and credits.

Scott Sumner writes:

John, I think you missed the point. I'm not interested in whether people pay more or less, that's not what's important about taxes. The issue is efficiency. Efficiency is far more important than distributional issues.

Even if I pay more under a tax code without deductions, I'm probably better off, just from the perspective of having fewer hassles in life.

I'm not saying the current bill would reduce everyone's taxes.

Thomas, You asked:

"What distortion in consumer/investor behavior is created by the S&LG tax deduction?"

The answer is simple; it reduces the efficiency of government, by providing a huge federal subsidy to state and local spending. Suppose a new bridge in California has a cost of $100 million and a benefit of $80 million. With the SALT, it's worth doing from the narrow perspective of California. (But not in the national interest.)

RPLong writes:

My main tax policy preference is lower taxes. Ideally, I'd like low taxes applied via a simplified tax code, but if I have to choose between low taxes and a simple tax code, I'll choose low taxes every time.

How about taking the opposite approach? Let's simplify the tax code by making loopholes larger. Let's make them incrementally larger and larger until they're so wide that they apply to everyone in every situation.

Todd Moodey writes:

My simple two-step reform of our political and tax systems is:

(1) eliminate all forms of payroll withholding, estimated tax payments and the like, and

(2)move all elections to April 16.

Ram writes:

The way they should’ve approached this is in a sequence of stages. First, come to a consensus on which deductions, credits, exemptions and exclusions to eliminate, or at least cap. Second, estimate the revenue gains from these changes. Third, lower MTRs on saving and investment (including full, immediate expensing), and eliminate complexifying measures like the AMT, by an amount that is at worst estimated to be revenue-neutral. Last, if the changes turn out to be revenue-raising, lower MTRs on work/consumption until revenue-neutrality is achieved. Along the way, keep an eye on horizontal equity, such as keeping the top corporate tax rate in line with the top individual tax rate such that no special “pass-through” rate is required, eliminating the marriage penalty, and leveling the playing field between US-based and foreign-based firms.

If it were up to me, I’d scrap the whole thing and implement the X tax in its place, but given the realities, this process would’ve ensured net benefits. Instead, they proposed arbitrary rate cuts, can’t come to a consensus on enough loophole-closing to make up the revenue, and so they’re being forced to add new complexity and raise MTRs indirectly, while still blowing a huge hole in the budget. It’s far from clear to me the whole package is a win for these reasons.

I like the standard deduction trick, which will reduce itemizing big time and shrink its political base, but I worry that it gives up one of the goals of closing loopholes—namely, creating revenue to finance rate cuts. I would prefer a large standard deduction to a morass of itemizing, but I would prefer lower rates more strongly.

Jack_D writes:

I hate the word "loophole." It's a pejorative word. I think it was former Senator Russell Long who said (accurately): "One man's loophole is another man's tax deduction."

Alan Goldhammer writes:

The problem is that this whole exercise was done behind closed doors with only one party making a determination what is good for the tax code. The House want to push for a vote this week and probably none of us really know what the full impact of this will be on individual tax filings.

I'm all in favor of tax reform but I certainly don't see this as tax reform. The carried interest loophole for private equity and hedge fund managers remains. We don't fully understand how LLCs and other pass through organizations will be treated. We don't even know what the impact will be on our President who has thus far refused to release his taxes. Maybe Special Prosecutor Mueller knows the answer to that one provided he has subpoenaed the recent tax returns.

The estate tax is proposed to be eliminated and it looks like there will be no effort made to tax the cumulative capital gains resulting from very large estates. I'm happy to give up my SALT deduction provided everyone else is being treated appropriately. This current House bill (we don't know yet what will come out of the Senate) certainly doesn't do that at all.

Justin D writes:

I don't get why they don't just take out all of the deductions except for something to offset taxes for low incomes and introduce a modicum of progressiveness.

Looking at all personal income plus various capital gains, plus the forecasted FY2017 revenue for individual income taxes ($1.66 trillion), and ignoring evasion, you can have a flat income tax rate of just 9.5%. Allowing for $1 trillion of unreported income, and two fully refundable deductions of $25,000 for adults and $15,000 for children, you can still get a flat rate of 18.5% and be revenue neutral. Applying the same 18.5% rate to a flat corporate income tax on GAAP EBIT, and you can actually raise revenue by $100 billion/yr.

You could also scrap all payroll taxes, lower the deduction sizes to $20,000 for adults and $10,000 for children, and set both rates to 25% and it would be revenue neutral.

bill writes:

Commenting on the opening topic, health insurance. The primary reason to buy health insurance is that prices for the uninsured can be ten times higher than for the insured. That's not right. It's immoral. But it also prevents people from even trying to be normal consumers who pay for what they use.

Uday writes:

The goal of tax reform is not to cut/raise taxes but to make the tax code more efficient. There was a lot of talk on the campaign trail about how to make the tax code simpler and more efficient but it appears that special interests have clogged the debate, meaning that we'll see a few deductions eliminated that favor wealthy urban elites in blue states, in favor of revenue losing tax cuts that probably won't pay for themselves. The hardest part of abolishing deduction is explaining how popular ones, like the mortgage and employer health insurance deductions disproportionally favor wealthier people who buy more and pricier homes and consume more health care.

Ideally, we should have a progressive VAT, with a progressive payroll tax, and a progressive LVT, as well as a flat carbon tax that would be indexed to inflation. Of course that won't happen in the near future because our political system is allergic to major reforms but its worth dreaming :).

MikeP writes:

The primary reason to buy health insurance is that prices for the uninsured can be ten times higher than for the insured. That's not right. It's immoral.

You are confusing the cause for the effect.

The reason the uninsured pay more for health care is because most payments -- even for completely expected and affordable services -- are made by insurance companies.

If health insurance was not tax deductible, much less of it would be purchased, and health care would be much more consumer oriented, with prices to match.

Andrew_FL writes:

There Ain't No Such Thing As A Big Simple Tax.

bill writes:

@MikeP,
I think the cause is that the insurance companies require it, directly or indirectly. I've literally gotten a bill for $50,000 (a one week stay in the hospital) where the insurance company paid the hospital $5,000 as usual and customary. I'd prefer to not have insurance and pay $5,000 when I need that type of coverage but that's not an option. If I don't buy the health insurance, I'd have to pay $50,000 if that situation were to reoccur. That discrepancy forces me to buy "insurance" (using scare quotes just as Scott did for the same reason).

All prices should have to be posted (online is fine) and the uninsured should pay the same as the insured. Then we might get some benefits from competition.

Gordon writes:

Scott, just wanted to give you an off-topic heads up that you were briefly featured in the latest Marginal Revolution University video which came out today and discussed monetarism.

Scott Sumner writes:

Thanks Gordon.

Scott Sumner writes:

Uday, You said:

"Ideally, we should have a progressive VAT, with a progressive payroll tax, and a progressive LVT, as well as a flat carbon tax that would be indexed to inflation. Of course that won't happen in the near future because our political system is allergic to major reforms but its worth dreaming :)."

That's my view as well.

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