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Tax Reform and the Tyranny of the Transitional Gains Trap

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by Richard B. McKenzie

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Professor Tullock's point is simple: the federal government should have long been wary of politically seductive proposals that carry rents

The late economist Gordon Tullock was ingenious in devising arguments that were both easily understood and relevant to political debates. He could have been a candidate for a Nobel Prize for his founding work in public choice economics, especially his theory of "rent seeking," a banner under which he argued that conventional monopoly theory understated the economic loss of state-granted monopolies, trade restrictions, and income-tax deductions. In search of monopoly profits (or "rents"), interest groups could be expected to magnify the welfare loss of state-established and protected rents by wasting resources lobbying for and defending those rents.

Professor Tullock's works will come back into political prominence, given the Republican's release of their tax-reform proposal on November 2, 2017. In "The Transitional Gains Trap," written in 1975, Tullock explained why President Trump and the Republican will face a tough political slough on curbing federal tax deductions and spending to allow for their proposed personal and corporate tax-rate cuts without growing deficits. Tullock explained that today's fiscal politics is largely "trapped" by the politics and granted largess of yesteryear.

Long ago, seeing substantial rents to be garnered, the housing industry, with the support of homeowners, invested lobbying (rent-seeking) resources to secure the mortgage-interest deduction, claiming that homeownership was critical to the achievement of the American Dream. When the Republicans recently suggested that the mortgage-interest deduction be capped, they confronted instant widespread and vigorous opposition from builders and homeowners, understandably.

Knowing that their mortgage interest payments are tax deductible, prospective homeowners did what came naturally: They bought more and larger houses than they otherwise would.

After a transitional period, the expected future benefits of the deduction became largely capitalized in housing through artificially inflated prices on more square footage. Those homeowners who sold their houses during the transition period reaped capital gains (close to the expected present value of future interest deductions). Those who bought their houses after the transition period paid full value -- both for their houses and for the expected value of the interest deduction into the future.

If the interest deduction is capped on mortgage interest paid on the first $500,000 of a mortgage, as the Republicans have proposed, housing prices, especially those over $500,000, can be expected to fall, giving rise to capital losses for homeowners. Understandably, current homeowners, supported by the housing industry, will vigorously oppose cuts in the deduction perhaps on justice grounds, if not legal thievery, reasoning that they've paid for future deductions.

If behavioral economists are correct on the "endowment effect," which means that people value what they have more than what they would pay for it, homeowners and the housing and real estate industries can be expected to work even harder (and devote even more lobbying resources) to keep the deduction than they would pay to get the deduction. (The Washington lobbying games began immediately after the Republicans' announcement.)

When the George W. Bush administration required oil companies to add ethanol to gasoline, corn farmers cheered because of the expected (and realized) increases in corn demand and prices, and they increased their demand for corn acreage, largely capitalizing the expected rents in land and equipment prices. Ethanol producers and gas stations capitalized their rents in expanded ethanol plants.

Accordingly, the Obama administration's one-third cut in the mandated ethanol production in 2015 handed Trump a political advantage (possibly a decisive one) over Hillary Clinton in the corn-belt states. The industry cheered again when, earlier this year, Trump assured the industry that "renewable fuels are essential to America's energy strategy" and that he would roll back the Obama mandate retreat, despite strong evidence that the mandate contributes to environmental decay.

The deduction for charitable contributions has done what it was intended to do, grow the country's charity industry, which now extends into all corners of American life, from churches to public radio to universities. All sectors of the philanthropy industry (including the supporting financial advisory components) will seek to defend their artificially inflated investments in people, buildings, and solicitation networks. They naturally prefer not to compete with for-profit sectors on equal terms for Americans' disposable dollars.

States, especially high-tax states like California, Connecticut, New Jersey, and New York can be expected to throttle any effort to curb the deduction for state taxes. They understand that the deduction has enabled them to increase their tax rates, effectively absorbing tax revenues that otherwise would go to the federal treasury. States have built up programs with long-term investments and commitments, assuming the state-tax deduction will remain in place. Governors understand that the Republicans' proposed cap on the deduction at $10,000 will, if enacted, pull away a portion of their tax revenues - and will pressure them to lower their tax rates.

Professor Tullock would have agreed with economist Dwight Lee's point that the larger the rents created from deductions' market distortions, the more vigorous will be the political defense of deductions. He would also accept economist Fred McChesney's point that some of the potential rents from deductions will likely be siphoned off by politicians in their quests for campaign funds and personal welfare enhancements, which can reduce political defenses of the deduction.

Professor Tullock would be the first to acknowledge that transitional-gains-trap analytics cannot be fully generalized to all forms of government largess and market restrictions and does not prohibit tax reform, but it surely is an unheralded formidable barrier to meaningful tax reduction. Professor Tullock's point is simple: the federal government should have long been wary of politically seductive proposals that carry rents. Government largess is all-too-often a political trap. Politicians should understand the wisdom in a guiding Russian adage: "Free cheese can be found only in mousetraps."

Richard McKenzie is the Walter B. Gerken Professor (emeritus) in the Merge Business School at the University of California, Irvine. He and Gordon Tulloch wrote The New World of Economics, widely used for decades in college classrooms.


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COMMENTS (6 to date)
robc writes:

The original 1913 income tax form had ALL interest as a deduction because as the recipient was paying income tax on the interest, to not deduct it would be double taxation.

So, isn't the mortgage interest deduction as exception that is actually correct and the problem is the lack of credit card interest deduction and etc?

Steve Y. writes:

"The original 1913 income tax form had ALL interest as a deduction because as the recipient was paying income tax on the interest, to not deduct it would be double taxation."

One used to be able to figure out a lot of tax law by knowing principles of taxation. Examples are: double taxation, symmetry, the tax-benefit rule, and respect for the autonomy of States.

Consumer (non-business) interest was eliminated by the 1986 TRA. I'm old enough to have taken an itemized deduction for car loans, and the loss of the deduction was mitigated by lowering of rates. The loss of the personal interest deduction is more a violation of symmetry than double taxation. Another example of non-symmetry is how the gain on one's house is taxable, but a loss is not deductible.

An example of the principle that one should not be double-taxed is the treatment of IRAs. If it was tax-deductible going in, then it should be taxable coming out, as it is with normal IRAs. (Roth IRAs stay true to the principle---non-deductible going in, and non-taxable coming out, though one may argue that distributions should be taxable in excess of one's contributions).

One example of double taxation is the corporate income tax. Another, I think clearer, example is Social Security. SS payroll taxes are, of course, non-deductible by individuals, and the pre-1984 rule was that SS benefits received were non-taxable. By taxing benefits above a now-low income threshold we have a clear violation of double taxation---non-deductible going in and taxable coming out.

Finally, the States and the Feds used to stay out of each other's lane. The U.S. didn't tax municipal bond interest, and the States didn't tax Savings Bond interest, they don't tax each other's income tax refunds, the States don't tax Social Security receipts, etc. etc. The Federal deductibility of State Income taxes is true to both the double taxation principle (it's theoretically possible to pay more than $1 on $1 of income) and State/Federal autonomy.

Since the mid-1980's you cannot figure out what the law is from first principles. There are so many violations of these that you just have to look it up.

Thaomas writes:

The effort to reduce the economic inefficiency of the housing market interest tax subsidy (ditto charitable contributions) would be easier it were in the form of a partial tax credit, which would also be fairer in that it would give low (or zero) tax rate citizens the same subsidy per dollar spent as the higher rate payers.

It's hard to see any justification for removing the state tax deduction. That's like income never received.

However the sticking pint of all of this is that these things are being contemplated in order to shift after tax income to high income people.

Billy Kaubashine writes:

If behavioral economists are correct on the "endowment effect," which means that people value what they have more than what they would pay for it, homeowners and the housing and real estate industries can be expected............"

I would expect that same "endowment effect" to keep people in the housing they purchased expecting the tax benefit, even though it has been lessened or eliminated.

David Friedman writes:

The decrease in the price of expensive homes should only matter to people who plan to move out of an expensive home and not into another, since otherwise it's a wash. The more broadly relevant cost is that people in expensive homes with large mortgages will be paying more taxes.

ZC writes:

"The decrease in the price of expensive homes should only matter to people who plan to move out of an expensive home and not into another, since otherwise it's a wash."

You're forgetting the parasites (real estate agents, local govt's) who take a percentage of home value. If prices go down, they get their % of a smaller whole. That's why the real estate agents care.

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