Reforming the tax code

Michael Drew makes a number of good points in the comments to the Simpson-Bowles post. Essentially, he believes that A) the trade-offs are unrealistic; B) they benefit the wealthy over the middle class by bringing income rates down much too far while eliminating tax exemptions that have traditionally been very good to the middle-class; and C) the proposal does address Medicare in a serious manner and instead focuses on the relatively minor problem of Social Security.

All of these are good points and I’m honestly not in a position to evaluate them with the care they deserve. Drastically lowering income taxes would be good for the American economy overall I think, especially in such a global, competitive economy, so long as you can pay for it through trade-offs; but I worry also that the cuts would benefit the rich too much while the middle and working class would suffer from the cuts. Then again, as North and others point out elsewhere, the capital gains tax reform would have a huge impact on the rich while leaving the poor and middle-class unscathed.

But here’s my theory: I think the commissioners made a lot of extreme proposals in the knowledge that they’d have to walk back from pretty much all of them some distance to reach consensus. So I would expect to see rates much higher, probably more brackets than just three, and fewer exemptions removed. I would expect the proposals for Social Security to be watered down significantly since they easily could be. And I would expect the healthcare problems to get kicked down the road since nobody is willing to tackle that Goliath at the moment, and probably won’t be until the new healthcare law is already up and running.

But that’s just a hunch. On the whole I like the direction the deficit commission is moving, but I agree that many details need to be improved upon, and we need to take extra care not to cut back too heavily on the middle class or move too quickly to remove things like the mortgage tax deduction.

Jon Chait has a pretty good take on all of this as well.

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12 thoughts on “Reforming the tax code

  1. As Chait hints at, I’m not at all sure that the tax expenditures eliminated in the proposal are, on the whole, more progressive than regressive. Obviously the big fish of those is the mortgage interest deduction. But certainly there is a sizable percentage of the middle class that doesn’t take much advantage of that deduction, either because they rent or because they only own one home, which they’ve owned long enough without a re-fi so as to see little to no benefit from the deduction. Meanwhile, I doubt there are many in the upper class who don’t own at least one home, and quite a few will own a second eligible property as well. Moreover, because of the progressive nature of the income tax, the deduction inherently reduces the amount of revenues collected from the upper class by a greater percentage than from the middle class.

    One thing in the report that stuck out at me was that it suggests tax expenditures currently reduce the taxable income of the upper quintile by about 12%, and the upper 1% by about 14%. By comparison, they reduce the taxable income of the other four quintiles by only 6-8%.

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  2. Yeah E.D. I agree with a lot of this. I think the most important question is not what is in this preliminary proposal. No I think the -reaction- to the preliminary proposal is what’s important. There are a lot of oxen getting gored in this. I suspect that a lot of the politicians are watching the electorate very closely right now to see if there’s really a broad deep constituency for balancing the budget.

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  3. “Drastically lowering income taxes would be good”. mmm, not so much. That’s what Bush II did and look where we are today.

    good things: a simpler tax code and enough revenue to balance obligations over the long term.
    bad things: a fetish over fewer rates or flatter rates (these tend to increase the obligations of the middle class to the benefit of the wealthiest.)

    30 years ago the wealthy declared a class war, and won without firing a shot and without a lot of people noticing. It’s time and past time for the middle class to return the favor. Let every estate hand out $1 million tax free (with a special exemption for land being actively farmed), then tax receipts from estates as ordinary income, but with a marginal rate of 50% at $ 1 million net present value. Tax capital gains like ordinary income. Put a marginal rate of 50% on income over $2 million. Require every corporation that does business with the federal government to have a truly independent compensation committee for all senior executives. Include ‘fairness in compensation’ standards in federal acquisition regulations that penalize corporations that dedicate more than X% of corporate revenue to senior executive compensation.

    Of course I’m fantasizing. But since the report is a conservative fantasy, why shouldn’t I get to do so also?

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  4. I think the point a lot of people are missing is that all tax expenditures based on how money is spent are regressive. Discretionary income grows faster with overall income for rich people, and its a lot easier to allocate discretionary income in a way that increases your tax deductions. If you’re struggling to make rent a buy groceries there’s not a lot of freedom to re-allocate income to tax exempt purposes, but if you’re not, owning a fancier house and taking compensation in the form of a better health plan can look like good options. Eliminating these deductions, if its accompanied by an equivalent cut in rates, is bound to affect the rich more than the middle class.

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  5. “Obviously the big fish of those is the mortgage interest deduction. But certainly there is a sizable percentage of the middle class that doesn’t take much advantage of that deduction, either because they rent or because they only own one home, which they’ve owned long enough without a re-fi so as to see little to no benefit from the deduction. Meanwhile, I doubt there are many in the upper class who don’t own at least one home, and quite a few will own a second eligible property as well.”

    While I wanted to hop on the Left’s bandwagon and recoil at the thought of abolishing things like the MID, it really does make a lot of sense. In fact, a lot of the more “regressive” reforms offered are very sensible. Rather than looking at the effects of making the tax code simpler and using those as reasons to reject doing so, progressives should look to somewhere else to make up the difference, somewhere other than the tax code.

    I’m all for rehabilitating the middle class. My parents for instance, a bus driver and a nurse, used the increase in home values and a solid credit score to refinance continually and use the benefits of equity loans and the MID to finance everything from home additions to their children’s educations.

    Instead of relying on warped mechanisms though, why not do away with all of the tax code’s idiosyncrasies and then, with a clearer view of where things stand, we can have a more clear-cut discussion about what revenue is available and where it should be invested.

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    • Here here. Personally I find the very idea that eliminating the MID is regressive to be a knee slapping howler. MID is expensive. It’s used by pretty much 100% of the rich and is available to considerably less than half of all the other classes. It’s paid for by everyone. The MID then is a regressive transfer to home owners at the expense of everyone else.

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      • Honestly it would make more sense, disturb less markets, and be more fair if we simply took the amount that gets deducted every year/divided it by tax payers total and simple gave everyone the result as a tax credit.

        Simply not providing the deduction is cool with me too.

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  6. Pace Erik’s other recent posts, I definitely came across as more certain than I actually am. Sometimes one has to do that to be heard. In fact, more than certainty what I was trying to communicate was a position of doubt that this works out as a relatively acceptable deal for the middle class. Where I am is pretty much where Mark is above – it’s not clear to me on the whole how this proposal ends up squaring out. And I admit that I hadn’t been factoring in the capital gains tax change into the argument, even though I knew about it, so that was kind of silly. That could well totally take care of any concerns. I’m just not well enough versed to know.

    As to he overall value of this discussion, I agree that the chairmen were essentially trying to start a conversation about tax policy here, and I guess that’s why this puzzles me. Tax policy is a great subject, but are our politics such that our deficit problems are going to be solved by talking a lot about tax policy? To me, this is all something of detour from the hard spending choices that are inevitable if we want to balance the budget.

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    • I think its a necessary complement. You can’t do everything with spending cuts – its extremely hard to cut medicare, social security or defense. Even if you cut those three as hard as possible and gut discretionary spending, there’s still a deficit to cover. So some tax increases are necessary. The the question is how do you do that?

      Barring fantasy tax policies like a VAT, and maintaining the pretense that FICA is not part of the general fund, the only option is income tax. A general increase in rates is very hard to justify and make work – high rates deter people from earning, or at least encourage them to find deductions, and this increases the distortionary impact and general unfairness of the system. Even ignoring the fairness aspect, thats just inefficient – every dollar of extra revenue comes at the expense of some amount lost from evasion and work and investment not undertaken because of the taxes make it not worthwhile. Sure you could restore rates to Clinton era levels or slightly more (and I’d favour that if we’re stuck with the current code) but it won’t generate enough revenue, especially over the long haul.

      But if you simplify the tax code by eliminating deductions, you make future income much more predictable and, because you make it fairer, you potentially increase public acceptance. When people understand not only what they’re paying but also what everyone else is paying, they’re much more likely to go along.

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  7. Lets do a little analysis, the rates would be for incomes of of single 34k and married 68 k the bottom bracket, 209k married and 171k single the middle bracket and the top bracket above that. So for the median family income the rates would likely be 15% or 8% (depending on if there is a standard deduction). It was stated at 20k married, so the typical couple would have about 20K taxable income and pay 3k in taxes with no deduction. Now a 30k married standard deduction would mean that the mortgage would likley have to have interest about 20k a year to possibly be deductable. 20k interest at 5% is about a 400k mortgage. Not much on the coasts but a lot in the interior. Now of course on 49k (the median family income) 20k for mortgage interest alone is clearly not sustainable. If you take the 31% limit (on payments) used today the interest would be about 15k a year. So the deduction benifits those above the median far more than those below the median if you build in the model with the standard deduction. (Note also a lot more folks could use the 1040a and not have to bother with itemization and all that).

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