Friday, April 17, 2015

Can You Name America's Worst Tax Break?

A couple of days ago was Tax Day. While it can be emotionally taxing to think that 31 percent of the average American's paycheck goes to taxes or that Americans spend more on taxes than food, housing, and clothing combined, my mind wandered elsewhere this Tax Day: "Which tax break is the worst one that the American tax code has to offer?"

Before continuing with that question, to illustrate some nuance in the wonderful world of taxation, tax breaks come in three forms: tax deductions, tax exemptions, and tax credits. A tax credit is an amount that taxpayers are able to subtract from the amount they owe to the government. Tax exemptions and deductions are indirect because they reduce the base at which one can be taxed. Tax exemptions relate to your filing status and number of dependents, whereas tax deductions relate to expenses one has.

Now that we cleared that up, back to the question at hand. The Pew Research Center recently posted the largest tax breaks (see below) based off of a Joint Committee on Taxation staff report:

In terms of size, the major culprits are employer-paid healthcare, dividends and capital gains, deferral of active income of controlled foreign corporations, the mortgage interest deduction, and the earned income tax credit (EITC). These top five tax breaks are just shy of $500B for the 2015FY. The current GDP is about $17.4T, which would make these tax breaks 2.9 percent of the United States GDP.

We could make this easy and simply say that the biggest tax break is the worst because "size matters"  (Some could argue that the government is giving money away, but I don't view foregone revenue as actual revenue until it hits the government's coffers because I actually assume that the money people earn through labor starts off as their own, but I slightly digress). "Size matters" assumes that size is the only factor in the equation, which it is not. If one of the functions of a tax is to disincentivize behavior, then a tax break is the government's way of trying to incentivize behavior by giving breaks. Having a "break" might sound good, but we must ask ourselves what sort of behavior is being incentivized with such a break. There are good tax breaks and there are bad tax breaks.

The Earned Income Tax Credit. Take the EITC, which is a negative income tax to help alleviate poverty, as an example of what can be considered a good tax break. What do I think of the EITC? I worry about the improper payment rate of 22 percent, and I worry about the feasibility of actually replacing the EITC with the current welfare state. However, as I pointed out a year ago, the benefits that come with the EITC are considerable. The EITC raises employment because it incentivizes work. It has also been shown to improve child health and scholastic achievement, as well as Social Security longevity. It's not perfect, but it does a better job of avoiding unintended consequences than most public policy.

Mortgage interest deduction. This tax break is for those who a) have mortgages [as opposed to homeowners], and b) actually itemize their taxes. Essentially, the government is subsidizing home debt through the tax code. Instead of providing affordable housing for middle-class Americans, all it has done is provided an artificially high demand for high-end housing (see Fichtner and Feldman, 2014Fisher and Huang, 2013). Especially after the housing bubble bursting in 2007, do we really want the government to be artificially inflating demand like that? Promoting homeownership like that should not be a public policy goal (Davis, 2012). Also, mortgage rates are historically lower than they have been in the past, so the value of this tax break has been diminished from what it was in years past. This tax break is bad enough where Brooking Institution scholar Alan Viard found that replacing the mortgage interest deduction would not only remove the artificial incentive to build high-end homes, but it would reduce the deficit by $300B over 10 years. While this tax break invokes a sense of disgust, I don't think it's the worst one out there.

Deferral of active income of controlled foreign corporations, and dividends on capital gains. Although these make it on the list because they are the second and third largest tax breaks, I want to break the suspense by saying that it is neither of these two that are the worst tax breaks in the American tax code. The United States has the highest statutory corporate tax rate, and has a considerably high effective rate. Corporate tax reform is needed because if there are enough inversions out there, it shows how problematic our tax system can be. If you want to read about either tax break, you can go here and here to read more about how we tax and provide exemptions for the corporate world, but I want to declare the "winner" for today, which is.........

Employer-paid healthcare! If any tax break can make me feel repulsed, it is employer-based health insurance. Although size does have some bearing to why employer-based health insurance insurance is the worst, I have plenty of reason behind my disdain for this tax break that goes well beyond the $170B we are going to spend on it this year. This WWII relic was a response to wage controls that the government enacted back in the 1940s. It is inequitable because those who could use the deduction the most (e.g., the poor) don't have access, which exacerbates income inequality. It creates a system in which healthcare is tied to one's job for the vast majority of Americans, and is thusly not treated as a portable good. It causes individuals to consume more healthcare than they would have otherwise, which ultimately drives up healthcare costs. The Rand Corporation also found that it is a barrier to entrepreneurship (Fairlie et al., 2010).

No other country in the world has such a perverse incentive built into its tax system. I would contend it is the primary reason that health care costs in the United States have increased relative to other developed countries. I hope that the next time I ask myself the question of which tax break is the worst, they will have at least reformed, if not completely repealed, this dastardly tax break.

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