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The Problem With Patching Up the Tax Code

BusinessWeek

As the U.S. approaches the fiscal cliff on Jan. 1, closing some of the tax loopholes that cost the Treasury $1.3 trillion a year is emerging as a seemingly easy way to end the impasse over budget reform. House Speaker John Boehner favors broadening the tax base to generate more revenue without raising rates. President Barack Obama, while continuing to demand higher rates on top incomes, says limiting the use of loopholes for the wealthy could be part of the solution.

Loopholes are woven into the fabric of daily life: the home mortgage interest deduction, the favorable tax treatment for investment income, the break that leads so much of health insurance to be provided by employers. Some benefit the rich; others the poor. Some enhance growth; others, not so much.

Tightening them up has potential, but done wrong it could cause more problems than it solves. A botched spackling job could hurt the poor and the middle class and also remove incentives for businesses to invest and grow—without producing a lot of revenue. “It may prove difficult to gain more than $100 billion to $150 billion in additional tax revenues through base broadening,” Congressional Research Service economists Jane Gravelle and Thomas Hungerford wrote in a report earlier this year.

Congress calls loopholes “tax expenditures” because they have the same effect as spending on the government’s bottom line. Econ 101 says that eliminating or curbing them allows the government to keep tax rates down, which gives people stronger incentives to work and invest. “Higher marginal tax rates distort behavior and reduce activity,” Columbia Business School Dean Glenn Hubbard, an economic adviser to Mitt Romney’s campaign, wrote in a Nov. 12 Op-Ed in the Financial Times.

Unfortunately, there’s less to the loophole-closing case than meets the eye. First, even if all loopholes were eliminated the government wouldn’t raise $1.3 trillion, because taxpayers would change their behavior to avoid higher levies. Second, closing loopholes would be harder on the middle class and poor than simply raising taxes on the rich. That’s because to raise a lot of money, budget balancers would have to get rid of breaks that benefit the nonrich, such as the earned-income and child tax credits. Reducing tax expenditures “will not raise nearly the revenue needed for sufficient deficit reduction without increasing taxes on the middle class significantly,” Robert Rubin, who was President Clinton’s Treasury secretary, wrote in a Nov. 13 Op-Ed in the New York Times. He called the pursuit of loopholes “the policy equivalent of a wild-goose chase.”

Third, the supposed economic advantage of “broadening the base”—subjecting more income to taxation—is that it enables reductions in marginal tax rates. But cutting rates isn’t economic Miracle-Gro. All base-broadening does is change the mix: Some activities face a lighter tax, while others face a heavier one.

Fourth, and most important, some loopholes serve vital public purposes. Take the research and development tax credit, which reduces the amount a company owes in taxes by a percentage of the R&D it performs. The credit encourages companies to do more research, which has spillover benefits for their employees, other businesses, and ultimately customers and taxpayers. Left to their own devices, companies would do less R&D than is optimal for society as a whole.

The U.S.’s R&D tax break is less than a fifth the size of those given by countries such as India, France, and the Netherlands, according to the Information Technology & Innovation Foundation, a Washington think tank. “We’re not even close” to the ideal amount of corporate R&D in the U.S., says Robert Atkinson, ITIF’s founder and president. Throwing the R&D credit out in the name of giving the budgetary balloon more lift would inadvertently harm the economy’s growth, says Atkinson: “The ballast is not actually ballast. It’s helium.”

The urge to start with a clean slate is strong, though. A report by Republican Alan Simpson and Democrat Erskine Bowles, the co-chairmen of President Obama’s deficit-reduction commission, offered as one option a “Zero Plan” that would wipe out all loopholes, good and bad alike. That would include breaks that are good for long-term growth such as the accelerated depreciation of business investment in equipment and the deduction for domestic production activities, which favors manufacturing in the U.S.

Economists don’t much like some of the biggest loopholes, such as the mortgage interest deduction, which cost the Treasury $78 billion in fiscal 2011, according to Congress’s Joint Committee on Taxation. That loophole induces people to load up on debt to buy more housing than they need. But it’s popular with middle-class voters, and eliminating it abruptly would make homeownership less appealing, causing home prices to fall. That would yank the rug out from under families that figured the break into what they paid for their homes. Then there are the preferential rates for capital gains and dividends, which cost the government $91 billion last year. Those breaks largely benefit the wealthy, and economists disagree on whether they meaningfully encourage investment. They’re also well-insulated on Capitol Hill. It turns out there’s little to no correlation between the economic value of loopholes and their political viability.

Romney pointed to one way out of this box: an annual cap on the total value of the tax breaks that a taxpayer could claim. He tossed out caps ranging from $17,000 to $50,000. That would have the biggest impact on the rich while sidestepping arguments about which loopholes are most worthwhile. Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said on Nov. 13 that a cap deserves a closer look. But unless the cap were low enough to affect the middle class as well as the rich, it would only put a modest dent in the deficit. Eventually the country will have to decide which loopholes it can’t live without—and how much it’s willing to raise taxes to cover their cost.

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