Economists Hate Them! Why We're Stuck with These Tax Loopholes

In late March, just before the first attempt by Republicans to kill the Affordable Care Act crashed and burned, Donald Trump sounded positively joyous about the prospect of wrapping up the healthcare fight and moving on to a new challenge.

"Then we immediately start on the tax cuts, and they're going to be really fantastic," he told a group of House Republicans. "I am looking forward to that one. That one's going to be fun."

Maybe Trump hasn't learned this by now, but legislative battles are hardly ever fun, tax reform least of all.

Already, a proposal to shift corporate taxes and target foreign imports has companies like Walmart and Nike battling other elements of the corporate world in Washington. And while much of the Republican Party seems hell-bent on cutting taxes for rich people, doing that means either blowing a big new hole in the federal budget or finding ways to make the money up elsewhere. One option would be making the tax cuts temporary, but that would hardly qualify as "reform" at all. Actual reform—a long-held bipartisan dream—would involve lowering tax rates and finding other ways to revenue. Like so many goals in Washington, it's theoretically doable but almost impossible in practice.

If politicians actually wanted to reform our tax system, there are some simple things they could do that would please economists and policy wonks from across the ideological spectrum. There are things that people who have studied this stuff for years agree on; there are also political reasons why their suggestions will never come to pass.

For the sake of understanding just how confused our tax system is, let's take a look at three big tax deductions that could be eliminated to free up room in the budget for tax cuts—and the reasons that would undoubtedly be met with screaming opposition. (The cost to the government cited here are estimates from the Treasury Department for 2017.)

As most people know, when you give money to the United Way or donate some taxidermied kittens to your local museum, the IRS lets you take a tax deduction. But most Americans don't take advantage of this, because it only makes sense to itemize deductions on your tax returns if your total eligible expenses add up to more than your standard deduction, which is $6,300 for an individual.

And guess who has more than $6,300 in tax-deductible expenses? Rich people. In 2011, fewer than 15 percent of tax filers making less than $50,000 a year claimed a deduction for charitable gifts. Among filers making more than $1 million, 94 percent did, reducing their taxable income by $134,000 on average. (This is despite people making less than $500,000 giving a similar amount to charity.)

Deductions work by reducing the total amount of income that people pay taxes on, so those who pay a higher rate get more value. The way the math works, if you're in the highest tax bracket the federal government is essentially funding 40 percent of your charitable giving. If you're in a lower bracket, just 15 percent of your giving might be covered.

"Really, it's an upside-down subsidy, subsidizing rich people more than poor people," said Roberton Williams, a senior fellow at the center-left Urban-Brookings Tax Policy Center.

This also influences what kinds of charities get donations. Really rich people mostly give to health, education, and arts groups. Think billionaires getting their name on a new hospital wing, parents giving to their kids' private schools, or cultured donors supporting the local symphony. People who make less than $100,000 devote two-thirds of their charitable giving to churches, compared with 17 percent among those who make more.

A reasonable question to ask is whether the government should be incentivizing all of that giving. As Stephen Moore of the conservative Heritage Foundation puts it, "[Warren] Buffett and Bill Gates escape income tax on billions of dollars in earnings by diverting the money into the Gates Foundation to support dubious 'charities' like the Sierra Club and Harvard."

The political trouble with doing away with the charity deduction, of course, is that philanthropic organizations worry people will stop giving as much if the deduction goes away. And any politician would have a hard time going up against the Society for Helping Cute Children on Capitol Hill. But if we really want to help people contribute to the causes of their choice, a better system might be simply giving out some kind of matching funds for contributions from people at all income levels.

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Of all the twists and turns in the tax code, the rule allowing interest on mortgages to be deducted may be the one that makes wonks of all stripes fume the most. Like the charitable deduction, it mostly helps those who have money. But it also distorts housing markets in ways that drive economists nuts.

"The decision on what to buy, how much mortgage to take out, is a voluntary consumption decision," Williams said. "For high-income people, the federal government will pay up to 40 percent of your mortgage interest."

Theoretically, the point of the deduction is to encourage people to buy a home rather than rent. Setting aside whether that's a good idea at all, Williams said it doesn't even work. Homeownership rates in places like Australia and Canada, which don't have a deduction, are as high as in the US. "There's no clear evidence that people are more likely to buy houses," Williams said. "What is clear is that people are more likely to buy bigger houses."

So, the big effect of the deduction is inflating the market for McMansions. Which also explains why it would be nearly impossible to kill. "The housing industry loves it," Williams said.

In fact, when Barack Obama proposed capping the value of itemized deductions for the rich at 28 percent, both the real estate and philanthropic sectors came out swinging. Some current Republican plans include a similar cap and also raise the value of the standard deduction, which would reduce the number of people who bother to itemize. Even these modest reforms have the real estate industry gearing up for a fight.

The deduction covering state income and sales taxes is the only one of the three big tax deductions that Republicans are looking at actually eliminating. Why? Well, blue states tend to tax their residents the most.

"It's a subsidy for state and local governments to charge local taxes with part of the charge being picked up by the federal government on people's tax returns," Williams said.

Not surprisingly, many state and local officials have panned this idea, which of course would add greatly to the burden of some Americans. New York governor Andrew Cuomo has said it would be a "deathblow" to his state.

Even liberals have reason to hate this tax break, however: It's even more of a sop to the rich than the other deductions on this list. On average, tax filers making more than $1 million a year use it to reduce their taxable income by more than $200,000, while those making under $50,000 get a deduction of less than $1,500. If we want the federal government to subsidize states and local communities, there are a ton of ways that would be much fairer.

Politically, though, given the number of senators and representatives who hail from places that benefit from the deduction, it's likely to be controversial even among Republicans.

That's the trouble with any type of tax reform that isn't a simple, deficit-ballooning cut. Any big "loophole" is bound to be beloved by some constituencies, and the bigger the loophole the more powerful constituency. Closing those loopholes is bound to be difficult, politically costly—and not at all fun.

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