November 14, 2012

Tax Loopholes Harm Economic Growth, But Don’t Help Taxpayers

Jeremy Horpedahl


Tax reform of this nature is feasible, and there is historical precedent in the tax reform of the 1980s. Whether Washington can rise to the challenge — and put what is best for the economy and Americans ahead of special interests — is yet to be seen.

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Democrats and Republicans tout "closing loopholes" as part of their plans to reform the tax code and reduce massive budget deficits. Indeed, the federal income tax code is riddled with special deductions and credits that reduced tax payments from individuals and corporations. In 2011 alone this amounted to about $1 trillion. To put that number in context — it's just under the total income taxes the government actually collected that same year, and nearly equal to the entire FY2011 discretionary budget. It was also greater than the annual federal spending on Medicare or Social Security.

So it's no wonder most of the current debate focuses on the lost tax revenue these tax expenditures represent. But as Brandon Pizzola and I found in our recent study, focusing solely on lost revenue misses the equal, if not greater, impact of these tax expenditures — the economic harm they create.

Our analysis looked at the economic distortions of the 10 largest tax expenditures for individuals and corporations. We argue that tax expenditures had many negative effects on the economic system, the primary and most notable being lower economic growth and a lower standard of living for Americans.

We also found that the stated economic intent of these tax expenditures for typical families did not materialize: intended beneficiaries were seldom the greatest beneficiaries, with groups other than taxpayers often benefitting from the loopholes. Most tax-expenditure benefits accrue disproportionately to higher-income earners, and encour­age "gaming" the system by those in a position to take advantage — often resulting in cronyism and the capture of the tax code for private gain.

Multiplying Losses

The home mortgage interest deduction is a widely discussed example. Beyond its political salience, this deduction is the largest explicit loophole in the personal income tax code. Individual loopholes make up the vast majority of tax expenditures — about 83 percent compared to 17 percent for corporations.

Because taxpayers must itemize deductions in order to receive any benefit, only about twenty-five percent of taxpayers actually benefit from the deduction. Of those claiming the deduction in the roughly "middle class" income group of $50,000-75,000, the average benefit of the deduction is $179, and only about one-third in this group claim the deduction. High income taxpayers, on the other hand, disproportionately benefit from the deduction: those with incomes over $200,000 receive an average benefit of around $2,221, and over 70 percent claim the deduction.

Broad Impacts

The greater impact is the economic distortions this tax expenditure creates. The home mortgage interest deduction changes patterns of consumer spending, leading consumers to spend more on housing than other goods. Capital allocation is distorted as well, as more capital resources are directed to housing construction. Income distribution is also altered by this deduction.

The deduction also invites a large amount of lobbying to keep it in place. The National Association of Realtors and similar groups have been expressing strong opposition to even a discussion of eliminating the mortgage interest deduction. These groups benefit significantly from the deduction, as it directs economic resources towards their industry. This lobbying activity is a pure economic waste, though the returns are often quite large for those engaged in lobbying.

In short, the mortgage interest deduction leads taxpayers to alter their behavior, creating large economic costs for society. And the average taxpayer does not largely benefit from this deduction, as it increases the price they have to pay for the house in the first place.

A Solution Is Possible

The home mortgage interest deduction is just the tip of the iceberg, making up about eight percent of total tax expenditures. Many more large and small loopholes in the federal income tax create similar economic inefficiencies as well.

The clearest solution is comprehensive tax reform that includes two key pieces: eliminating tax expenditures and lowering marginal rates across the board. Eliminating expenditures without simultaneously lowering tax rates would amount to a tax increase on the economy as a whole, resulting in lower economic growth.

Further, while a one-shot elimination of tax expenditures may seem unlikely, it is more likely to be successful than a piecemeal approach. Comprehensive reform would give all taxpayers an immediately recognizable benefit — lower taxes, less lobbying, and less time preparing taxes — to offset losses.

Tax reform of this nature is feasible, and there is historical precedent in the tax reform of the 1980s. Whether Washington can rise to the challenge — and put what is best for the economy and Americans ahead of special interests — is yet to be seen.