The Tax Deductions Economists Hate

By
from FiveThirtyEight

If you’ve already filed your tax return,1 chances are you spent time (or paid someone else to spend it) poring over the forms looking for deductions and credits. Have a mortgage? Deduction. Pay state income tax? Deduction. Move for a job? Deduction.

For most taxpayers, every deduction feels like a little victory, victories that can add up to thousands of dollars. But economists have a different reaction. They would get rid of many — maybe even most — of those deductions. They don’t call it the “dismal science” for nothing.2

Economists aren’t coming for your deductions because they want you to pay more taxes, at least not necessarily. They’re coming for them because, as a general rule, they like tax codes to be as simple as possible. To economists, tax codes are all about incentives: Whatever the government taxes, people will use less of; whatever it taxes less, people will use more of; and taxpayers will exploit every loophole and technicality to minimize how much they have to send to Uncle Sam. The more complex a tax system is, the more loopholes there are to exploit, making taxes easier to avoid and harder to enforce. And since the wealthy can afford the best tax lawyers, complexity will tend to make the system less fair as well.3

That doesn’t mean economists want to get rid of deductions and credits entirely. Well-structured tax incentives can promote behavior the government wants to encourage, such as saving, working or having children.4 But the key phrase there is “well-structured” — in practice, tax laws often end up having unintended consequences.

Of course, to say “economists” think anything is a bit nuts. There are thousands of economists in the U.S., with widely varying ideologies and opinions. When it comes to taxes, much of that disagreement focuses on tax rates — both how much the government should be raising in total and how evenly distributed those taxes should be up and down the income ladder. There’s less disagreement (though certainly not none) on how those taxes should be structured. And there are some tax breaks that a wide swath of economists hate.

At the top of many economists’ hit list is the mortgage-interest deduction. If you have a mortgage on your home, you don’t have to pay taxes on the interest on that loan. According to the Congressional Budget Office, that tax break cost the federal government $70 billion in 2013.

Economists have all sorts of problems with the mortgage-interest deduction. For one thing, because wealthier people own bigger homes with bigger mortgages, the benefit disproportionately benefits the rich. In 2013, 73 percent of that $70 billion went to the wealthiest 20 percent of earners; 15 percent went to the richest 1 percent. The poorest 20 percent, who rarely own homes, got essentially nothing.

The problems don’t stop there, economists say. The mortgage-interest deduction also gives people an incentive to borrow as much money as possible — to buy bigger homes and make smaller down payments. That probably isn’t good for either homeowners or the economy (remember the housing bubble?), and it might even drive up home prices artificially, making homes less affordable for new buyers.

Perhaps because of the effect on prices, the mortgage-interest deduction doesn’t even seem to encourage homeownership. Thomas L. Hungerford, an economist with the liberal Economic Policy Institute, notes that Canada and the United Kingdom have homeownership rates similar to that of the U.S., even though they don’t let borrowers write off the interest on their mortgages. “Having the mortgage-interest deduction does almost nothing for increasing homeownership rates,” Hungerford said. Economists at the libertarian think tank Reason reached the same conclusion in a 2011 report.

There are a few economists who offer a defense of the mortgage-interest deduction on the grounds that the interest you pay on your mortgage is income for the bank that lent you the money,5 which then has to pay taxes on it. Those taxes drive up borrowing costs for homeowners (because banks pass on the costs of the taxes to their customers), and the mortgage-interest deduction helps to offset those, argues Curtis Dubay, an economist with the conservative Heritage Foundation.

But sorry, homeowners, you aren’t off the hook yet. Dubay would keep the interest deduction, but he still thinks the tax code unfairly favors homeownership. He just has a different — and way more complicated — way to change it: taxing imputed rental income.6

Homeowners are effectively their own landlords. But unlike traditional landlords, they don’t have to pay taxes on the “rent” they pay themselves to live in their homes. This theoretical rent — “imputed rent” in econ jargon — is a form of income, and right now, that income is tax-free. That amounts to a big subsidy for homeownership; if you invested that money in pretty much any other way, you’d owe tax on the income.

This is a tricky concept, but it isn’t actually controversial among economists or tax experts. The White House even includes an estimate in its budget for how much revenue the government is giving up by leaving imputed rent untaxed: $75 billion in 2014. (For a more complete explanation of this concept, see this New York Times article by Bruce Bartlett, who served in the Reagan and George H.W. Bush administrations.)

There are huge practical challenges to taxing imputed rent, and even bigger political ones. Even Dubay acknowledges that there’s no way it’ll ever happen. That’s one reason why so many economists would rather eliminate the mortgage-interest deduction — an idea that, while still a long-shot, has at least won the backing of some real-world political leaders.

Next up on economists’ chopping block: the deduction for state and local taxes. Right now, if you pay taxes in your home state, you can write them offon your federal tax return.7 That might seem reasonable — you’re already paying taxes once! — but from the federal government’s perspective, state taxes really aren’t much different from any other expenditures. Your taxes pay for roads, schools and police protection, the same way your rent pays for housing.8

The deduction for state and local taxes helps the rich even more than the mortgage-interest deduction. Eighty percent of the benefit goes to the top 20 percent of earners, and 30 percent to the top 1 percent. That’s hardly surprising: The wealthy pay more state and local income tax, both because they have more income and because most state income taxes are progressive — they tax the rich at a higher rate.

Inequality isn’t the only issue, though. “It’s in effect a subsidy for having higher taxes at a state level,” said Alan Cole, an economist at the Tax Foundation, a Washington think tank. If New York raises its state taxes, its citizens don’t actually have to pay for that full tax increase themselves because they can deduct the state taxes on their federal returns. Instead, taxpayers around the country are in effect picking up part of the tab. That especially bothers conservative economists, since it makes it easier for some states to have higher taxes. But even liberal economists generally agree that it isn’t the most efficient system.

If we’re killing off the mortgage-interest and state tax deductions, we might as well get rid of itemized deductions altogether. Schedule A of Form 1040 lists more than a dozen possible deductions, from medical expenses to tax-preparation fees. But two-thirds of taxpayers don’t even fill out that form; they take the so-called standard deduction, an all-in-one amount based on their age and marital status.9 This year, the standard deduction for a non-elderly married couple filing a joint return is $12,400.

Economists don’t necessarily have a problem with the specific deductions on Schedule A. Apart from the mortgage-interest and state tax deductions, they’re mostly small in any case. But the one-third of taxpayers who itemize their deductions are disproportionately wealthy — since the wealthy tend to have bigger mortgages and pay more state taxes — so the benefits mostly go to the rich, too. Eliminating itemized deductions would also make the tax code simpler: The standard deduction is much easier and less prone to manipulation.

There’s one itemized deduction, however, that many (though not all) economists would stand up for: the deduction for charitable giving. Nonprofits fear they would lose out on millions if donors couldn’t write off their contributions. But there are other ways to encourage donations: Hungerford of the Economic Policy Institute suggests creating a charitable-giving tax credit, for example.

The other big tax break that many economists would love to get rid of doesn’t show up anywhere on your tax return: the exclusion of employer-provided health insurance. If your employer provides you with health insurance (or more likely pays a share of your insurance premium), you aren’t taxed on that compensation as income.

But employer-sponsored insurance is income, even if most people don’t think of it that way. It costs companies money to provide it.10 It provides a benefit to the people who receive it. If you don’t get insurance through your employer, you have to buy it on your own out of pocket.

This is a huge tax break, bigger than all the previous ones combined. The CBO estimates that it cost the federal government $248 billion in 2013, 1.5 percent of the entire U.S. economy.11 The benefits are skewed toward the wealthy, but much less so than the other items on this list: 34 percent of the benefit goes to the richest 20 percent, and even the poorest 20 percent see some benefit.

The problem, then, is less with how the tax break is distributed and more with its effects. Both employers and employees have an incentive to shift compensation away from the type that is taxed (salary) and toward the type that isn’t (health insurance). That means people are getting more insurance than they otherwise would, which in turn could contribute to rising health care costs.12

In practice, however, even many economists don’t think it makes sense to start taxing health benefits, at least not without a broader overhaul of the tax system. For one thing, it’s hard to know how to value them, Hungerford said. Should older or sicker workers be taxed more because their health care costs more? For another, as Dean Baker of the liberal Center for Economic and Policy Research has noted, many workers have implicitly or explicitly negotiated better health benefits in exchange for lower pay. Taxing health benefits, then, could amount to a significant pay cut.13

Baker’s point highlights a larger issue: Even economists who oppose certain tax provisions on principle don’t necessarily think they should be repealed in practice. Not that there’s much chance of that happening anyway.

“Economists tend to bandy these ideas around,” said Cole of the Tax Foundation, “and then you don’t see much of them in Congress or other organizations that are responsible to the general public.”

In other words, odds are you’ll get to hunt for deductions again next year.

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