Balancing Act V: Scrap most tax deductions

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Fifth in a series

It's no secret the federal tax code is riddled with special-interest loopholes. What you may not know is which special interests are the biggest beneficiaries. Take a look in the mirror. That's right. We have met the enemy and it is us.

There are breaks of one kind or another for most everyone, including businesses and investors. But some of the biggest-ticket items are middle-class favorites such as deductions for mortgage interest and state and local taxes, for contributions employers make toward workers' medical insurance premiums, and the tax exclusion for contributions to retirement savings accounts. Together those breaks were worth $415 billion in 2010.

Policy mavens call the deductions, exclusions and special rates "tax expenditures," because they're little different from government spending.

They deprive the treasury of $1.1 trillion a year it would otherwise collect, while the federal government is drowning in red ink and burdening our children with debt. Their proliferation, through good times and bad, attests to how far we've strayed from what should be the tax code's singular purpose: raising money to run the government. It's an abysmal state of affairs that, fortunately, presents a golden opportunity for reform.

Congress should scrap practically all the tax breaks littering the tax code and, in exchange, just lower our tax rates.

That would simplify the 3.8-million-word abomination. And, because the richer you are the more lucrative the breaks, reform should be designed to extract more revenue from the well-heeled, revenue needed to help cut the budget deficit down to size.

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Some of the more notorious tax expenditures benefit powerful industries -- for instance, about $4 billion a year for the oil industry and $12 billion a year for agribusiness. It makes no difference whether Washington writes those checks or writes a provision in the tax code that reduces the taxes companies in those industries pay. The impact on the government's bottom line is the same: less money for schools or national defense or to hold down debt. Such sweetheart deals for the rich and wired have to go.

But eliminating only the other guy's breaks won't be enough. Many expenditures we've all come to know and love also have to be scrapped or curtailed.

 

Mortgage deduction's downside

The deduction for home mortgage interest, for one, should be reduced and then gradually eliminated. Right now, homeowners claim a variety of popular tax expenditures that together totaled $147 billion in 2008. They include deductions for mortgage interest and property taxes, and an exemption from taxation for up to $500,000 per couple on profit from the sale of a home.

The conventional wisdom is all those breaks make home ownership more affordable. But all that additional money in the housing market drives up the price of homes and rewards people for buying bigger houses than they need or might otherwise choose. And other countries, such as Canada, that don't allow a mortgage-interest deduction have home ownership rates roughly equal to the United States.

The mortgage deduction is currently available on loans up to $1 million for primary residences and vacation homes. The cap should be reduced to $500,000. People who can afford to mortgage more than that would still get the deduction for interest paid on up to $500,000. Average taxpayers, most of whom could never afford a mortgage that size, shouldn't be forced to subsidize the fortunate few who can.

Eventually the mortgage-interest deduction should be phased out entirely, perhaps over 15 years.

The deduction for employer contributions to worker medical insurance premiums should also be eliminated. At $131 billion a year, it's the largest single tax expenditure in the code. This deduction masks the actual cost of health insurance. What we need is a better way to pay for medical care.

 

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Deductions with merit

Some familiar breaks ought to be left intact. The deduction for property taxes, and for state and local taxes generally, should be retained. Without that deduction, people would be required to pay federal income tax on money previously paid in taxes to states or municipalities.

Washington should also leave intact the tax exemption for profit from the sale of a primary residence. The home they live in is the largest single investment most people make. Those nest eggs of up to $250,000 per person, or $500,000 per couple, are a crucial component of retirement savings for many people. That money shouldn't be taxed.

But Congress should scour the tax code with an eye to eliminate or reduce virtually all of the other tax expenditures for individuals, businesses and investors, such as the deduction for depreciating machinery and equipment and the lower tax rates for capital gains.

That may sound like heresy and, yes, there would be net winners and losers. But the payoff for letting go of popular tax breaks would be a much simpler tax code, smaller deficits, shrinking debt and much lower tax rates. That's a deal worth making.

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Friday: Super solutions

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