This article first appeared in the St. Louis Beacon, Dec. 10, 2012 - The political debate as we approach the fiscal cliff will unfortunately focus on what individuals in the top tiers of income pay in taxes. While it continues to stoke populist indignation, that debate distracts us from the true problem: balancing increasingly demanding entitlement claims against insufficient projected revenues.
Since the time frame is too shortened to achieve real change, what should we expect in the coming year? On the tax side, Congress must raise tax rates or widen the tax base, the latter achieved through closing the myriad loopholes that now characterize the byzantine tax code.
It is unlikely that the president or Congress will agree to appreciably raise tax rates on personal income. Even if focused on only the wealthy, such a change will do nothing to solve the country’s continuing deficit problem. There also is talk about raising taxes on capital gains. While that also will increase revenue, it will not appreciably reduce the deficit. More likely, it will decrease the incentive to invest, thus reducing the flow of funds that businesses use to expand operations and employ workers.
What is more likely to occur is the closing of loopholes in the tax code. This is a reasonable way to broaden the tax base, an idea favored by most economists, without raising marginal tax rates. It also makes the tax code fairer. While both views are correct, there are many facets of loophole closing that will make it a fierce political battle.
To see this, let’s consider just one such loophole: the deduction of interest on home mortgages.
The mortgage interest deduction is often viewed as a sacred cow of the tax code, even though most analysts agree that it is a failure. “If promoting homeownership is the desideratum of U.S. housing policies,” says University of California-Davis law professor Dennis Ventry, “then the MID [mortgage interest deduction] is a terribly inefficient and inequitable policy vehicle.”
Why is it inefficient? A number of studies have found that the deduction leads to over-investment in housing by some groups in the economy. Specifically, the deduction does not increase ownership as much as it increases the purchase of larger and more expensive housing by those able to take advantage of the tax deduction. Based on his analysis of IRS data, Gerald Prante of the Tax Foundation finds that “the deduction primarily encourages larger and more expensive homes among a relatively small share of taxpayers, rather than promoting broad-based home ownership among ordinary American citizens.”
Why inequitable? The mortgage interest deduction is highly regressive, claimed only by those who can itemize their deductions. Roger Lowenstein reports in the New York Times that “more than 70 percent of tax filers don’t get any benefit from the deduction at all.” In effect, the deduction subsidizes home ownership for the higher-income segments of the economy to a much greater extent than those at lower incomes. And for those households who claim the standard deduction, about two-thirds of all taxpayers, the deduction provides no benefit at all.
It is also costly. Lowenstein reports that in 2006 the cost to the Treasury amounted to about $76 billion in lost revenue. By 2010, Ventry reports, cost had risen to almost $110 billion. Indeed, the mortgage-interest deduction usually ranks as one of the government’s costliest tax-reduction programs.
The mortgage interest deduction, long derided by economists as inefficient and inequitable, should once again be the cross-hairs of tax reform policy. While it has survived previous attempts at reform, perhaps the stakes are high enough that this zombie of past policy will meet its demise.
Rik Hafer is a distinguished research professor in the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.