Why Our Tax Code?

By James Kwak

In honor of the deficit commission, Ezra Klein is running a number of posts about the commission’s proposals and our tax code, including one about the mortgage interest tax deduction. Although this is often defended as a middle-class tax break, on a percentage-of-income basis it mainly benefits people between the 80th and 99th income percentiles; above that they make so much money that they can’t buy big enough houses to keep up. (On a dollar basis, of course, the correlation between income and tax savings is perfect.)

This should not be surprising, since like any itemized deduction (a) it’s worthless if you have a small house and take the standard deduction instead, (b) it’s proportional to the size of your mortgage, and (c) it’s proportional to your tax bracket. Klein says, “I’m not really clear why we’re giving people making hundreds of thousands a year large subsidies to buy a house, but I’m sure there’s a good reason.” I’m sure he knows the reason, but I’ll spell it out anyway.

This issue comes up occasionally in my tax class, where I have a long-running but mostly silent debate with my professor. When he asked why we have some quirk in the tax code (I forget which), I said, “It’s a political economy thing: it benefits rich people, and they have more political power.” He said something like, “Maybe, but that argument proves too much, because the rich do pay taxes, and if they really called all the shots they wouldn’t pay any taxes.” Which is a reasonable point, so I’ve mainly let the issue lie.

But if you are the rich people in a democratic society where most people believe in reduced inequality, what kind of tax code do you want? You want to start with an overall progressive structure (so the people won’t revolt), and then you want a boatload of exceptions to that structure that (a) favor the rich and (b) can be individually defended on plausible (and sometimes even reasonable) grounds. Which is what we’ve got:

  • Mortgage interest tax deduction
  • State and local (property) tax deduction
  • Charitable deduction
  • Lower rates for capital gains and dividends
  • Exclusion (or tax deferral) for retirement and educational savings accounts
  • Exclusion of capital gains on home sales
  • Ability to donate appreciated assets to charity and deduct appreciated value without paying tax on appreciation

As I said, you can defend most of these individually without being laughed at. But the net effect is to water down the progressivity of the system without admitting that that’s what you’re doing. And instead of ordinary people revolting against the rich, this year we had (some) ordinary people revolting in favor of cutting taxes for the rich.

45 responses to “Why Our Tax Code?

  1. Deductions are for folks who have uses for them. Let the poor eat cake.

  2. The impact of removing the interest tax break is probably overestimated for a number of reasons – among them, the AMT wipes out much of the tax deduction right now. Also, broadening the base drops the high tax brackets overall. I’m not clear how much 80% to 99% loses in net yet with the proposal.

    Still, I don’t doubt the main beneficiaries are upper middle income.

    Probably the bigger disparity, however, is between those who own houses with debt, and those who are debt free. Re-instating the mortgage deduction (if it were not grandfathered) would have the effect of INCREASING real debt burdens among young upper income families. Older families with lower debt burdens benefit as well, though asset values decline. Renters with no debt really benefit. One could grandfather existing loans, but that loses revenue, and creates problems with household mobility (which Calculated Risk likes to talk about a lot). Not so easy to solve.

    Still, it’s probably the right thing to do – but so is cutting wages/benefits for civil servants and state/federal pensions (which have been indexed to inflation even as private sector wages remain static).

    From a personal perspective, I’d be willing to accept the mortgage deduction elimination if the other suggestions were also implemeted as part of a grand deal – but will it happen? I’m guessing not until the crisis gets much worse than it is today.

  3. James, you are GOOD. Thank you for an excellent post.

  4. I would say I agree with 80% of the general gist of what Mr. Kwak is saying. But let me just put one major caveat. I think 529 College Savings funds are much more beneficial to poor people than to rich. Parents with a relatively low income (at least low-middle class, and arguably even dirt poor) who are persistent and determined can give their children a bright future with the 529 College Savings Plans. I think you would find although rich also take advantage of these 529 plans, from a “returns to scale” standpoint they are very good for the poor. Education is almost inevitably the lone pathway out of trailer home parks, ghettos, and homes located near the railroad tracks/airport.

    Also I think we should put much stricter standards on what qualifies as a charitable donation, but I would presume James would agree with me on the latter.

  5. The home mortgage interest deduction is a subsidy that is capitalized into the price of housing. Indirectly, but inexorably it is a subsidy to home builders, owners, and sellers, not buyers. Removing it will have a one-time downward influence on home prices and will reduce (but my guess is very slightly) the supply of new homes built. Reducing supply will slightly countervail the downward price adjustment. After the adjustment, houses will be at least as affordable as they were with the deduction. Renting will increase because it no longer has a subsidy disparity.

  6. The professor’s point isn’t reasonable. It’s stupid. As you said, under neoliberal pseudo-democracy a rational rich person wants to find the sweet spot where he pays the minimum while enough non-rich people find the system tolerable. That was the whole point of representative pseudo-democracy, right from the start.

    Indeed, the main question today is at what point, in their evident psychopathy, the criminals are going to go too far.

    (But they’re also clearly preparing Plan B, overt fascism, just in case they need to try it.)

    The professor’s another corporatized academic hack. His job is to cause the student to think there’s any answer whatsoever other than the one James gave.

    But that is the only answer.

    Why are people willing to follow house hacks like Klein in parsing the arcana of what’s obviously a criminal plan to assault and rob us, which simply has to be rejected outright with all the contempt it deserves?

    We know damn well something like the mortgage interest deduction isn’t going anywhere as a result of a plan like this. That’s just in there for show, as hacks like Klein well know. But his job is to use it for misdirection. That’s why it’s in there in the first place. He and others hope to distract us from the #1 question:

    Why should we consider the deficit a problem at all under these economic circumstances? It’s a Big Lie.

    There’s only one human imperative in any case like this:

    Total Austerity for the Criminals, Not One Cent More from the People.

  7. Here’s a cute little graph for all the Republican fear-mongers on the deficit. You think John Boehner and Mitch McConnell are smart enough to read this graph??? I wonder if Glenn Beck will ever put this up on his blackboard for illiterates. Using pictures to explain things should be right up Beck fans’ alley.
    http://maddowblog.msnbc.msn.com/_news/2010/11/17/5479240-links-for-the-1116-trms

  8. Try this out, http://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html.

    It allows you to pick items to cut in the budget or to increase taxes. See if you can solve out budget deficit.

    Have fun.

  9. Renters benefit from deductibility of interest by their landlords deducting from their taxes. The equal footing is the basic argument for that.

    Removing HMID will crush the home market the same way a move on rates from 4.4% to 5.5%. The HMID is no more ‘baked into today’s prices’ than the sub-5% rates. The better way to eliminate (which should have a commensurate assessment of business interest deductions) is to lower the maximum size of the mortgage that can be deducted. It’s at $1M now, and the proposal is to take it down to $500k. That reduction would probably be painless to the overall economy. It might be reduced further from there, some percentage each year.

    The other thing to reduce its impact is to raise the standard deduction. That should be much more middle-class friendly and help to reduce tax complexity (something Republicans claim to support).

  10. you got it james. but its also a way to secure the votes of those marginally upper middle income taxpayers. we give generally the same breaks to those persons so that their votes will be secured in line with the rich. like u say political economic reasons.

  11. Last time I looked the Internal Revenue Code was 4000 pages long. The rate tables occupy one page; remaining pages create loopholes which reduce the effective tax rate of large corporations to 7% and the effective tax rate of the wealthiest 1/10% (who own 25% of everything worth owning) well below 20% of what they choose to categorize as their income.

    Internal Revenue snoops are ill equipped to audit the wealthy and effectively paralyzed by corporate slight of hand. Their efforts concentrate on the pettifogging evasions of non filers, deduction and exemption exaggerators and nitwits misled by fanatical evasion proselytizers marketing offshore accounts, foreign trusts, similar preposterous scams. Every year around April 1, govt press releases announce evasion prosecutions calculated to hold the sheep in line. The only real purpose of the income tax is to keep workers poor, force them to keep humping, bringing in the food, carting out the trash. Without such efforts, what passes for civilization would stop within a week.

    The only reason anyone studies tax law is to learn techniques of avoidance (which are legal). There is big money in this but the attendant boredom can be stupifying.

    Incidentally, James, you don’t learn anything worth knowing in the law school income tax course, which is why most tax lawyers have an LLM. Wish I could sell you mine.

  12. One of the most powerful ideas for unlocking U.S. job growth and global competitiveness is transitioning from an income tax based system to a consumption tax based system.

    http://www.polycapitalist.com/2010/11/surprising-key-to-unlocking-us-global.html

  13. I think this is a very good point. People think that the mortgage interest deduction helps people buying houses. But because it pushes up the price of houses, a lot of it ends up helping sellers. I’ve never understood why it’s in our national interest to make shelter more expensive.

  14. So, to defend my professor: My preferred political economy explanation doesn’t work as a unicausal theory of the tax code. For example, we have the earned income tax credit. And the state and local tax deduction gets disallowed under AMT. So I do agree with him that there’s a limit to how much you can explain with the “rich people are powerful” theory. But I think you can explain a lot.

  15. In general, you can’t deduct interest on a rental property. You can deduct interest on a second home, but I doubt you can deduct it if you are renting it out. In any case you can’t deduct interest on more than two houses.

    If we’re going to keep a tax subsidy for owning a house, lowering the cap would help, but I think we should make it a tax credit to eliminate the distortion that it’s worth more per dollar of house the richer you are.

  16. I thought the AMT still allows the mortgage interest deduction. But it does disallow some of the other deductions that benefit the rich.

  17. Businesses that own & rent properties can deduct their interest. You can’t deduct the interest on the property you rent, but your landlord can, and those savings would eventually get back to renters.

  18. You’re assuming that people take on the same amount of leverage when buying. What HMID does is subsidize the 100% financing person at the expense of the person putting 20% or more down. That has a more complicated impact than just raising prices. It produced an incentive to put as little as possible down on your primary home, and many people then took the rest of that down payment and used it on another ‘investment’ property. Limiting the LTV on HMID – only the interest on the first 75% of the value of a home is deductible – could be possible too, but that would add complexity.

  19. … medical expenses are also deductible, after exclusion of a percentage of gross income.

  20. Landlords can deduct the interest they pay to finance rental properties, but they pay income tax on the rents they receive. Landlords can also depreciate the rental property. It’s quite a different tax scheme – it’s more akin to running a capital-intensive business than it is to the home mortgage interest deduction.

  21. A portion of it – for some high income with expensive houses (imagine S.F. area), not all, and not an equity pullout to fund certain things. For example, if someone drew equity to pay back student loans or consolidate consumer loans. I’m unclear/unfamiliar with equity withdrawals to fund small business expenses.

    “Much” may be a bit of overstatement, though – true.

    Honestly, the AMT isn’t bad – if everyone paid it (eliminate income thresholds). Wouldn’t this be close to the progressive/simplified tax reform everyone wants? Until, of course, they have to pay it.

    In reality, the real federal tax burden on the 50% of americans below median income is low (very low) – the conservatives have this right. When they say broaden the tax base, they mean “make the lower middle class pay their share”. Generally, I agree with this, but the problem with restoring a broader tax base is that the bottom 50% have so little of the national income pie. The story is really about household real income distribution, but Republicans avoid this and Democrats are terrified to touch it. Conservative economists have spent the last 30 years writing papers to convince us that this is due to rising returns to education, as if the skill-compensation differential is unrelated to globalization…

  22. What is your definition of “rich”? I take all the deductions you mentioned, but don’t consider myself anywhere near “rich”.

  23. James,

    With all due respect, the timing for this component of tax reform could not be worse.

    We are collectively worried about the residential real estate market, which is the primary store of value for many in the middle to upper-middle class, and yet you want to abolish it? What exactly do you think that will do to the housing market, which is already under seige?

  24. CBS from the West

    StatsGuy:

    Welcome back! I’ve missed the erudition of your posts.

  25. There is no better time than now–a falling housing market–to do away with the mortgage interest deduction. For the vast majority of home owners, there is no benefit of the mortgage deduction, and the real-estate crash has significantly lowered the benefit for many more.
    Prices and interest rates are so low that interest on a typical home loan for a median-priced house (just $178,000) is LESS than the standard deduction. Even on the coasts, prices and rates have fallen far enough that the mortgage deduction is becoming less and less valuable. (See The Wall Street Journal Complete Home Owner’s Guidebook, pg. 19).
    Where homes are still expensive, there is no reason the deduction couldn’t be phased out–over 5 or even 10 years, long enough for anyone wealthy enough for that kind of house to do some financial adjustments.
    And the super wealthy don’t even borrow to buy properties anyway, so the ones with all the political power don’t even have dogs in the hunt.

  26. I am not alone in that if the mortgage interest deduction is terminated I would be forced to sell my home… and I live in a two bedroom home.

  27. Shouldn’t the TOTAL tax burden as a % of income be considered?

    The property tax a “home owner” with a mortgage pays in certain parts of the country is a lot more than the tax deduction from the interest paid on the mortgage.

    So when you put in all the taxes people pay – local, state, federal, clothes, home maintenance tools and on and on and on

    – and then more and more creative airport and car rental and other “taxes” – the upper 1% who get tax deductions on “capital gains” and who get welfare assistance for their corporation – oil and coal and nuclear – they pay no %.

    Seriously, what’s the POINT, James?

  28. All the tired old arguments were dragged out and given a good flogging in Britain before the mtg interest decution was abolished (in a phased manner). The result? The sun came up the morning after, minimal adjustment to the market as it adjusted to the trauma (I jest, the thing was planned so far in advance the market had time to adjust), lo & behold life went on. The proof? We even had an unsustainable price bubble AFTER abolition as we found other reasons to push prices sky high. Now newer generations of buyers have forgotten it ever was deductible, if they ever knew. But to listen to the shroud waving, shrieking and whinnying beforehand led many to the conclusion the world was about to end. Nope, never happened. I think it a tempest in a teapot – with phasing and preparation and byers and sellers being able to plan a couple of years or more in advance then markets do and would adjust.

  29. Just a pretty face

    Actually, you don’t learn anything in law school, period. It’s supposed to be a barrier to entry of the legal profession. It’s some sort of economics thing.

  30. Just a pretty face

    You might add lenders to the list of those getting a subsidy out of this. I’m surprised a co-author of 13 Bankers missed this.

  31. theotherguydidit

    Not buying into the new math of all will be well if you bleed me just a bit more. Just a cup full? Just a glass full more?
    No. The answer is no.

  32. For everybody’s information, money that landlords save is never–I repeat–NEVER returned to renters. Landlords keep it.

  33. Bayard Waterbury

    I still say, trash the tax code, initiate a flat tax, decide what percentage of income tax is needed to fund the annual budget (always voted on nearly a year before it’s effective). Make the flat tax kick in at, oh, say $50,000 for individual income. Tax corporations and capital gains at the same flat rate. How simple can it get. We don’t need to make public policy through taxation, and, in fact, with a multi-thousand page tax code, and Warren Buffet paying a lower rate than his personal secretary, why should anyone argue. Let’s say, for the sake of argument that that rate ends up a 25% (probably high), then everyone will be happy. The rich will pay a lower rate, the middle class will lose some deductions, but the individual exemption will largely take care of those, and those making less than $50,000 will not pay taxes. What’s not to like. Collection will be easier, because the IRS will require that every dollar received from a payment sourse which would qualify as income of eny kind be taxed at the source. Escape will be impossible. And, the big Wall Street guys will end up paying a higher percentage than they do now. Problem solved. Either that or we go back to the tax code in effect in 1950. Gee, we didn’t hear much complaint in those days, but then the media was not then a part of the problem. (91% top marginal rate)

  34. I would the elimination of or the high exemption of the estate tax. Additionally, the stepped up cost basis in estate matters.

  35. James, I would add to your list the elimination of or the high exemption of the estate tax. Additionally, the stepped up cost basis in estate matters.

  36. James, Taxes are also a way for governments to promote their agenda.

    But as a middle middle class family the tax codes as they stand right now help me pay for my son’s college education. To change them right now would force me to have to take out loans so he could continue — with the furlough my husband went through, 15% of income, the tax deductions of interest, college tuition to X, property tax, etc. kept us from taking out those extra loans.

    Last year was a bad year for us as emergency savings (not to be confused with retirement savings) went almost to nothing as it seemed like the year of endless repairs on appliances, new tires for both cars and a serpantene (sp?) belt, etc.

    I know some here would say tell your son to work for his college, and to that I say he does here on the farm taking my place so I can see my parents, plus fencing, helping with the basic health care of the sheep and beef, etc.

    I would remind you to not only look at the numbers, but talk to the people these deductions help.

  37. Seriously – Just a pretty face is spot on. As Nemo once said, and I quote roughly “the Mortgage Interest Tax deduction is a subsidy for mortgage finance lenders – a subsidy for buyer and sellers of homes would subsidize the price of a home, not the manner of financing the purchase”

  38. Bruce E. Woych

    http://www.greedandgood.org/BookPDFs/gghistoric.pdf

    A chapter in the history of attempts to balance a fair taxing system in the context of crisis.

  39. Precisely. The professor has made a strawman of the argument, by taking it to its logical extreme. In fact, the rich call more of the shots, and that is enough to explain why the tax code offers them so much, and everybody else progressively less, down to the point of the earned income tax credit. Oh, and correct me if I’m wrong, but doesn’t the Simpson/Bowles plan lump EITC in with other “tax expenditures” that need to be done away with?

    That tax professor is, consciously or not, selling snake oil on behalf of the haves. Defending him when he is serving a bad cause defends that bad cause. No need to vilify him, but he’s selling an intellectual product, and the product is faulty. For that, he deserves criticism.

  40. In a textbook world, tax breaks to landlords get back to renters, and tax breaks to employers get back to workers. In the real world, where adjustment is imperfect, it ain’t necessarily so. It is often the case that the initial “incidence” of the tax, or the tax break, is where a good bit of it sticks. Certainly, that is true in the short run. The long run is, after all, just a bunch of short runs strung together.

  41. Ignoring payroll taxes, which passed income taxes last year as a source of federal revenue. I think anyway, they came close.

  42. Any savings to landlords is baked into the pie. You can be sure that any _increase_ in the cost of landlordship will be passed onto the renters. Rent, leaving aside Section 8 housing, is determined by supply (and the quality thereof) and demand. If you don’t like it, save up to buy a house. It’s pretty easy these days.

  43. I’ll give up my (individual) mortgage interest deduction if commercial real estate folks give up theirs.

    But more importantly, why give debt a favorable tax treatment at all? We’re just pushing taxation upon capital and labor, which represent productive elements of our economy, as opposed to slumlording, e.g., which doesn’t.

  44. I don’t think of myself as poor, but since I am cash flow negative in my current situation, it’s a little hard to participate in funding my children’s future education.

  45. .like this article.