The Deduction Fairy

By James Kwak

Incoming Treasury Secretary Steven Mnuchin promised a big tax cut for corporations and the “middle class,” but not for the rich. “Any tax cuts for the upper class will be offset by less deductions that pay for it,” he said on CNBC.

This is impossible.

The tax cutting mantra comes in two forms. The more extreme one claims that reducing the overall tax burden on the rich will turbocharge the economy because they will save more, increasing investment, and will also work more, starting companies and doing all those other wonderful things that rich people do. The less extreme version is that we should lower tax rates to reduce distortions in the tax code, but we can maintain the current level of taxes paid by the rich by eliminating those famous “loopholes and deductions.” Donald Trump the candidate stuck with the former: his tax proposal, as scored by the Tax Policy Center, gave 47% of its total tax cuts to the top 1%, who also enjoyed by far the largest reduction in their average tax rate.

Mnuchin’s comment implies that he favors the latter version: lowering rates but making it up by “broadening the base.” This math might work for the merely rich—say, families making $200,000–400,000 per year. Take away the mortgage interest tax deduction, the deduction for retirement plan contributions, and the exclusion for employer-provided health care—which together can easily shield $50–75,000 in income—and you could probably fund several percentage points of rate decreases. (Of course, it would be politically impossible to completely eliminate those tax breaks, but that’s another story.)

When it comes to the truly rich, however, there just aren’t enough deductions out there to eliminate. You can only deduct interest on a mortgage up to $1 million. The fanciest employer-provided family health plan isn’t worth more than $30,000 or so. The aggregate limit for employer retirement plan contributions is around $50,000. At the top end of the wealth hierarchy, where people make millions or tens of millions of dollars per year, these are rounding errors; eliminating these deductions wouldn’t even make up for a reduction in tax rates of a single percentage point.

There are some tax breaks that matter for very rich families. Only one is technically a deduction: the deduction for charitable contributions. But obviously that only affects (to a significant degree) a small number of wealthy people in any given year, and those people can work around any limits in this deduction by simply cutting back on donations. (By contrast, if you get rid of the exclusion for employer-provided health care, employees won’t respond by foregoing health care altogether.)

The biggest tax breaks for the very rich (as I’ve written about before) are the preferential tax rate for capital gains, the deferral of taxes on those gains until you sell the assets, and the step-up in basis at death (which means that, if you pass on assets to your children, no one ever pays tax on the appreciation during your lifetime). Given that Republicans have been trying to reduce capital gains tax rates for decades (with Paul Ryan occasionally saying they should be zero), we can be sure that preferential rates aren’t going away. Taxing gains in assets when accrued is also certain not to happen. Trump has in the past supported a version of eliminating step-up in basis at death, but that was along with slashing tax rates and getting rid of the estate tax, which would be a net win for the wealthy.

In short, the idea that you can reduce tax rates without reducing the tax burden at the top end of the income distribution is a fantasy on par with the idea that you can increase tax revenue by raising rates—plausible in theory but impossible given current reality. That Mnuchin is taking this line is simply evidence that the Trump administration will try to reconcile a massive tax cut for the rich with their fake-populist rhetoric for as long as possible. In the end, we know which one will win out.

9 thoughts on “The Deduction Fairy

  1. It only works if the rich don’t work for corporations, otherwise its repatriation storming the beaches as the middle classes cost of living rises with the tide, then goes with the flow.

  2. Ah, the old “lowering the rate and broadening the base” in which those deductions always creep back in.

  3. You really have to consider taxing capital differently from taxing income. An investment fund should be a different accounting entity from the person owning it, as if it were a company. Every time the owner draws money from the fund, whether by sale or dividend or any other mechanics, it’s income.

    That opens up meaningful political discussion on how to tax capital. Maybe it should be zero, which means you only tax consumption and it’s regressive. Or maybe capital appreciation should be taxed by diluting the ownership of the fund and giving a slice of ownership to the state.

    You need a system like that in order to tax capital effectively. Otherwise, attempts to convert capital appreciation to cash will founder on arguments as to when to realise the gains, how to deduct losses, etc. and they’ll either be too burdensome to impose or they’ll be easy to evade and ineffective.

  4. Are you SERIOUS? Everyone, including the real middle class who have saved for their retirement outside an IRA would be HIT by changing the “deferral of taxes on those gains (capital gains) until you sell the assets”. I assume you mean that we should all pay taxes on any gains at the end of every year regardless of whether we have sold the asset or not. In this case, it is not hard to envision paying taxes repeatedly on the same assets in subsequent years if the value of an investment were to rise and fall over years it is held.

    Why would I want to take a chance and invest in a company if I had to pay taxes on unrealized capital gains before I sold the asset? Could this really be what you meant?

    Taxing any “expected gains” prior to actually realizing those gains could cripple our economy. You somehow seem to imply all investments as being assets held only by the wealthy. Let me assure you I am not part of that group and have sacrificed, saved and done without all my adult life to ensure that I saved enough to ensure that my wife has adequate funds for retirement.

    Narrow minded attitudes such as yours have helped to get us into the political situation we currently find ourselves. I have always been an Independent finding both parties equally untruthful and more than willing to abuse power when they hold control of the Congress and the White House.

  5. … a fantasy on par with the idea that you can increase tax revenue by raising rates….. ?????

  6. Did you mean to say “fantasy…that you can increase tax revenue by LOWERING rates”? That’s the Laffer curve BS.

  7. OMG!!! A Treasury Secretary who doesn’t know the difference between ‘less’ and ‘fewer’. (” “Any tax cuts for the upper class will be offset by less deductions that pay for it,””.)(I know this is petty but I couldn’t resist)

    I tend to agree with David in regards to changing the “deferral of taxes on those gains (capital gains) until you sell the assets”. The proposed change would do little to solve the bigger problem of increasing taxes of the very rich, but it would increase taxes on the not-so-rich.

    There seems to be a simple solution too, the capital gains tax needs to be increased to whatever the marginal income rate happens to be. Plus, the pre-death appreciation should be taxed right along with any other gains upon the sale of the applicable assets. Maybe I’m missing some unintended consequence here, but… income is a ‘gain’, and a gain is ‘income’. So, perhaps the primary goal should be to be to appoint and elect public officials with a better grasp of our language, lol.

  8. You have to tax investments differently because first of all they have downside risk. Suppose I put $10,000 into a stock trading account. The next day stocks go up slightly so I make $100, and they day after that they go down so I lose $100. This continues for the next 30 days, fifteen up, fifteen down. It you wanted to tax my gains immediately you’d have to tax me for $1,500 but in reality I made $0, my fund is still at $10,000, so it’s unfair. If you taxed me this way my fund would dwindle. Or you’d have to refund me tax any time I make a loss, which is too generous. In practice what we do is tally the gains or losses over the whole tax year, which works for a business or for day trading because the gains or losses happen faster and amortise.

    But that doesn’t work for real estate, which is both lumpy and not always liquid. I’ll eventually inherit a nice farmhouse in Greece. It’s been in our family for over 100 years and generates no income. At the same time it’s more valuable than I could afford to buy, nor could I spare enough cash to pay any significant fraction of its value, say 10%, as tax on appreciation. I’d have to liquidate it, or something else, and if that happens during a slump that’s also unfair. Also, I don’t want to. If estate tax is meant to force land into productive use that’s a policy choice but if not, if taxation is merely a call to share gains, the system is too blunt.

    A much better way would be to let wealth grow unencumbered, in other words let the owner decide when and how gains are realised, and hand over to the state a minority ownership as its tax share. I’d be happy to name the state as 40% beneficiary of my stock fund and hand over 40% of profits if I ever make any. If I liquidate the original $10,000 it’s still mine. Same for the farm, I’d be more than happy for the state to keep a silent 40% ownership and take 40% of the cash if we ever sell it. The same idea would apply to a company, where you could set aside a portion of stock and give it to the state as the firm appreciates, instead of paying corporate income taxes.

    Wealth and income are different things, delicately balanced, and because they’re delicately balanced and tax authorities don’t want to be destructive wealth is significantly undertaxed. We need to treat wealth as different from income and invent new ways to tax it appropriately. Capitalism certainly has the mechanisms, we need to have the political discussion.

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