The World Needs More Ninjas

Color me underwhelmed by the tax reform commission’s recommendations. I guess it’s a start, though I doubt a lot of them will ever survive the political process. It basically looks like they’re just fiddling with deductions here and there. Some of the ones that are sure to be the most unpopular actually make pretty good sense:

• Limiting the Interest Deduction for Mortgages: In theory, it sounds nice: giving hard-working people the chance to own their own home. In practice, it results in renters, who tend to be lower income, subsidizing owners, who tend to be higher income. Plus, the fact that it’s only on interest gives incentives for speculative, unsound behavior (e.g., interest-only mortgages)
• Limiting the Health Care Deduction: The fact that the government has to pay a lot for health care, but doesn’t reap the benefits of an increased revenue stream that comes from rising costs is definitely a problem. Probably a drop in the bucket considering the bigger health care problem, but a positive step, nonetheless. Here’s an interesting perspective on America’s health care woes by Milton Friedman that mentions this as one of the steps.
• Removing Deductions for Local and State Taxes: It’s kind of silly to force communities which choose lower taxes to subsidize communities which choose higher taxes. Those decisions should be made without this transfer by the federal government as a factor.

Update: In reading Dan’s comment, I realized that, in my haste, I wasn’t as clear as I could have been. I am by no means referring to the tax system as a whole. People spend lifetimes trying to quantify the results of such a large system. Rather, I was looking only at the direct effect of each said deduction.

For concreteness, consider this example that illustrates how the mortgage interest deduction is used as a subsidy. Let’s abstract away the complexity and look at two families. Both families make $50,000 in income per year. Family A rents as they are just starting out. Family B is just starting out as well, but has received a $20,000 tax-free windfall (I’m not very familiar with tax exemption methods, so let’s just say they use Andy Dufresne’s suggestion from The Shawshank Redemption and use a gift exemption). With this extra money, Family B has purchased a house.

Now, let’s say that the government needs to raise $10,000 in revenue for the year from a flat income tax and, for simplicity, Family A and Family B represent their entire tax base. Now, look at two taxing methods. In the first, there is no deduction for mortgage interest. Thus, from an income taxing perspective, the obvious solution is to set the tax rate at 10% since there is $100,000 total of taxable income. Both Family A and Family B pay $5,000 and the revenue has been raised.

Now, let’s look at a second taxing method, still with a flat income tax, but now a deduction is allowed for mortgage interest. Let’s say that Family B’s mortgage interest for the year was $10,000. Obviously, Family A doesn’t have any mortgage interest since they are renting. Thus, Family B’s taxed income is now $40,000 after the deduction. In this case, the tax rate must be set to 11.1% to raise the desired revenue since the total taxable income is now only $90,000.

Thus, Family A pays ($50,000 * 0.111) = $5,556 and Family B pays ($40,000 * 0.111) = $4,444. The net effect is that Family A pays $556 extra to subsidize Family B owning a house.