Errors Of Commission

The President's Advisory Panel on Tax Reform is about to disgorge its recommendations. Early reports suggest that it will push for three general changes:

  • Simplify the individual income tax by reducing or eliminating the Alternative Minimum Tax (AMT) and some deductions;

  • Increase the exclusion of investment income from tax;

  • Consolidate tax benefits for working families with children.

The malignant pattern underlying the first two priorities is an increasing shift of the tax burden to labor compensation used by working people to finance basic needs -- in other words, to tax nothing but the wages that most people use to finance consumption.

Simplify This

Itemized deductions in the income tax are widely thought to be middle-class benefits. But while they are broadly distributed, their value increases with income; the higher your tax bracket, the greater your savings and the more you're likely to pay in mortgage interest, state income tax, and so on. Although itemized deductions are popular, they're regressive on two counts. There is a case for cutting them back or, as the commission suggests, converting them into credits that are equally valuable to taxpayers regardless of income level.

The commission proposes to change a few large and broadly distributed deductions, including the deduction for mortgage interest and the exclusion for employer-paid health insurance. A cap on mortgage interest for loans above, say, $400,000 would mainly affect relatively high-income persons and those who live in very hot real estate markets. But it would also have negative repercussions for existing homeowners, since it could reduce the resale value of their homes.

The commission talks of capping the exclusion for employee health insurance premiums paid by employers. While this would affect those in highly paid occupations with more expensive health insurance policies, its effects would be more severe down the scale -- particularly for workers in hazardous occupations. A universal cap would encourage companies to provide less expensive policies, resulting in higher deductibles, higher co-payments, and less adequate coverage. The lower a worker's income, the more harmful this change could be.

The commission has also spoken of eliminating the deduction for state and local income tax. This would strike a much broader class of taxpayers, but have most of its impact in states with higher average incomes and bigger liberal electorates. A suspiciously crimson array of states -- Florida and Texas in particular -- have no state income tax.

All of these measures raise revenue, but George W. Bush's panel is not in the tax increase business. It would use the proceeds to eliminate the Alternative Minimum Tax (AMT), which limits the extent to which taxpayers in high tax brackets can use deductions to escape tax liability altogether.

Although the AMT was originally supposed to apply only to the very wealthy, its substitute standard deduction is not indexed to inflation. Consequently, more and more taxpayers fall under the AMT each year. That growth is exacerbated by the Bush tax cuts, as lower income tax liability pushes more people into the AMT. Conversely, rescinding part of the Bush tax cuts would lessen the AMT problem. Politics will dictate some relaxing of the AMT, probably by indexing it to inflation, and budget needs will dictate tax increases. But preserving the tax cuts and abolishing the AMT altogether goes in precisely the wrong direction.

The result of these changes would depend on where the various caps are set, but eliminating the AMT and capping the mortgage interest and health benefit would probably affect roughly the same upper-income class of taxpayers. In any case, it will alter the size of tax liabilities for many individuals within that group. By contrast, many whose taxes are increased by elimination of the deduction for state income tax will not benefit from abolition of the AMT.

Eliminating the AMT simplifies taxes, since the AMT is basically a parallel tax system forcing taxpayers to calculate their taxes two different ways. Eliminating deductions simplifies your taxes as well, though it doesn't necessarily make you happier. Capping deductions adds complexity, though it could also enhance progressivity.

In general, this field of endeavor is ripe for cultivation, but there are political boulders in the dirt.

The Simple Tax-Free Life

Much more dubious is the commission's goal of reducing or eliminating taxes on capital income -- chiefly capital gains, dividends, interest, and profits.

For individuals, the process is well underway. Capital gains have long received preferential treatment, and recent tax cuts have granted dividends preferred status. The commission would continue this process, as well as provide new breaks for profits and interest income.

Although many people receive a modest amount of capital income, it's generally concentrated among high-income recipients relative to wage income. So a shift away from taxing capital income is a shift “from wealth to work,” in John Edwards' felicitous phrase. Every new exception to applying the standard tax rates to capital income is a move towards a regime of wage taxation. (As is including fringe benefits in the tax base, as the commission would do with the exclusion for employer-paid health insurance.)

On the business side, liberalization of rules for deducting capital expenses narrows the coverage of taxes on business income. As for individuals, the earlier and larger the deduction, the more value it gains over time, implicitly offsetting the superficial tax on income. The only thing left to tax would be unusually high profits.

Say Something Nice

A single ray of light in all this is the commission's interest in reforming the complex array of tax benefits for low-income families with children. The Earned Income Tax Credit (EITC), Child Tax Credit (CTC), Additional Child Credit (ACC), dependent exemption, and head-of-household filing status all hinge on the same characteristic: having dependent children. Yet eligibility rules for these diverse benefits vary, leading to filing errors, litigation, and administrative headaches for the IRS.

The commission has proposed to consolidate this array of benefits into two credits: one for families with children, the other for workers. This approach has already been written into legislation offered by Representatives Dennis Kucinich, Bernie Sanders, and Barbara Lee. Their bill, H.R. 3655, unifies eligibility criteria for these benefits around two expanded, refundable tax benefits. One is a payroll tax credit, the other a child credit. Besides simplifying taxes for working families, this approach has the merit of precluding marriage penalties, since the benefits can be the same regardless of the marital status of the taxpayer.

Low-income families have seen little in the way of tax relief since 2000, an oversight that expanding these benefits would remedy. The question is whether the specific benefit levels and other details suggested by the commission will raise or reduce existing benefits.

What's It All About?

The reform of refundable tax credits could end up helping or hurting working people, depending on the details. Otherwise, the overall approach is to reduce taxes on high salaries, investment, and business income, and to reduce tax benefits for consumption of state and local public services, health care, and housing. The consequence would be more of what we've already seen from the Bush tax cuts: taxing work more, and wealth less.

Max B. Sawicky is an economist at the Economic Policy Institute and the author of the MaxSpeak blog.