Capping Deductions – The Next Tax Reform Guillotine
The expression “waiting for the axe to fall” describes our expectation of an undesirable event. It conjures up images of a prisoner awaiting execution, which in ancient Europe occurred by way of the guillotine — created by French physician Dr. Joseph-Ignance Guillotin after the French Revolution as a less painful device through which to perform capital punishment.
The myth of less pain is interesting as it places the executor in the position of the executed — which necessarily under-appreciates the notion of “pain” itself. It’s like a mugger offering, “I wanted to stab you but I’ll shoot you instead since it will not hurt as much!”
No more fitting metaphor can be applied to the ideas emerging out of Washington as bi-partisan consensus on tax policy. Indeed, the White House and Congress are both moving down a course that will turn Washington into a city of Dr. Guillotines.
Summarizing An Earlier Position
In Rethinking Fiscal Policy, I argued among other things that both Republicans and Democrats are conveying a level of policy rhetoric that must be balanced by a responsible public in order to arrive at sensible solutions to our nation’s financial woes. Truth resides in the brick of neither party, but takes up residence in the mortar. We might note, for instance:
- Contrary to GOP persistent charges of Obama wanting to raise taxes on the wealthy, this at-best shades the truth of Bush Tax Cuts [BTC]. That is, changing marginal tax rates, including pushing the top rate from 35% to 39%, is not raising taxes. The BTC regime was a “temporary” measure. The associated tax rate reductions were designed to end according to timetables outlined in the legislation, returning all taxpayers to pre-BTC tax rates. For the GOP to label terminating BTC a tax increase requires summarily neglecting the legislative context that gave birth to BTC.
- As for the Democrats, ending BTC provisions targeted at the highest income earners is necessary, but not sufficient for the level of deficits and debts our nation is experiencing. In 2011, our nation exceeded $1.1 trillion in deficits, while witnessing our national debt climb beyond $16 trillion. Republican administrations have contributed to this. But Obama’s misadventures exacerbated our problems. We have dug ourselves into a hole from which no class of taxpayers, including the most wealthy, can free our nation in the near-term.
- Without addressing a number of structural transformations in American society and our economy, no tax reform will successfully address deficit/debt problems that plague our nation. For instance, America followed the Japanese along a productivity race.that intensified in the 1970s and 1980s. We have now so altered the technology-labor input ratio that permanent shifts in unemployment, protracted lower payroll taxes to the Social Security Trust Fund, and a large population receiving entitlements complicate our annual budgets.
Post-Election “Fiscal Cliff” Positioning
We can be certain that neither party wants to carry the luggage of the country over the looming fiscal cliff. That virtually guarantees jockeying before December 31st.
Consequently, the public must likely be keen about the emerging consensus between two seemingly disjointed views about tax reform. Ordinary citizens will be well-advised to lay down party dogma and membership cards to take a sober look at a conversation that is gradually creeping into Washington discourse under the guise of compromise and cooperation.
One particular area of concern is growing talk about capping tax deductions. South Carolina Republican Senator Lindsey Graham is conceding a shift in raising taxes. Media outlets are hailing this as an olive branch to President Obama despite the supposed violation of Graham’s Tax Protection Pledge made to Grover Norquist, Founder and President of Americans for Tax Reform and member of the Council on Foreign Relations. Norquist contends that Graham will not follow-through with his pursuit of tax increases because Graham “likes being a Senator”. Norguist has garnered the support of Tea Party to push his small government/tax reduction agenda. However, the Tea Party was dealt a serious blow during the presidential campaign — first by the poor showing of Ron Paul, then by a Democratic victory that many cite as backlash from the Tea Party’s treatment of President Obama.
On the surface, Graham appears to acquiesce to Obama’s get-tough position on upper-income Americans paying their fair share. Indeed, Graham invokes the buzz-word “millionaires” when discussing his evolving position. But Graham is specific that while he does not support increasing tax rates, particularly at the higher end, he is in-favor of capping deductions.
Policy Beyond Class
Is This a Reagan II Moment?
Sacred Cow Rumblings
The times are changing. What survived 1986 might very well meet its demise under the current fiscal environment. Economists are again citing a plethora of reasons to end various tax deductions. For instance, Roger Lowenstein contends:
The first modern federal income tax was created in 1894. Interest — all forms of interest — was deductible; the Supreme Court, however, quickly ruled that the tax was unconstitutional. In 1913, the Constitution was amended and a new income tax was enacted. Once again, interest was deductible.
There is no evidence, however, that Congress thought much about this provision. It certainly wasn’t thinking of the interest deduction as a stepping-stone to middle-class homeownership, because the tax excluded the first $3,000 (or for married couples, $4,000) of income; less than 1 percent of the population earned more than that. The people paying taxes — Andrew Carnegie and such — did not need the deduction to afford their homes or their yachts.
There is another reason Congress could not have had homeownership in mind. The great majority of people who owned a home did not have a mortgage. The exceptions were farmers. But most folks bought their homes with cash; they had no mortgage interest to deduct.
When Congress made interest deductible, it was probably thinking of business interest. Just as today, the aim was to tax a business’s profits after expenses had been netted out, and interest was an expense like any other. In a nation of small proprietors, basically all interest looked like business interest. Whether it was interest on a farm mortgage, or interest on a loan to purchase a tractor, or interest charged to a general store that purchased its inventory on credit, it all would have looked like a business expense. Credit cards did not exist. So Congress just said, “Deduct it.”
It was not until the 1920’s and the spread of the automobile that home mortgages outnumbered farm mortgages. In the 1930’s, the mortgage industry got a huge assist from the feds — not from the tax deduction, but from agencies like the Federal Housing Administration, which insured 30-year loans, and, over time, the newly created Federal National Mortgage Association, or Fannie Mae. Before then, the corner bank would issue a mortgage and wait for the homeowner to pay them back; now savings and loans could replenish their capital by selling their mortgages to Fannie Mae — meaning they could turn around and issue a new mortgage to someone else.
Lowenstein’s thesis reflects a libertarian philosophy and growing push for a flat tax structure — something I sternly oppose for various reasons. Lowenstein’s arguments are debatable. As an example, to discount mortgage interest deduction as our government’s attempt to stimulate homeownership by citing the prevailing use of cash purchases in 1913 ignores the policy goals. While it is true that homes were often purchased by cash, that system yielded low homeownership rates. In 1910, only Idaho, Maine, Michigan, Minnesota, Montana, New Mexico, North Dakota, Oregon, South Dakota, and Wisconsin boasted homeownership rates of 60% or higher. By 2000, only California, District of Columbia, Hawaii, and New York fell below the 60% mark, with 17 states at 70% or higher. Mortgage interest also facilitated the construction of multi-family that while not always contributing to homeownership, provided sufficient supply to support the growth of America’s urban centers as well as innovative real estate contracts. Further, mortgage interest deduction enabled generational wealth transference and allowed real estate to become a key sector in our macro-economy.
Similar counterpoints can be made in a discussion about a tax code built around progressive tax rates and deductions. Here, the central point is that voices to end deductions are ringing louder. And there are growing advocates in both major parties.
Who Needs Tax Reform?
This rush to cap deductions is a part of a larger scheme to convert our nation’s financing from a progressive tax system to a regressive system. The most plausible reasons for making changes implode under inspection.
The following will either: 1) fail to address the systemic/structural problems in our economy that feed deficits/debts [F]; 2) offer benefits grossly insignificant to their societal costs [S]; 3) reflect philosophies that have not been proven [P]; and/or 4) further shift tax burden onto middle- and lower-income families [B]. They include:
- Reduce the cost of tax preparation [S]
- Generate more tax revenue [P]
- Leave Americans with more money to build the economy [F, P]
- Enable more fair taxing [B].
What’s At Stake
- Return marginal tax rates to pre-BTC levels
- Return marginal tax rates to pre-BTC levels for certain income brackets
- Cap total deduction
- End or limit amounts of mortgage interest deductions
- Limit deductions for charitable donations
- Revise mortgage interest deductions e.g., one residence only
- Disqualify interest deductions on second mortgages
- Increase eligibility age for Social Security retirement payments
- Reduce unemployment insurance amounts through formula revisions
- Reduce the number of weeks for unemployment insurance
- Reductions in programs that support moderate- and low-income families
- Revise formulas on entitlement programs — Medicare, Medicaid, Social Security
- Reduce various credits e.g., dependency
- Slow the growth/cut military spending
- Alter means tests for some government programs e.g., college tuition
- Revise formulas for subsidies to states e.g., Community Development Block Grants, transportation, education
- Introduce more rigorous competitive grant structures e.g., convert 50% Fed Share to 33% Fed Share
- Eliminate certain programs, particularly those with questionable outcomes.
5. Discourages Charitable Giving.
An overhaul of the tax code that includes either capping deductions or ending them completely will discourage charitable giving at a time when charities are most needed. Advocates for tax reform routinely assert that America’s tax code places high burdens on job creators — businesses and [high-income] individuals. Currently, these taxpayer groups often seek to reduce tax liabilities through charitable contributions that range from church donations to community development corporations. This is not to suggest that charity is solely rooted in financial motivations. Prior to charitable deductions, we can trace giving back to antiquity as in the case of practice of gleaning the fields found in the Book of Ruth.
In the Final Analysis
If Washington does pursue these challenges, ordinary Americans — that is, the 99% — will be forced to consider the road ahead. And that road will run through mainstream as well as Wall Street. Despite the rhetorical jousts between Republicans and Democrats, many will be surprised that both parties are prepared to deal with sacred cows of their core constituencies, including mortgage interest deduction.
So what say you?….
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