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.

Cap on Deductions

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:

  1. 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.
  2. 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.
  3. 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

 
Lindsey Graham

Senator Lindsey Graham, Republican, South Carolina. This United States Congress image is in the public domain. This may be because it is an official Congressional portrait, because it was taken by an official employee of the Congress, or because it has been released into the public domain and posted on the official websites of a member of Congress. As a work of the U.S. federal government, the image is in the public domain.

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.

The Senator asserts that capping deductions by $40,000 will generate $1 trillion in revenues. Millionaires are the focus, at-least in Graham’s recent statements and those previously made by Obama.

Policy Beyond Class

 
The very mention of the phrase “millionaires pay more” elicits cheers from the left, particularly after the class-warfare programming  waged against Mitt Romney in the recent elections. But this is where middle- and lower-income Democratic voters are being led to a frustrating solution. Namely, while millionaires are served-up as political fodder, the effect of capping deductions or in the more extreme model of flat-tax reform, ending write-offs altogether, will have extraordinary effects on middle-America that would disproportionately pay to resolve America’s fiscal woes. When Washington discusses additional revenues by lowering deductions, ordinary citizens must ask, “What deductions? What caps?” The answers are not restricted the interests of millionaires, but extend to non-millionaires who will also feel the brunt of these changes that cut as cleanly and quickly as a guillotine.

Is This a Reagan II Moment?

 
Our political memory should not be as short to forget that we have been down this path before. The most glaring example occurred when Ronald Reagan’s sweeping tax reforms eliminated an array of loan interest write-offs. In 1913, Washington enacted tax legislation that permitted taxpayers to reduce their tax liability by deducting all forms of interest on loans, given certain limitations. These deductions most often included credit card interest, interest on installments loans for automobiles, and student loan interests.  
[pullquote align=”right” textalign=”left” width=”35%”]
The Tax Reform Act of 1986 ended the aforementioned deductions. Not only were top marginal rates reduced from 50% to 28%, but also deductions on the aforementioned types of interests (i.e., consumer, installment) were eliminated. The middle-class, disproportionately hit by these changes, in-effect subsidized tax reductions on higher-income taxpayers. Nearly 30 years removed from Reagan’s dramatic tax reform, younger consumers might find it surprising that just three decades ago, the interest paid for loans to finance vacations, loans to purchase an SUV, and loans to buy furniture for an apartment or first home would have been deducted when calculating tax liability.
Arguments can be made for restoring these deductions. For instance, deductions on loans to purpose American made automobiles could have enormous impact on domestic output. That said, once gone, deductions seldom, if ever, return.
[/pullquote]  

In addition to the above, deductions on mortgage interests were intended to accomplish a variety of socioeconomic goals. Mortgage deduction evolved over the years, survived the Tax Reform Act of 1986 — as per 26 U.S.C. § 163(h) of the Internal Revenue Code — and continues today. Tax Reform Act of 1986 preserved mortgage interest deductions. However, new laws restricted qualified loans on those for principal and secondary residents. Further, taxpayers could only claim interest on mortgage debt up to $1 million.
 
Proposals circulating during the run up to 1986 legislation called for elimination of the mortgage interest deduction, However, in a 1984 speech before National Association of Realtors, President Ronald Reagan emphasized, “I strongly agreed with the home mortgage interest deduction, which is so vital to millions of hard-working Americans. And in case there’s still any doubt, I want you to know we will preserve that part of the American dream.

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].
[half]
I will dedicate future article to these topics. However, we can readily determine the hidden/vested interest in tax reform by considering the source of growing calls for it. That is, are middle-income and low-income families screaming for tax reform? I would say not. Are we to conclude that multi-millionaires (e.g., Malcolm Forbes) are pushing tax reform so that they can pay more taxes? And while American might not enjoy the inconveniences of preparing taxes, how often do we witness a stampede of ordinary citizens yelling, “We demand a simple tax code!“?
[/half]
[half]
[important]Humor Advisor…[/important]
[/half]

What’s At Stake

It might come as a surprise to the political party faithful, but powerful interests control the direction of these institutions. Demonstrating this is beyond the scope of this article. But I encourage readers to take an in-depth review of our political system and major influences that shape everything from the 2-party system to lack of campaign finance  reform to lobbyist/special interests.
 
Addressing our fiscal crisis is first about power; power to influence the placement of national burden in fixing deficit and debt problems. Economic units, including corporations, have not traditionally shown an interest in taking on the heavy burdens. The dynamics of our financial markets make little room for that kind of altruism. Ultimately, ordinary citizens, those whose power is most explicit defined by casting votes for representative government leaders, will be looked upon to correct problems few of this class actually created. And party affiliation will matter little.
 
Consequently, the stakes must be known. Here, I offer a number of issues with Graham’s recommendation:
 
1.  The Deductions Cap Is Too Low.
 
Graham’s suggestion that deductions be capped at $40,000 might breeze by casual listeners. Many might automatically assume that such as high percentage will only impact the upper income. Graham masks what are several problems with the ideas of flat tax/tax reform, in-general. That is, it will strip away benefits that average Americans enjoy under the current tax code. While the $40,000 cap appears to be high, consider that ordinary Americans can well exceed Graham’s proposed deductions. Consider, a hypothetical family of four with the following financial profile that might include: mortgage interest, charitable contributions, dependent exemptions, college expenses, college loan interest, and medical expenses. In this scenario, Graham’s $40,000 cap could very well translate into an increase in tax liability.
 
2.  Shifts Fiscal Burden to Middle- and Low-Income.
 
A discussion of fiscal solutions that includes “widening” the net of those who pay taxes is effectively placing the burden of our nation’s problems on the shoulders of lower-income citizens. And this is a part of a policy combination punch when coupled with spending cuts. What’s most disturbing is the public policy and industry changed that led to an entitlements crisis did not come out of this group. Again, one has to look at America’s gradual exporting of jobs and other decisions that created structural problems.
 
3.  Marginal Rates.
 
The other side of proposed caps on deductions is the question, “What will be the marginal tax rates under a new tax code?” Irrespective of what happens to deductions, the net effect is known when tax rate schedules are decided. Here, even a generous deductions caps can be nullified by tax rates that effectively leave middle- and low-income families paying [disproportionately] higher net taxes.
 
To illustrate, assume the above family paid taxes on net income of $62,500 at a marginal tax rate of 20%. The tax liability would be %$12,500. Now, assume tax revisions specified the $40,000 cap on deductions and a marginal tax rate of 17%. The adjusted gross income of $85,000 would result in a tax liability of $14,450. Changes in the tax code would increase this family’s taxes by 15.6%!
 
Again, these are hypothetical scenarios. But they illustrate how a move to cap deductions and “simply” the tax structure could shift the burden of our nation’s deficits onto the middle-class, at a time where wages are falling and unemployment is a constant foe.
 
4. Myriad Upheavals in American Life.
 
It remains to be seen whether Congress and The White House will tackle the serious decisions required to get our nation’s fiscal house in order. Citizens cannot afford to view these decisions from a class perspective as they will assuredly transcend class. To illustrate, the following lists only a few of the many potential changes that Washington might enact to address our fiscal woes:
  • 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.

 
 
The above list is broader than deductions, but serves to remind us that a class orientation/expectation for what is to come of fiscal policy is misguided to say the least. We all benefited in some ways from past policies and must now absorb the cost of those benefits. That said, we should be highly skeptical that Washington’s rush to reforms might unleash unintended rippling effects on everything from the ability of local churches to provide afterschool programs to the prospects for Joe the Carpenter who relies on home remodeling jobs to feed his family.
 

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?….

 

 

[cardoza_wp_poll id=4]

 

 

 

The following two tabs change content below.
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •  
  •