On a crisp, clear January night, the president of the United States travels to Capitol Hill to deliver the State of the Union address. After declaring that “the state of our union is strong”—they always say that—the president runs quickly through half a dozen minor policy proposals, pauses dramatically, and then sets forth the administration’s major new initiative for the year. “I will send legislation to Congress,” the president intones proudly, “that directs the Treasury Department to send a check for $7,500 to anybody who buys a $100,000 sports car. This will provide a generous handout to the wealthiest Americans and a major boon to automakers, including those in Germany and Japan. The average wage earner will get no benefit from this new program. By the way, it will increase the deficit by $700 million each year.”
Of course, that’s a fantasy. No president would make such a proposal. Welfare for the rich? Subsidies to foreign car companies? A serious increase in the deficit, with minimal benefit for average Americans? We would never establish a federal giveaway like that.
Except we already have.
In the Energy Improvement and Extension Act of 2008, Congress created a lucrative tax break—it’s Section 30(D) of the Internal Revenue Code—for people who can afford to buy electric or plug-in hybrid cars. It’s formally known as the “new qualified plug-in electric drive motor vehicle credit.” It says anybody buying a qualified plug-in electric car—the list of approved vehicles includes sleek, sporty cars like the $105,000 Tesla Model S P85D and the $138,000 BMW i8—can subtract up to $7,500 from the income tax he or she owes Uncle Sam. There are some less exotic cars that qualify—and get a smaller tax credit—but even those models, for the most part, are priced well beyond the reach of an American family making the median income.
In 2016, the IRS estimates, this tax credit reduced government revenues by about $740 million—money that would have come to the Treasury if the credit didn’t exist. That $740 million could have been used to treat wounded veterans or tighten border controls or reduce the deficit, if we hadn’t chosen to use it to subsidize upper-bracket auto buyers.
No president or member of Congress would dare suggest a spending bill that paid the rich for buying sports cars. But in Congress, Section 30(D) is not considered “spending”; it’s a tax credit. In the simplistic formula of congressional politics, spending is bad, and a tax break is good—even when they amount to the same thing. For the government, the impact is identical; the tax credit costs the same hundreds of millions as a spending bill. Because the language is different, though, Congress readily goes along with giveaways like this one.
Indeed, there are hundreds of credits, subsidies, deductions, and allowances scattered through the Internal Revenue Code that would never be authorized if proposed in a spending bill. “If tested in direct expenditure terms,” wrote Stanley Surrey, a renowned tax scholar at Harvard Law School, “many tax incentives will be seen as either inequitable—often to the point of being so grossly unfair as to be ludicrous—or ineffective.”1 Ludicrous or not, once these loopholes get into the code, they generally don’t go away. The individuals and corporations that benefit from these fiscal gifts fight fiercely to protect them against any efforts at repeal.
That’s why it’s so hard to achieve tax reform through the mechanism of broad base, low rates. Everybody agrees that BBLR should be the driving principle behind the design of a tax system. But big, expensive giveaways like the credit for fancy sports cars keep working their way into the tax code. It happens in every country.
The easy part of BBLR is the low rates. Everybody likes lower tax rates. Economists tell us that low rates make the tax system “neutral.” If the tax burden is small, economic decisions will be based on business and personal considerations, not on tax implications. Governments like low rates because they make a tax system simpler to administer, and they increase voluntary compliance; there’s less motivation to evade taxes if the tax takes only a small part of your income. And taxpayers like a low rate because it makes taxation feel less like robbery.
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SOME OF THESE TAX INCENTIVES serve a useful purpose, encouraging good behavior and discouraging bad. Supporters of the “new qualified plug-in electric drive motor vehicle credit” would say it encourages people to buy environmentally friendly cars that don’t increase our need for foreign oil. But if that’s a legitimate purpose of the tax code, why would there also be a deduction for people who buy recreational vehicles, which are notorious gas-guzzlers?2 Congress doesn’t always act logically when handing out tax breaks.
If a government giveaway is justified by social benefits, its backers should make their case and ask Congress to appropriate the money. If a handout to a specific business or group can’t be justified as a direct government subsidy, it can’t be justified as a tax break, either.
The members of Congress who sponsor these loopholes know that many or most of them could not survive public scrutiny. In fact, the sponsors are so embarrassed to admit what they’re up to that they routinely conceal the real impact of a tax break behind obscure clouds of language that nobody can decipher (except the taxpayer getting the benefit).
Section 512(b)(15) of the Internal Revenue Code, for example, provided a tax exemption for any for-profit enterprise started on May 27, 1959, and owned by a religious organization. Its sponsor, Senator Russell Long of Louisiana, never mentioned that the only enterprise in the whole country that met these requirements was a commercial radio station in his state, WWL, a profitable business that was run by Loyola University. There’s another section of the code, pushed by the Michigan delegation, that gives special preference to “an automobile manufacturer incorporated in Delaware on October 13, 1916.” That would be General Motors, although the name of the firm does not appear.
This kind of loophole is known as a “rifle shot” tax provision, because it is sharply targeted at just a few specific taxpayers. Rich individuals and corporations are willing to pay for these favors—in the form of campaign contributions to the sponsors. That’s one of the reasons members of Congress are always eager to win a spot on the Ways and Means Committee—the tax-writing committee of the House of Representatives—or its Senate counterpart, the Finance Committee. Appointment to either of those committees opens the spigot for contributions to flow freely into a member’s reelection fund from donors hoping for a rifle shot of their own.
After loud complaints from journalists and tax-reform activists about deliberately murky legislative language—critics called it “taxation without comprehension”—Congress took aim at rifle shot taxation in 2007. Since then, the rules of each house urge—but do not require—the chairs of the tax-writing committees to identify the recipients of any tax break that benefits ten or fewer taxpayers. Because it is in the chairs’ discretion whether or not to make this information public, we don’t know whether Congress is still larding the tax code each year with giveaways for specific constituents. What do you think?
Among economists, there’s a term of art for this form of backdoor government spending. The various exemptions, exclusions, credits, allowances, deductions, and such are known as “tax expenditures.” This label was coined by the aforementioned professor Stanley Surrey. In the 1960s, Surrey took a leave from Harvard when his friend John F. Kennedy appointed him to the top policy position at the Treasury Department. This gave him access to all sorts of previously unpublished IRS data on giveaways in the tax code and their cost in lost revenue. When Surrey added them up, he was stunned to find how much revenue the government gave up, or “spent,” through tax breaks. Surrey’s office at the Treasury issued a report on this form of “expenditure” in 1968. It hit like a bombshell.
Until Surrey’s report, nobody knew how much revenue the government lost because of the various credits and exemptions. The 1968 report revealed the totals and made the comparison to the normal kind of government spending. It showed that the sum of the various giveaways was greater than the budget of any federal agency or program, including the Pentagon and Social Security. (It still is today.) Once Congress realized how much it was spending through the tax code, the concept of “tax expenditures” became a central element of tax policy. Today, Treasury is required by law to make public detailed listings each year on the amount lost through tax expenditures for both the individual and the corporate income tax.
Back in his classes at Harvard, Surrey attacked tax expenditures with great zeal. He loved to propose nutty hypothetical spending bills. When he taught his students about the deduction for home mortgage interest, he made it sound ridiculous. He laid it out something like this:
The federal government wants to help some Americans pay their mortgage. Here’s how it works: For a couple with $200,000 of income, and a mortgage interest payment of $1000 per month, the government will pay the bank $700 and the homeowners will have to pay only $300. For a couple with $20,000 of income and a mortgage interest payment of $1000 per month, the government will pay $190, leaving the couple to pay $810. For a couple making less than $10,000, the government will pay zero—so the low-income couple has to pay the full $1000 of mortgage interest.
Surrey would then point out that such a proposal—giving a big payment to the rich, a smaller payment to the middle class, and nothing to the poor—wouldn’t stand a chance in Congress as a direct appropriation. But, in fact, this system already exists—in the tax code. The mortgage interest deduction—or any deduction, for that matter—saves far more for taxpayers in the top bracket than for the average family or the poor. Surrey’s hypothetical was based on tax rates in effect at the time, when the top marginal rate was 70%. But even today, with a top rate of 39.6%, the mortgage interest deduction has the same reverse Robin Hood impact. It saves a rich family $396 for every $1,000 of mortgage interest due—but saves zero for low-income homeowners. Those who least need help get a subsidy, while those who most need it get nothing. This is a common pattern for tax expenditures. “The unfairness of the deduction,” Surrey wrote, “in its favoritism for upper bracket taxpayers is . . . evident.”
Tax expenditures take several different forms, and the structure of each tax break determines how it affects different groups of taxpayers. As Surrey taught, a deduction or an exemption from income gives a larger tax benefit to the rich, which he considered unfair favoritism. A tax credit, in contrast, gives the same benefit to all taxpayers.
If a tax preference is an “exemption” or an “exclusion” from income, then it reduces the amount of income you have to report. A “deduction” works the same way; a certain amount is deducted from the taxpayer’s actual income, to make his taxable income smaller. The tax rate is then applied to the taxable income; the higher the rate you have to pay, the more you save with each deduction. The result: a high-bracket family, paying 39.6% of taxable income, will get a larger write-off than a low-income family paying at the 10% rate. This benefits the rich more than the poor. The low-income taxpayers who need a tax cut the most actually get the least.
In contrast, a tax preference that is structured as a “credit” gives the average earner and the upper-bracket earner the same amount of tax savings. A credit is subtracted from the tax that is due after all the deductions and exemptions have been applied. Thus a tax credit of $100 will cut the taxes of the richest families by $100 and cut the average family’s tax bill by the same amount, $100.
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STANLEY SURREY’S NOTION OF tax breaks as “expenditures” caught on as well with the economists at the World Bank and the OECD. Those organizations quickly endorsed this American innovation and urged their member countries to tally tax expenditures annually in order to “clarify the trade-off between tax and spending programs in budget decisions.” Today more than two dozen of the world’s richest countries issue public reports each year on their tax expenditures. (South Korea compiles the same information but does not make it public.)3
Despite its prestigious academic pedigree and its broad international acceptance, the very concept of “tax expenditures” remains controversial, in the United States and in many other countries. The basic idea grates on people. If big government allows me to keep some of my own money in my wallet through a tax exemption, how can you call that “spending” by the government? It was never the government’s money to spend! Professor Surrey’s idea has been ridiculed from both right and left, by conservative Republicans and by Jon Stewart on The Daily Show. The British parliamentarian Stafford Northcote offered a famous denunciation of the concept: “The right honorable gentleman, if he took £5 out of the pocket of a man with £100, would put the case as if he gave the man £95.”
In the United States, the chairman of the Senate Finance Committee, the generally mild-mannered senator Orrin Hatch of Utah, was moved to uncharacteristic heat on this topic in a speech on the Senate floor. “The federal government cannot ‘spend’ money that it never touched and never possessed,” the senator complained. “What tax expenditures do is let people keep more of their own money.” Hatch argued that the whole idea of a “tax expenditure” was just a gimmick used by liberals to justify tax increases. “When tax hike proponents say ‘We are giving businesses and individuals all this money in tax expenditures,’ they are incorrectly assuming that the government has the money to give in the first place, when in fact it does not.”4
Whatever the nomenclature, the annual reports from the Treasury Department and from finance ministries around the world make it clear that some of the rich democracies forgo large sums of potential revenue through tax preferences. On the personal income tax, a broad range of exemptions, deductions, credits, and so on reduce Great Britain’s tax revenues by 50% from what they would be without all those preferences. Italy’s revenues are 40.6% lower than they would be if all the credits and such were eliminated; in Spain, 34.6% lower; in Austria, 30% lower. In the United States, revenue is 37% lower than it would be without all the tax breaks. That means Congress could cut everybody’s tax rate by 37% and take in the same amount of revenue if we didn’t have all those tax expenditures.
For sheer creativity, the Italian income tax code is the world champion at inventing new credits. Like the United States and many other countries, Italy gives a tax deduction for paying the mortgage on your home. But the Italians also get a tax break for buying a home, renting a home, or renting an apartment for a child away at college. There is an income tax credit in Italy for “the annual subscription of children between 5 and 18 years old to gyms, swimming pools, and sporting clubs.” Any Italian who gets a salary or a pension from the Vatican is exempt from income tax. Italy gives a tax credit for life insurance premiums.5
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BUT THIS LEVEL OF tax expenditure is not a natural or a necessary aspect of a tax regime. Many developed countries—those that have broadened the base by eliminating tax expenditures—have minimal revenue losses. New Zealand’s income tax revenues are just 2% less than what they would be without any preferences. Denmark, Norway, France, and Germany are other countries that have a small revenue loss due to giveaways in the tax code. When these governments feel a need to provide subsidies to a particular group of people or businesses, the parliament passes a bill for a new spending program. That makes the whole process more transparent, it simplifies the tax code, and it means tax rates can be lower than they would be with a plethora of loopholes.
In the United States, the cost of tax expenditures is greater today than when Stanley Surrey’s blockbuster report came out in 1968. In fiscal year 2014, the total of tax preferences in the personal and corporate income tax came to $1.17 trillion, far more than any single government program. The breakdown looks like this:
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Federal spending by program, 2014 |
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Social Security |
$845 billion |
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Medicare and Medicaid |
$807 billion |
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Defense (including Afghanistan) |
$696 billion |
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Civilian departments and agencies |
$582 billion |
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Tax expenditures |
$1,169 billion |
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Source: Office of Management and Budget, Budget of the United States, Fiscal Year 2014, Historical Tables 8.5 |
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The United States offers tax breaks for contributing to charity, taking a night-school course, paying local property tax, growing sugarcane, moving to a new city for a job, replanting a forest, insulating the attic, paying off a mortgage, destroying old farm equipment, employing Native Americans, commuting to work by bicycle (but only for a bike that is “regularly used for a substantial portion of travel,” whatever that means),6 or buying a plug-in hybrid sports car. Congress’s Joint Committee on Taxation counts more than two hundred separate tax expenditures.
Because many of these giveaways replicate the kinds of benefits provided by governments in left-leaning European countries, tax expenditures have been called America’s “hidden welfare state.” That is, we give people welfare through the tax code even when we aren’t willing to provide the same kind of support by sending a welfare check.
When our family lived in Great Britain, we received a check each month from the government for something called “child benefit.” We still had two kids under eighteen then, and we got about $100 per month for each of them. They pay you just to have children! That sure seemed like the European welfare state to me; can you imagine the U.S. government sending welfare checks to an upper-bracket family like ours just for having kids? In fact, we do—through the tax code. An American taxpayer gets a tax exemption for each dependent child under eighteen (plus any child over nineteen who is still a student); in 2016, it was $4,050 per child. For me, the tax saving I got in the United States from the exemption was just about the same amount as those “child benefit” checks I got in Europe. (Beyond that exemption, there’s also a “child credit” provision that cuts the tax bill by $1,000 per child for many American families.)
Following Stanley Surrey’s example, the Treasury Department reports each year on how much revenue is lost due to each specific tax break. This annual report is a long and nearly impenetrable document that seems designed to make the information as opaque as possible. In its 2015 report, Treasury listed 169 specific tax breaks, including “Exclusion of interest on life insurance savings” ($17.1 billion), “multi-period timber growing costs” ($360 million), and the “Indian Employment Credit” ($30 million). But the report does not bother to show the total cost of all these giveaways; the department’s explanation is that the law requires a “list” of tax expenditures but not a “total.” (As noted above, if you add them all up, they total about $1.17 trillion.) To complicate things further, the congressional Joint Committee on Taxation issues its own yearly report on tax expenditures, with figures that are different from the Treasury’s in many cases.
Every year, the number one exemption is the rule that says the premium your employer pays for health insurance is not counted as taxable income; for 2016, the Treasury Department said, this would cost the government $216 billion. The economists say this makes no sense; paying an employee’s insurance premium is the same thing as paying an employee’s wages and should be taxed the same way. Other countries that have private health insurance companies generally do not allow this tax exclusion. In any case, health insurance is so much cheaper in the other developed countries that exclusion would amount to a fairly small revenue loss. It’s only the United States that adds $200 billion to its deficit every year through this tax break.
After that huge one, the major tax expenditures in the Internal Revenue Code involve deductions for homeowners, tax breaks for retirement savings, the decision not to tax corporate profits that are held overseas, and the deduction for charitable contributions.
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TO BROADEN THE BASE and lower the rates, we have to get rid of these costly expenditures. It should be easy to go after hard-to-defend tax breaks like the credit for buying a $105,000 sports car or for destroying an obsolete tractor. There are dozens of these loopholes in the code that could not be justified if they were proposed as outright spending programs. Unfortunately, most of the obviously stupid tax expenditures involve a relatively small loss of revenue. If we’re going to make any serious headway against the avalanche of giveaways in our tax code—so that the rates can be cut—we will have to get rid of some of the biggest and best-liked tax deductions as well.
Probably the most popular tax break in the Internal Revenue Code is the deduction for charitable contributions. Everybody likes the idea of rewarding people for being generous. You give money to a charity; you deduct that amount from your income; you end up paying less tax. The charity gets money it needs for good causes; the taxpayer saves some money on April 15. The downside is that government takes in $50 billion less revenue every year. (It’s possible, though, that the charitable contribution might also save the government some money, by funding a public purpose that would otherwise be left to government.)
This deduction probably matters more to Americans than anybody else because we give more to charity than the citizens of any other country. And the United States has more officially recognized charities—that is, organizations that earn a tax deduction for their contributors—than any other country. The Chronicle of Philanthropy says the number of different organizations eligible to receive tax-deductible contributions is over one million; in other countries, the number tends to be a few dozen.
At first blush, the notion of encouraging people through the tax code to give to charity seems as pure and sweet as mother’s milk. But the whole idea turns sour when you look at it closely; that’s why more and more developed countries have sharply limited this deduction or dropped it altogether.
One major sore point is that the charitable deduction is a deduction and thus saves far more for upper-bracket taxpayers than for the average worker. If a woman so rich that she is taxed at the top rate (39.6%) gives $100 to her church, that gift will reduce her tax bill by $39.60. A woman at the medium income, paying tax at a rate of 15%, will save only $15 for the same $100 contribution. This is the problem Professor Surrey used to illuminate for his students: “The unfairness of the deduction in its favoritism for upper bracket taxpayers is . . . evident.”
But that’s not the only problem with the deduction for charitable donations:
—Most people who give to charity get no deduction for it. To take advantage of the charitable deduction, you have to fill out the IRS form for “itemized deductions.” But only about one-third of all taxpayers use this form. The majority of taxpayers just take the standard deduction, which gives you the same deduction whether or not you give money to charity. Therefore, most people get no tax benefit for giving to charity. The millionaire who gives enough to get her name on a dorm at her alma mater gets a big tax break, while the median-income mom who gives $50 to the local PTA gets none.
—The most common forms of charity don’t qualify. In a nation of churchgoers, putting cash in the collection plate at weekly services is probably the most common way people give money, along with giving a homeless panhandler a dollar or dropping $5 into the pot to help fund the school baseball team. But these familiar acts of charity will not get you a tax deduction. Cash contributions don’t count.
—It’s widely abused. If you write a check for $100 to the Boy Scouts, or give an old car to the public radio station, these contributions are easy to value. But the richest taxpayers often make charitable donations with a cash value that is hard to determine—land or buildings or works of art. The most common problem here comes in gifts of paintings or sculpture to museums. To determine the value of the contribution, the donor or the museum often turns to an “independent” appraiser. The appraiser’s fees are paid by the donor or the museum. And the appraiser knows, of course, that those who pay her fee want to claim the highest plausible value; that way, the donor gets the largest possible tax deduction, and the museum can boast about its fabulously expensive new acquisition.
This situation is abused so frequently that tax collection agencies around the world have had to set up their own appraisal offices; in the United States, the IRS has the Office of Art Appraisal Services and the Art Advisory Panel. In about two-thirds of the cases it reviews, the IRS finds that the donated work of art is worth significantly less than the donor’s appraisal. That finding, in turn, often leads to an extended and expensive battle in court.7
In addition to excessive valuations, donors of artworks have devised various stratagems that let them take the deduction without actually giving up the art. One gambit is called fractional giving. This means that you give the painting to a museum for a fraction of the year (maybe for three months, while you’re at your summer home in the South of France), take a tax deduction for this contribution, and then put the painting back in your living room. Congress cracked down somewhat on this scheme in 2008. That reform prompted rich donors to create a different dodge: the “private museum.” This means you build a museum next to your house, sometimes way out in the country, with no sign on the door. You give your art to this “private museum” and take a tax deduction—for giving art to yourself. The Glenstone museum, for example, has provided its founder with major tax deductions since it was created in 2006. It is situated on the estate of its owner in Potomac, Maryland, with a gate and a guardhouse to protect the privacy of the collection.8
—It’s not easy to define a “charity.” When Congress wrote the law setting forth which organizations qualify as charities, it threw in everything but the kitchen sink. If any group’s activities are “religious, educational, charitable, scientific, literary, testing for public safety, to foster national or international amateur sports competition or prevention of cruelty to animals,” it qualifies. Some of the outfits to which contributions are tax deductible are one-room soup kitchens run by volunteers in the church basement; others are huge and highly prosperous organizations. Your gift to Harvard University, for example, is treated as a deductible contribution to “charity,” even though Harvard is sitting on an endowment of $37 billion and earns more than $1 billion each year in the securities markets.
The IRS rules list twenty-eight different forms of “exempt organizations.” Some are eligible for tax-deductible contributions; some are not. If you send money to the Heritage Foundation, a Washington, D.C., think tank that advocates conservative policies, that’s deductible, but if you send money to Heritage Action for America, an organization that has the same address and campaigns for the same conservative policies, that’s not deductible. Keeping track of which organizations are really charities, and which ones are actually business or political operations masquerading as “social welfare” operations, is a full-time job for several hundred IRS staffers. The designations change so often that the IRS finally had to stop printing its list of authorized charities and switch instead to an online document so that it could be updated daily.9 Because Congress, as usual, failed to make clear distinctions in the laws it wrote, the task of distinguishing charities from non-charities falls to IRS bureaucrats. This became the subject of angry political uproar in 2013 when it was charged that IRS staffers were singling out Tea Party groups for extra scrutiny when they applied for tax-exempt status. To avoid future controversies, the IRS today grants “exempt” status to 95% of all the groups that apply for it.10
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ALL THOSE ISSUES SHOULD be enough to demonstrate that the deduction for charitable contributions is costly, unfair, and easy to abuse. But there’s actually a more fundamental problem with this particular deduction: It doesn’t work. Although it costs governments a lot of money in the form of reduced revenues, it doesn’t do what it is supposed to do.
The purpose of this deduction is to encourage people to give more and thus increase the money available for charity. But there’s no evidence—no studies, no data—that shows people contribute more because of the tax deduction. In the United States, the last few decades seem to show the opposite. When tax rates go up—which makes the deduction more valuable to the giver—contributions stay about the same. When tax rates go down—so that each contribution is less valuable on Tax Day—contributions stay about the same. With the big 1986 tax cut, the top rate fell from 50% to 28%. This made a contribution far less valuable in tax terms, and many charitable groups predicted a disastrous drop in donations. In fact, the effect was minimal. Contributions dropped slightly for a couple of years after the 1986 rate cut and then started going up again.
Still, the politics of eliminating the charitable deduction can be difficult. Here, too, we can learn from other nations. Most developed democracies that used to allow a full deduction for gifts to charity have sharply curtailed or eliminated this problematic tax break.
One common approach is to put a limit on how much any taxpayer can write off for charitable gifts in a single year. The United States has such a limit; generally, people can deduct no more than 50% of their income for contributions. Other countries have made the limit stricter. In much of Europe, the total of deductible contributions can’t exceed 20% of income, which means a much lower loss of revenue; in the Netherlands, the limit is 10%. To deal with Professor Surrey’s “unfairness” problem—giving the rich a bigger write-off than average earners who contribute the same amount—some countries (for example, Canada and France) give a tax credit, rather than a deduction, for contributions. Most developed countries have a much tighter definition of what constitutes a “charity” that is eligible for deductible contributions. The U.S. roster, more than a million approved charities, runs for scores of pages on the Internet; Japan’s entire list of eligible charities fits on one side of one sheet of paper. Japan also gives a tax deduction for contributions to government agencies, but that list is also fairly short.
The best way, though, to avoid the unfairness, the abuses, and the revenue loss from the charitable deduction is to get rid of this deduction altogether. Austria, Finland, Ireland, Italy, Sweden, and Switzerland all have flourishing charity sectors, even after they took away the tax break for contributions; New Zealand, of course, got rid of it in that first base-broadening exercise in the 1980s. None of these countries saw any significant drop in charitable contributions. All over the world, people contribute mainly because of a belief in a particular cause or because of a basic human desire to help others. Getting a tax break is, at most, a minor motivation. The tax deduction for charitable contributions cheapens the charitable impulse by implying that you and I wouldn’t give a dime to charity unless we got a little financial gain on the side.
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AN EVEN LARGER DRAIN on tax revenues comes from the several provisions in the tax code that benefit homeowners. Most countries provide some tax relief for homeowners; the United States is the most generous of all in this area. Just like the charity deduction, the homeowner provisions are extremely popular. Economically, though, they don’t make much sense. Like the charity deduction, the benefits for home ownership are strongly skewed to the richest taxpayers. Millions of homeowners—those who don’t itemize deductions—get little or no benefit from the homeowner deductions. Like the charity deduction, they cost a lot in lost revenue; the Treasury Department estimates about $200 billion in 2016. And like the charity deduction, these tax breaks are unnecessary. They are supposed to encourage home ownership, but countries that don’t allow these deductions have ownership rates as high as ours.
The economists say that the tax code benefits homeowners in four ways.
While this deduction is promoted by realtors and mortgage bankers as a boon to home buyers, it is just as likely to make a home purchase more difficult. All studies (except those funded by the real estate industry) find that a mortgage interest deduction raises the price of a house. When the OECD investigated the impact of the mortgage interest deduction in wealthy countries where it is still in place, it concluded that “new purchasers . . . are not necessarily the beneficiaries of these tax provisions,” because the interest deduction forces them to pay an increased price. Whatever benefit a buyer might get from the tax break is just about completely offset by the higher price of the house.11 So the deduction doesn’t do what it is supposed to do—make it easier for people to buy a home.
Because of the large cost of this tax break and the small impact, Congress has repeatedly tried to take it away. This always fails, because of effective lobbying from realtors and bankers. But Congress has managed to put limits, sort of, on this write-off. It applies only to mortgages up to $1 million, and you get a write-off for the mortgage on only two of your houses, but no more than that. Clearly, these are not limits that touch any average homeowner. Other countries have imposed similar restrictions. Some have made the preference for mortgage interest a credit rather than a deduction, which means everybody gets the same tax break.
But Australia, Canada, Germany, Great Britain, Israel, Japan, the Netherlands, and New Zealand, for example, have no deduction for mortgage interest at all. Yet eliminating the deduction seems to have no impact on home ownership. In all the industrialized democracies, the rate of home ownership is just about the same. Roughly 65% of families own their home in countries that have the mortgage interest deduction, and about 65% of families own their home in countries that do not.
Just like the charitable deduction, though, the write-off for mortgage interest is hard to get rid of. It has been part of the tax code for so long (more than a hundred years) that people see it as a basic right. Beyond that, eliminating the deduction would probably reduce the price a buyer will pay—at least in the short run—and reducing the price of houses would depress the value of what is most Americans’ largest investment. There are ways to make the change gradually, so as to protect the investment of current homeowners. Still, anybody who tries to get rid of this tax break faces a severe political challenge.
Some twenty years ago, however, Great Britain figured out a politically palatable way. Until the 1980s, Brits could write off mortgage interest of just about any amount on any number of houses; just as in the United States, this created a boon to the wealthy and a significant revenue loss for the government. And then, gradually, the Inland Revenue began snipping away at this deduction. At first, the size of the mortgage was limited so that it applied only to mortgages of about $75,000 or less; you could take a deduction for interest up to a loan of that amount but no more. This change cut the deduction for the richest homeowners, but it had only a moderate impact on most British taxpayers. So it was fairly easy to enact. In 1988, the deduction was limited to a mortgage on only one house per family; this, too, had minimal impact on average earners, and it, too, was fairly easy to enact. Beginning in 1992, the government ruled that the deduction could not reduce the tax due by more than 25%. That meant upper-bracket taxpayers got less of a deduction than they had before, but average earners did not. Over the next eight years, the deduction was reduced to 20%, then 15%, then 10%, then 5%. Each change caused a protest, but the bottom-line difference each time was so small for most taxpayers that complaints were muted. Finally, in 2000, the deduction was reduced from 5% to zero. One of the most popular of all tax breaks was completely eliminated.
Because this change occurred during a decade when home prices were rising in most of Britain, few homeowners saw the value of their investment decline. Indeed, the Labour Party government that presided over the demise of the mortgage interest deduction easily won the next two national elections. And of course, tax policy experts advocating the BBLR principle were thrilled. Paul Johnson, the director of the Institute for Fiscal Studies, a prestigious London think tank, related the whole story to me with a tone of sheer delight. “This was a triumph of tax policy!” he declared. “The fact that it proved possible . . . gradually to phase it out is good evidence that reform really is possible even when the tax break being abolished is popular and many losers are created.”
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THE ELIMINATION OF ANY “tax expenditure” will of course create some losers. The beneficiaries, of course, will always make the best case for their particular tax credit, no matter how “ludicrous” it may look to others. One man’s “loophole” is another man’s “essential provision to provide jobs and growth.”
As a general rule, those who advocate the BBLR approach want to reduce tax rates for everybody. But some economists and political figures favor a different reform: they want to reduce rates, but only for taxpayers in the upper brackets. This concept is called a flat tax, and it has its champions in the United States. During the 2016 presidential primaries, five of the Republican candidates proposed a flat-tax regime. But would it work?