A Truly Absurd Tax Code Illustrates the Need for Rational Reform
Tax season is over for all but the greatest procrastinators among us. Two-thirds of taxpayers are celebrating their forthcoming refunds while tens of millions of others have grudgingly written a check to the IRS. Either way, this is the time of year when Americans are most acutely aware of the federal income tax system and all its flaws. Our tax code is extraordinarily difficult to navigate and it sometimes seems that it's more concerned with advancing social and industrial policy goals than raising the money needed to fund government. The plethora of preferential deductions and credits that narrow the tax base and distort the economy cry out for fundamental reform.
In 2012, the 33 percent of filers who claimed itemized deductions, including home mortgage interest, charitable donations, and state and local taxes, reduced their tax liability by $1.2 trillion-the same amount that the federal individual income tax collected in total that year. The child tax credit, various education tax credits, the foreign tax credit, and the earned income tax credit lowered taxes by $71 billion and also triggered cash payments in excess of tax liability of nearly $90 billion. These are not the components of a simple, fair, or pro-growth tax code.
Today, Washington's most committed and powerful tax reform advocate is House Ways and Means Committee Chairman Dave Camp (R-MI). While policymakers and policy analysts alike have extolled the virtues of tax reform, Chairman Camp has painstakingly drafted a bill that embraces the two pillars of a simpler and fairer income tax system: lower statutory tax rates and a broader tax base.
The Camp bill is nearly 1,000 pages long, a testament to the difficulty and complexity of pursuing tax simplification. While irrefutably bold, Camp's proposal is not without compromise. It is on net neither a tax hike nor a tax cut but includes roughly 200 reforms that raise revenue over the next decade, generally by repealing special preferences and tax breaks. That revenue is then used to create three lower tax rates of 10, 25, and 35 percent, increase the standard deduction and child tax credit, and repeal the Alternative Minimum Tax.
Overall, Camp's tax reform bill would make great strides in broadening the tax base and removing distortions from the tax code. But at the same time, it is not purely a clean slate. Reflecting both political realities and perhaps a desire to maintain some tax incentives for particular activities such as charitable giving, Camp often proposes nuanced reforms of tax preferences rather than complete repeal. Take, for example, his treatment of the home mortgage interest deduction.
Under current law, homeowners can deduct interest on mortgages of up to $1 million. Given that the median U.S. home price is just $261,800, this is clearly not a policy targeting just the middle class. Because the tax break is a deduction as opposed to a credit, taxpayers in the top marginal tax bracket enjoy a 39.6 percent federal subsidy for their mortgage interest while middle-income taxpayers' subsidy is just 25 percent. In 2012, taxpayers earning more than $100,000 a year claimed more than half of mortgage interest deductions, even though they filed less than 15 percent of all tax returns.
Camp's reform proposal chips away at the home mortgage interest deduction by gradually lowering the maximum mortgage amount for which interest can be deducted to $500,000. This change would increase federal income tax revenue by halting what is in most cases a government subsidy for those who borrow heavily to buy mansions.
On this tax break, other tax reform advocates have been more aggressive than Camp. Last year, my colleague Alan Viard proposed replacing the home mortgage interest deduction with a refundable 15 percent credit and limiting the credit to interest on $300,000 of mortgage debt. In a tax reform proposal I authored in 2012, I advocated a 12 percent nonrefundable credit on interest on up to $500,000 of mortgage debt, a policy that the Simpson-Bowles Commission had proposed in 2010. In 2005, President Bush's Tax Reform Panel proposed replacing the deduction with a 15 percent nonrefundable credit. In short, the change to the mortgage interest deduction that Camp has proposed, while an important step in the right direction, is relatively modest.
Ultimately, tax reform will be a political negotiation. Neither a "perfect" income tax nor an idealized consumption tax will ever be enacted into law. Compromise will be necessary, but it is absurd to maintain the current tax code. A simpler, more efficient, more growth-oriented tax system is feasible if lawmakers are willing to remove or restructure the current array of distortionary tax breaks. Although Chairman Camp, the reform movement's strongest elected ally, will, unfortunately, retire from Congress at the end of 2014, he leaves his successor with a map for carrying the reform effort forward.