A friend of mine in the film business once told me that there was no shortage of good ideas for movies. He said, “The difference between a good idea for a movie and a real movie is the money.”
Tax reform is very much like that. It is a good idea that lacks the other vital ingredient that will make it real: a constituency. The people who have the most to gain from tax reform – we – aren’t very well organized when it comes to lobbying Congress on this issue.
Besides, we all have good reason to be skeptical about tax reform.
Every year our federal tax system is reformed, and every year it becomes worse. Instead of becoming simpler the Internal Revenue Service code is now fully encoded. It is written in a language not comprehensible by ordinary mortals, but needing to be parsed and interpreted by a priestly order of selected CPAs and lawyers.
All of this is Congress’s responsibility, and some of it is Congress’s fault. The federal tax system, very much like the federal budget, is a compilation of constituent interests, the more powerful and generous of which are awarded the title, special.
This is definitely a complex system under the best of circumstances. And, sadly, some of the special interests influencing Congress are re-election constituencies rather than genuine voter constituencies, and that doesn’t make the process or the result any prettier.
Some of the difficulty with the tax system, though, is less the fault of Congress than it is the growing complexity of our economic lives. A few years ago, for example, who would have thought that ordinary people would be carrying half a million dollars worth of mortgage debt on their homes? Who would have expected ordinary wage earners in the course of saving for retirement to acquire financial assets whose tax implications are fully comprehended only by members of some math-worshiping cult?
The original intent of the tax code’s treatment of mortgage interest was to encourage home ownership, and we shouldn’t forget that it succeeded. The economic effect of the code in many cases today, though, is to divert funds from the U.S. Treasury into the private financial sector, money that would have been paid as taxes is instead paid as interest.
Mortgage interest as a tax deduction is one of the issues taken up by President Bush’s Advisory Panel on Federal Tax Reform. It is now wrapping up its work after nearly two years, and has proposed two alternative reform packages, both of which contain a significant change to the mortgage interest deduction.
Currently, the interest on mortgages up to $1 million is tax deductible. Under the plan proposed by the advisory panel, the upper limit would be reduced to the maximum loan amount that the Federal Housing Administration would insure. That amount varies widely, depending on the local real estate market, but the nationwide average is just below $250,000.
Another feature of the advisory panel’s proposals is that most of what are now tax deductions for individuals, including mortgage interest, would be converted into tax credits. That is a fundamental change in the arithmetic, and the fairness, of the tax code.
The reason it is significant comes from the structure of our progressive tax system. We have six tax brackets, which apply a higher tax rate to people with higher taxable incomes. People with the lowest incomes pay 15 percent while the people with the highest pay 35 percent.
With this kind of system, a tax deduction is worth more to people with big incomes than it is to people with smaller incomes. A deduction of, say, $100 will reduce my taxes by $15 if I am in the lowest bracket while it would reduce my taxes by $35 if I were fortunate enough to be in the highest bracket.
By converting to a tax credit system, the value of the tax reduction for mortgage interest, for example, would be worth the same dollar amount to people with modest incomes as it is to the wealthy.
The advisory panel’s proposal also attempts to simplify what is now a bewildering array of tax-exempt, tax-deferred, and taxable retirement savings accounts. Whether or not this is a real simplification or just another layer of interpretive language for taxpayers to puzzle over will depend on the details of the proposal, which have not yet been made public.
This particular pass at tax reform is “revenue-neutral,” which means it doesn’t change the total taxes paid to the feds. Whether the tax reform script is anything more than a good idea remains to be seen. But one thing is certain: it would make one heck of a movie.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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