Economics, Taxes and Spending

Separating Fact from Fallacy in the Tax Debate

The ongoing debate about the potential role of tax changes in a deficit reduction package appears to be descending into a clash between rival misperceptions. One fallacy rejects all tax increases, including measures, such as repeal of the ethanol tax credit, that level the playing field and thereby allow economic resources to be allocated by the market rather than a distortionary tax system. Some who oppose this fallacy embrace an alternative fallacy holding that any measure that broadens the tax base rather than explicitly increasing marginal tax rates must be conducive to economic growth and efficiency. In reality, as I have observed elsewhere, some base broadening provisions actually tilt the playing field and impede efficiency. In the end, of course, each proposed tax change must be weighed on its own merits.

Unfortunately, many of the tax proposals advanced by the Obama administration and congressional Democrats are misplaced. For example, the proposal to repeal last-in, first-out (LIFO) inventory accounting rests on the mistaken belief that it gives inventories preferential treatment. As I have observed, however, economic studies consistently show that inventories are already taxed more heavily than almost all other business investment. I have also previously pointed out the dangers of proposals that would single out five companies (“Big Oil”) for special tax rules based solely on the public hostility aroused by their size and rises in the price of their product.

Another questionable proposal would apply ordinary income tax rates, rather than capital gains rates, to carried interest received by managers of private equity and similar funds, even when the carried interest is an allocation of the fund’s capital gains income. Kevin Hassett and I have noted here (and again) that, despite the claims of the proposal’s supporters, the current tax treatment of carried interest is an application of general partnership tax law principles rather than a special preference for these funds. Some versions of the proposal take the even more dubious step of applying ordinary tax rates to capital gains earned by the founders of the firms that sponsor these funds.

These proposals, as well as the administration’s proposal to lengthen depreciation schedules for corporate jets, appear to be motivated by populist sentiment more than sound tax policy. Unsurprisingly, these proposals shrink from addressing any of the popular and widespread individual income tax preferences.

But, the administration is on firmer ground in proposing to limit the tax savings from itemized deductions for high-income taxpayers. Of course, one can question some aspects of the proposal, such as why the limit applies to preferences structured as itemized deductions while ignoring those structured as exclusions or credits. Tom Miller recently offered some critiques and suggestions for improvement. Nevertheless, the proposal is one way to limit some of the income tax’s prominent inefficiencies, notably its extravagant subsidy for the construction of luxurious homes. Building on ideas like this one could pave the way for a bipartisan deal that curtails inefficient features of the tax system while slowing the growth of entitlement spending.

One thought on “Separating Fact from Fallacy in the Tax Debate

  1. We should modify the cap gains tax. One year before a discount, more after 5 and even more after ten. This would be good for people who build businesses and bad for carried interest users.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>