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Tilts in the tax code: Pictures of regressive deductions

Source: Tax Policy Center
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In an economy that’s fraught with shortfalls of the revenue side and high levels of income inequality, you might wonder why we waste so much of our national treasure on tax breaks that favor the most well-off. I’ll give you a quiz:

a) It’s a trickle-down incentive to the “job creators.”

b) Because the folks getting these tax breaks pay for the politicians who keep them in place.

I’ll make and defend my answer in a moment, but let me first show you of what I speak, using some new results from those stalwart number crunchers over at the Tax Policy Center. Each figure shows the share of the money from a different tax preference or deduction claimed by the poorest fifth of the income scale, the middle fifth, the top fifth, and the richest 1 percent.

First, in the chart above we see the results of the preferential treatment that the tax code bestows on realized capital gains and dividends, a source of income particularly concentrated at the top of the scale. About 90 percent of the benefits of the lower rates applied to these appreciated assets upon their realization or distribution go to the top fifth, with the vast majority of that coming from the top 1 percent, average pretax income: a cool $2 mil.

The next three figures are for tax deductions for charitable contributions, mortgage interest deductions, and state and local tax deductions. Paradoxically, these deductions are regressive because our federal income tax code is progressive. That is, tax rates increase with income and you can deduct your spending in these areas at your top marginal rate. Thus, the wealthier you are, the bigger the tax cut on the interest payments on your mortgage.

My fellow nerds at CBPP call these “upside down” tax expenditures. They also show that the revenue  the Treasury loses each year from deductions, exemptions, and other special tax preferences is larger than the annual cost of Medicare and Medicaid, or Social Security, or the defense budget.

There’s a simple, elegant solution to this problem which I’ll share with you in a moment, but first, is there any economic rationale for these tax breaks?

Not much. First, advocates of a low capital gains rate argue that it’s needed to free up investment capital, but the evidence isn’t there. As for the other stuff, as my colleagues put it: “these tax expenditures provide their largest subsidies to high-income people even though those are the individuals least likely to need a financial incentive to engage in the activities that tax incentives are generally designed to promote, such as buying a home, sending a child to college, or saving for retirement. Meanwhile, middle-class families receive considerably smaller tax-expenditure benefits for engaging in these activities.”

No one’s guaranteeing that charitable giving or home prices, for example, wouldn’t take any hit at all if the deductions were lessened, but our best guess is that much of this sort of spending is fairly unresponsive to changes in the tax code.

That said, we can do a whole lot of good with a pretty cautious step that doesn’t end the deductions: instead of letting the richest Americans deduct them at the top marginal tax rate of about 40 percent, we can reduce the write-off rate to 28 percent.

While purists will understandably object, this deduction reduction preserves alleged incentives while making them less upside down, loses a lot less money for the Treasury (about $600 billion over 10 years), and, in a rational tax debate, would be viewed as a compromise.

Which brings me back to the quiz. I’m afraid the right answer is “b” which means it’s going to be really, really hard to change the way those bars stack up.

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