What Do You Want: Lower Tax Rates or More Tax Deductions?

by FRANK HILL May 4, 2017

Corporate America Uses Far Fewer Tax Breaks Than People Do

Raise your hand if you understand the US federal tax code.

Seriously. How can anything have gotten so complicated?

Well, if you call your congressional representative and US Senator and tell them to get rid of most of the US tax code, you may see it done this year.

Let's think out loud about some of this:

1.      The purpose of ANY tax system is to raise needed revenue to pay for necessary government programs that benefit us all.

2.      The tax code should not be used as part of a 'class warfare' arsenal to 'punish' certain people for being successful.

3.      The tax code should not be used to push a social agenda one way or the other. Pass fiscal policies to do that if you want.

4.      The tax code should not be used to 'favor' one industry over the other. That is just unfair.

5.      The federal government should not be allowed to spend more in any year than it takes in as revenue.

The tax code should be transparent, unbiased and clearly understood by the common person. 'If I buy something and I have to pay a 10% consumption tax on the transaction' would be something clearly understood by everyone if all we had was a consumption tax instead of the cornucopia of tax systems we have in America today.

Have any idea of what this tax citation for section 509(a) means?

For purposes of paragraph (3), an organization described in paragraph (2) shall be deemed to include an organization described in section 501(c)(4), (5), or (6) which would be described in paragraph (2) if it were an organization described in section 501(c)(3).

President Ronald Reagan used this quote as an example of why the tax code needed to be 'simplified' in the last substantive tax reform effort of 1986, which resulted in neither a 'simplification' of the tax code nor did it reform the tax code in much of a positive manner.

Some people are putting up a stink against the repeal of any tax provision because of the 'deleterious effect it will have on X industry!' as if that industry will completely dry up without the tax advantages it enjoys in the US tax code.

As a result of that same 1986 Tax Reform (sic) Act, interest on car loans was phased out. Car makers and distributors and dealers all descended on Capitol Hill screaming that 'car sales will drop to zero if the deduction for car loan interest is repealed!'

How ridiculous was that argument? People were all of a sudden not going to buy a new car because they couldn't deduct $1000 on their income tax?

11.4 million new cars were manufactured and sold in 1986. 17.5 million new cars were manufactured and sold in 2016.

So much for the red herring of repealing tax deductions for interest on car loans.

The same can be said for the repeal of almost all tax deductions now in the tax code. People are going to buy houses to live in whether they can deduct the interest on their mortgages or not. There might be a dip in the market as people adjust to the loss of taxpayer support of their purchase of a home, which is what the tax deduction for mortgage interest really is, whether it is a $50,000 house or a $10 million mansion financed somehow through a bank.

Repealing ALL of the tax breaks makes sense especially if the trade-off is much lower income tax rates in the absence of such tax breaks, which, truth be told, are usually only reserved to the well-off who can afford to hire the tax accountants and lawyers to find these tax breaks in the voluminous tax code and then hire the lobbyists in DC to keep them in force.

When we left Washington, DC in 2007, 35,000 lobbyists were registered to lobby Capitol Hill. An average of 65 lobbyists for every US Senator or Congressman.

We have to imagine it might be closer to 100 lobbyists per every elected representative in Washington today.

Take a look at this following list to see if you, as an average American taxpayer, use ANY of these tax-favored provisions beyond the 3 highlighted in red, all 3 of which would remain in the Trump tax plan as introduced last week:

Table 17-3. INCOME TAX EXPENDITURES (i.e. tax breaks)

Exclusion of employer contributions for medical insurance premiums and medical care 
• Deductibility of mortgage interest on owner-occupied homes
• Step-up basis of capital gains at death

  • 401(k) plans

• Exclusion of net imputed rental income       
• Deductibility of nonbusiness State and local taxes other than on owner-occupied homes
  Accelerated depreciation of machinery and equipment (normal tax method)       
• Capital gains (except agriculture, timber, iron ore, and coal)
Deductibility of charitable contributions, other than education and health

  • Employer plans

• Exclusion of interest on public purpose State and local bonds

  • Capital gains exclusion on home sales

• Deferral of income from controlled foreign corporations (normal tax method)  
• Deductibility of State and local property tax on owner-occupied homes  
• Exclusion of interest on life insurance savings 
• Social Security benefits for retired workers

  • Keogh plans

• Exception from passive loss rules for $25,000 of rental loss

  • Deduction for US production activities
  • Individual Retirement Accounts

• Exclusion of benefits and allowances to armed forces personnel

  • Deductibility of medical expenses
  • Child credit
  • Earned income tax credit

• Social Security benefits for disabled workers

  • Exclusion of workers' compensation benefits
  • Self-employed medical insurance premiums
  • Credit for low-income housing investments

• Expensing of research and experimentation expenditures (normal tax method)  
• Exclusion of veterans death benefits and disability compensation  
• Exclusion of income earned abroad by US citizens

  • Lifetime Learning tax credit

• Deductibility of charitable contributions (education)

  • HOPE tax credit

• Deductibility of charitable contributions (health)
• Exclusion of interest on hospital construction bonds 
• Credit for employee health insurance expenses of small business 
• Inventory property sales source rules exception 
• Graduated corporation income tax rate (normal tax method) 
• Exclusion of interest on bonds for private nonprofit educational facilities  
• Social Security benefits for spouses, dependents and survivors 
• Exclusion of reimbursed employee parking expenses  
• Exclusion of scholarship and fellowship income (normal tax method)

  • Additional deduction for the elderly

• Parental personal exemption for students age 19 or over

  • Carryover basis of capital gains on gifts

• Medical Savings Accounts / Health Savings Accounts

  • Premiums on group term life insurance
  • Credit for increasing research activities
  • State prepaid tuition plans

• Exclusion of interest on owner-occupied mortgage subsidy bonds

  • New technology credit
  • Special ESOP rules
  • Employer provided child care exclusion
  • Exemption of credit union income

• Exclusion of interest on rental housing bonds  
• Credit for child and dependent care expenses

  • Deferral of interest on US savings bonds
  • Exclusion of GI bill benefits

• Exclusion of employee meals and lodging (other than military)

  • Low and moderate income savers credit

• Exclusion of interest for airport, dock, and similar bonds

  • Deferral of income from installment sales

• Exclusion of certain allowances for Federal employees abroad  
• Excess of percentage over cost depletion, fuels

  • Deductibility of student-loan interest
  • Energy investment credit
  • Tax credit for orphan drug research
  • Exclusion of parsonage allowances
  • Exclusion of interest on student-loan bonds

• Exclusion of public assistance benefits (normal tax method) 
• Excess of percentage over cost depletion, nonfuel minerals

  • New markets tax credit

• Exclusion of interest spread of financial institutions 
• Exclusion of interest on bonds for water, sewage, and hazardous waste facilities

  • Capital gains treatment of certain income
  • Special Blue Cross/Blue Shield deduction
  • Assistance for adopted foster children

• Exclusion for employer-provided transit passes 
• Empowerment zones, Enterprise communities, and Renewal communities

  • Qualified school construction bonds

• Capital gains exclusion of small corporation stock

  • Exclusion of interest on small issue bonds

• Expensing of exploration and development costs, fuels  
• Credit for energy efficiency improvements to existing homes  
• Tax incentives for preservation of historic structures 
• Distributions from retirement plans for premiums for health and long-term care insurance

  • Exclusion of certain foster care payments

• Premiums on accident and disability insurance

  • Deductibility of casualty losses

• Credit for investment in clean coal facilities

  • Exclusion of veterans pensions

• Tax credit and deduction for clean-fuel burning vehicles  
• Expensing of multiperiod timber growing costs  
• Exclusion of railroad retirement system benefits

  • Discharge of mortgage indebtedness
  • Work opportunity tax credit
  • Advanced Energy Property Credit

• 30% credit for residential purchases/installations of solar and fuel cells

  • Exclusion of utility conservation subsidies

• Tax exemption of certain insurance companies owned by tax-exempt organizations 
• Exclusion of interest on bonds for Financing of Highway Projects/rail-truck transfer facilities
• Expensing of certain multiperiod production costs

  • Credit for holders of zone academy bonds

• Expensing of exploration and development costs, nonfuel minerals

  • Expensing of certain capital outlays

• Exemption of certain mutuals' and cooperatives' income

  • Adoption credit and exclusion
  • Exclusion of military disability pensions
  • Income averaging for farmers

• Industrial CO2 capture and sequestration tax credit

  • Education Individual Retirement Accounts

• Natural gas distribution pipelines treated as 15-year property

  • Expensing of reforestation expenditures

• Credit for holding clean renewable energy bonds  
• Capital gains treatment of royalties on coal  
• Capital gains treatment of certain timber income

  • Alcohol fuel credits

• Allowance of deduction for certain energy efficient commercial building property 
• Ordinary income treatment of loss from small business corporation stock sale  
• Income of trusts to finance supplementary unemployment benefits

  • Alternative fuel production credit
  • Credit to holders of Gulf Tax Credit Bonds

• Amortize all geological and geophysical expenditures over 2 years

  • Exceptions from imputed interest rules
  • Additional deduction for the blind

• Deduction for endangered species recovery expenditures  
• Exclusion of special benefits for disabled coal miners  
• Special alternative tax on small property and casualty insurance companies  
• Exclusion of interest on energy facility bonds 
• Exception from passive loss limitation for working interests in oil and gas properties

  • Small life insurance company deduction
  • Qualified energy conservation bonds

• Exclusion of interest on veterans housing bonds  
• Exclusion of interest on savings bonds redeemed to finance educational expenses

  • Tribal Economic Development Bonds

• Treatment of loans forgiven for solvent farmers

  • Deferral of gain on sale of farm refiners
  • Deferral of tax on shipping companies

• Investment credit for rehabilitation of structures (other than historic)

  • Discharge of student loan indebtedness
  • Credit for disabled access expenditures

• Exclusion of gain or loss on sale or exchange of certain brownfield sites
• Special rules for certain film and TV production  
• Tax credit for certain expenditures for maintaining railroad tracks

  • Tax credit for the elderly and disabled

• Credit for construction of new energy efficient homes  
• Employee retention credit for employers affected by Hurricane Katrina, Rita, and Wilma
• Deferred taxes for financial firms on certain income earned overseas  
• Bio-Diesel and small agri-biodiesel producer tax credits

  • Credit for energy efficient appliances
  • Treatment of qualified dividends
  • Recovery Zone Bonds
  • Lifetime Learning tax credit
  • Deduction for higher education expenses

• Exclusion of employer-provided educational assistance

  • Special deduction for teacher expenses
  • Welfare-to-work tax credit
  • Employer-provided child care credit

• Exclusion for benefits provided to volunteer EMS and firefighters

  • Making work pay tax credit

• Tax credit for health insurance purchased by certain displaced and retired individuals
• Exclusion of unemployment insurance benefits  
• Build America Bonds

If you used more than 2-3 other provisions on the above list outside of the mortgage interest, health care plan and charitable contribution deductions, you are probably in a very narrow minority of US taxpayers to do so for any particular one.

Now, imagine that all of these deductions above were repealed or eliminated by some sort of cosmic sunspot shower that destroyed all of the 10 million words now in the US tax code. Try to walk through your mental index of your last tax return and try to think about what the tax rates would have to be to make sure you did not have to pay an exorbitant amount of taxes should there be such a monumental earthquake of tax reform to roll through Washington:

Assume you had $100,000 in taxable marginal income for simplicity's sake barring any other considerations. Declaring $15,000 in mortgage interest on your taxes might save you $5000 in taxes if applied solely to that $100,000 of marginal income.

Going from 28% to 18% in income tax rates on that $100,000 of marginal income would save you $10,000, from $28,000 down to just $18,000.

Would you rather have $10,000 more money in your pocket from lower tax RATES or $5000 in less taxes paid to the government (which is still money in your pocket where it belongs) because you were able to get a deduction for $15,000 in mortgage interest?

Everyone's situation is different. However, it is widely assumed that the vast majority of people in this country who pay income taxes (about 50% do not pay any income tax today which means they can not get a tax cut on $0 paid in income taxes) would benefit much more under a lower tax rate regime with hardly any (or none) tax breaks than staying under the current high tax rate system with 164 tax sheltering provisions noted above.

You know who would probably wind up paying more in tax to the government under a low tax rate, no tax deduction tax code in the US?

Wealthy people. They are the only ones who can afford to pay people to find these tax shelters and provisions in the first place. Getting Bill Gates or Warren Buffett to pay $100 million per year in some combination of income or capital gains taxes would be far preferable to thinking they SHOULD pay $200 million in taxes but avoid them by clever use of current federal tax laws at the corporate and individual level.

Want to hear a fact that will blow your mind? The cost of the tax expenditure represented by the corporate deduction for health plans is the largest in the tax code. It accounts for the equivalent of $196 billion in lost tax revenues per year.

According to the Tax Foundation:

In addition to this lost income tax revenue (of $196 billion/year), Treasury estimates that in 2014 it will reduce payroll tax revenue by $123 billion for a combined total revenue loss of $319 billion.

This is larger than corporate tax revenue collections in a typical year.

Our US tax code now 'costs' us more in lost revenue to the Treasury than we collect every year chasing down corporate accountants and auditing them and all that.

That is the definition of insanity.

Clearing out the US tax code like Hercules cleared out the Augean Stables might be the best thing that could happen to our nation in 2017.

*Charts and data about tax expenditures obtained from Tax Foundation

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Contributing Editor Frank Hill ran for Congress at the age of 28 and served as chief of staff for former Congressman Alex McMillan (NC-9) and Senator Elizabeth Dole (NC). He was a budget associate on the House Budget Committee for 4 years and worked on the 1994 Commission on Entitlement and Tax Reform. He now lives in Charlotte, North Carolina where he does some consulting and lots of worrying about federal spending issues.

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