The Insidious Nature of Tax Preferences

Posted by Bob Lord

The Romney tax plan would exempt from income tax all
investment income of those whose total income does not exceed $200,000. So, if
you have a $200,000 salary and I have a $100,000 salary and $100,000 of
interest income from by bond portfolio, I’ll pay a lot less in tax. That part’s
easy. But what if we both have a $100,000 salary and I have my $100,000
interest income? Are our tax liabilities about the same? If you said yes, you’d
likely be wrong. My liability likely still is much lower than yours. Because I
have that extra $100,000 of income, I’ll spend more, and in all likelihood I’ll
have more itemized deductions. I’ll have a larger mortgage; I’ll give a little
more to charity; my property tax bill will be a bit higher, and so forth. So,
even though I make twice as much as you, my tax bill will be considerably
lower. Fair, huh?

Paul Ryan would add interest income to the types of income
that are taxed at a lower rate. That is not entirely illogical. If you’re
taxing some forms of investment income, capital gains and dividends, at a lower
rate, it makes sense that all investment income at a lower rate. The problem
lies in the deductibility of interest by many people of the interest they pay. I
borrow from you to start a business. As I deduct my interest expense to reduce
the taxable income of the business, my tax liability is reduced at ordinary
income tax rates. You, however, pay tax on the interest you receive from me at
reduced, preferential rates. In the process, the public fisc is whipsawed.
Every time money is borrowed, total tax revenues decline. The borrower’s tax is
reduced at ordinary rates, while the lender’s tax is increased at preferential
rates.

George W. Bush passed legislation that allowed the cost of
trucks used in a business to be written off over a short period. So, doctors
who make hospital calls, lawyers who drive to court, and realtors who schlep
their clients bought new SUVs that fit the definition of “trucks.” Good for the
oil industry perhaps, but not good for a country dependent on foreign oil and a world struggling to contain climate change.

Fifteen years ago, we created Roth IRAs. You don’t get a
deduction from income for the contributions you make (up to $5,000 per year) to
a Roth IRA, but the money you pull out is not taxable, no matter how large the
IRA grows. Many wealthy taxpayers have gamed the system. I don’t know how they
did it, but we have folks who have turned their $5,000 yearly contributions
into tens of millions stashed into Roth IRAs. And all of the income that
accrues to those IRAs will be forever exempt from tax.

The bottom line: More often than not, tax preferences have
insidious side effects. If we eliminated them overnight, the disruptions to the
market would be horrendous. But we’d be better off they were phased out.