Friday, August 25, 2017

Tax Loopholes and Tax Reform

Not sure they will get around to tax reform this year, but I am told that tax reform is high on the legislative agenda. Tax reform usually involves significant changes in income and/or business tax rates. For example, we hear talk that US corporations pay tax rates that are very high. A tax reform might, therefore, reduce the rate to something lower. Tax reform might instead lower tax rates for the middle class or for rich people. There are many ways to do tax reform.

As a result of the lower tax rates of a tax reform, tax revenues would likely fall. So an important part of any tax reform that lowers tax rates but does not want to create larger government deficits is the accompanying ways to raise tax revenue. One approach would create a totally new tax. Some thought was given to the USA adopting a value added tax or perhaps an import tax. More likely, however, is the closing of existing tax loopholes. That approach sounds much better to most of us. But as I will show below, it is not so easy and the attempt to close loopholes may actually doom tax reform.

First, our friend Wikipedia says a loophole is an ambiguity or inadequacy of a system, such as a law or security, which can be used to circumvent or otherwise avoid the purpose, implied or explicitly stated, of the system. That makes a loophole sound pretty bad. It should be easy to eliminate tax avoidance. But a further look at tax loopholes suggests that many of the biggest ones are there for specific reasons.

We sometimes use the word tax expenditure for myriad reasons that allow people to avoid paying tax. Tax expenditures are defined as special provisions of the tax law such as exclusions, deductions, deferrals, credits, and tax rates that benefit specific activities or groups of taxpayers. Tax expenditure? Tax loophole? Pretty much the same thing. But the wording is kinder. Why? Because it implies that it isn’t an error or a deficiency in the system. Rather, it is an intent to promote an end. Getting rid of a loophole sounds easy. But a tax expenditure has a purpose. Do we really want to end it? If so, who gets hurt?

Below I list only some of the major tax expenditures and the amounts (in billions of dollars) estimated by the Tax Policy Center for 2018 (
Exclusion of employer contribution for medical care premiums
  and medical care $235.8
Exclusion of net imputed rental income $112.7
Deferral of income from controlled foreign corporations $112.6
Capital gains $108.6
Defined benefit and defined contribution employer health plans $140.4
Mortgage interest expense on owner-occupied homes $68.1
Earned income tax credit $63.6
Deductibility of state taxes $63.3
Child credit $54.3
Charitable giving $51.2

There are plenty more but this list adds up to just short of a trillion dollars. Thus we learn two points. First, that’s a healthy amount of money if we are looking for loopholes to close. Second, who is going to resist closing each one of these? People who want cheaper healthcare? People who receive rental income and capital gains? State and local governments? Poor people and those who represent poor people? Parents? Homeowners?

Other federal government tax loopholes?
            American Opportunity Tax Credit to reduce the cost of education
            Savers Tax Credit helps low income people save for retirement
            Lifetime Learning Credit to reduce cost of education
            Retirement Saving Accounts
            Carried Interest Loophole for mostly high income taxpayers
  529 College Saving Plan for parents saving for child’s education
Finally comes the fun part. There are so many loopholes in our tax system that you would have difficulty listing them all. Investopedia ( found some interesting ones that relate to state and local taxes:
            The Florida Rent-A-Cow Credit
            Washington DIY Cigarette Discount
            The Arkansas Credit for Naturally Destroyed Autos
            The Accelerated Depreciation of NASCAR Tracks
            Larry’s JD exemption (just kidding)

Even with these last few loopholes, there were reasons for instituting them. Closing tax loopholes is not a slam dunk. Tax reform and reducing our tax rates is valuable for many reasons. But if tax reform is not going to blow a hole in our national deficit and debt, then some of these tax loopholes have to go. Which ones will you vote for? 


  1. I would be for eliminating those loopholes which by any other name would be subsidies, altho that rent-a-cow thingy may have some merit.

  2. Dear LSD. Thanks for listing all those deductions . . . wasn’t aware of many of them. Generally I favor doing away with all simply to simplify the tax code—but also because some alter free market dynamics—e.g. screw up natural supply and demand.

    Deductions that survive the assumed impending “tax reform” should benefit stuff we as a country value in general and not favor any one special or special interest group (e.g. the Arkansas Credit for Naturally Destroyed Autos and NASCAR Tracks)—e.g. edukation, business growth, health, saving and retirement, home ownership, and the truly needy. However, there is a caveat to my naming the aforementioned: Deductions should incentivize individual taxpayers to pursue those things that could lead to positive and healthy outcomes (e.g. improve the economic, financial, and physical health of the nation) and not incentivize suppliers/providers of services and products to increase their prices just because they might be deductible and lower the cost to consumers. Two specific examples: edukation and health care. The imposition of the federal govomit in both has resulted in those two entities increasing their prices due to direct subsidies and costs’ deductibility—ergo screwed up the market dynamics.

    A particularly egregious loophole that should be slammed shut is the carried interest for high income earners. Let Warren Buffet pay the same marginal rate as his secretary. Let’s see if the Beltway crooks who take gobs of $$$ from Wall Street have the cajones to do so.

    1. You are swimming uphill on this one
      Tuna. It might be tricky to create incentives for healthy activities without triggering price increases. And your point about carried interest and high income earners...would you let low income earners have carried interest? Where does low income become high income? How high? And finally I am wondering how our lovely politicians could come together long enough to do away with any of these loopholes. They can't seem to agree on anything. By what magic would they come together to make sensitive changes? Seems hopeless to me. It is much easier to enact tax cuts and then point at the other guy as the deficit balloons even larger.

    2. Dear LSD. I think you mean swimming into the incoming current . . . always have a problem with that.

      I get your point that arriving at the outcomes I listed will be difficult. To my point that edukation and healthcare increase prices because the fed interferes with those markets can be mitigated by the fed exiting . . . . let market dynamics affect pricing according to supply and demand . . . and competition. At least that’s what the Rs say . . .

      Should low income earners have carried interest? That’s somewhat of a red-herring, eh? Low income earners typically don’t own income-producing assets . . . and if they did incur carried interest it should be taxed as ordinary income subject to prevailing marginal tax rates . . . just like Warren Buffet being taxed at the same marginal rate as his secretary. A level playing (er, taxing . . . ) field.

    3. Point taken on uphill -- but you gotta admit that swimming uphill could be tough -- even for a tuna.
      Many, including some economists, would point out to you that education and healthcare should not be left to market devices. Notice that in most countries that is the prevailing thought. There are market imperfections that hinder a market's working in those areas. But I am one who still prefers markets in healthcare, though with some government involvement. As for carried interest I don't get it at all. Carried income is not labor income. It gets taxed at a lower rate to encourage people to invest. It has nothing to do with low or high income -- its our philosophy of taxation. We could change it -- but like any tax loophole -- closing it will have negative consequences. If we want to tax the rich there might be better ways that have less impact on financial markets.