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 (http://www.taxpolicycenter.org/briefing-book/what-are-largest-tax-expenditures)

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 (http://www.investopedia.com/financial-edge/0512/americas-most-outrageous-tax-loopholes.aspx) 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?