Tax reform

Reportedly (a little birdie told me), some people more in the know than I am are betting that the Tax Reform Commission will endorse neither the X-tax, which I would favor, nor the Graetz model, on which I’ve made my views clear, but rather will propose making various changes to the current income tax system. Some of the main possible features that I have heard about (plus my comments on them) are as follows:

1) Exemption for capital income plus elimination of interest deductibility. Even if you like consumption taxation, as I do under the right circumstances, impossible to comment on this without seeing exactly how it would be done, as the details are all-important. David Bradford, although a consumption tax advocate, would have classified lots of “capital income” (in the formal sense) as in fact representing returns to work that he wanted to tax. So a key question would be whether the plan’s design worked properly in this regard. Note also that something akin to interest deductibility would remain for home mortgage interest (see #3 below), potentially leading to arbitrage problems. (Borrow more against your home and get a credit, invest the funds and exclude the income.)

2) Replace personal exemptions with a single, unified child tax credit. I would argue that the credit should be made refundable (i.e., allowable even if in excess of current-year income tax liability). Dream on.

3) Replace various itemized deductions, such as those for charitable contributions and home mortgage interest, with percentage credits. In illustration, if these items became 15% credits, a taxpayer with $10,000 of home mortgage interest would save $1,500 of tax no matter what her marginal rate bracket. There often are good arguments for such an approach where the aim of a tax benefit is not income measurement, but something else such as influencing behavior (my NYU colleague Lily Batchelder has work in progress that will discuss this point). The Bradley-Gephardt tax reform bill that helped inspire the Tax Reform Act of 1986 had this feature. Once again, there could be arguments for refundability that I am sure will have to be ignored.

4) A $10,000 cap on the exclusion for employer-provided health insurance. I would once again say: why not a refundable percentage credit (e.g., 15% on health insurance value up to $10,000)? But an important virtue of this proposal, even if not turned into a credit, is that it addresses the incentive to over-insure – an important cause of our country’s growing healthcare crisis – without eliminating the nudge in the direction of having some insurance, which many would argue is socially desirable.

All in all, the plan could certainly be worse – a tribute, perhaps to good people on the Commission and staff, notwithstanding the constraints under which they are operating. But I tend to doubt that it will go anywhere, or that the Democrats will want to have anything to do with it under present political circumstances. Indeed, I would expect them to demagogue even its good features given where we are today after 4-1/2 years of Republican gutter politics.