Monday, November 21, 2011

Brilliant Deduction

A lot of the same conservatives who decry “crony capitalism” and government subsidies for businesses or farms are unwilling to even consider changing the mortgage interest deduction as part of a broader tax reform plan. This despite the fact that it’s undeniable that the mortgage interest deduction is a subsidy (indirect perhaps) to the construction and real estate industries and that it distorts the housing market. There are three problems that this creates for conservatives:

1. It leaves us open to legitimate charges of inconsistency. If we truly support free markets and don’t believe that government should favor pet industries or interests then let’s live up to those principles.

2. It makes us seem unserious. When you talk about a looming fiscal crisis that threatens the country’s future, but then balk as soon as anyone suggests changing something that you support, it’s easy for people to dismiss the threat and your commitment to meeting it.

3. It makes it almost impossible to achieve any sort of real , meaningful tax reform. The reality is that if you want a simpler, flatter tax code with lower rates, you’re going to have to give up some or even maybe all of the current deductions.

Michael Barone probably knows more about American politics than anyone alive today. And the noted sage says that it’s time to Put Tax Breaks for Mortgages, Local Taxes on Table. Barone begins his piece with the salient point that if you want to be able to pull off tax reform that matters you need to go to where the money is:

The problem in putting such a measure together is that most really egregious tax preferences don't add up to much money. Just as the big money for long-term spending cuts must come from changes in entitlements -- Social Security, Medicare, Medicaid -- so the big money you can get from eliminating tax preferences comes from three provisions that are widely popular.

The three are the charitable deduction, the home mortgage interest deduction, and the state and local tax deduction.

The charitable deduction should probably be off the table. The Obama administration has proposed reducing it for high earners. But this obvious attempt to channel flows of money away from the voluntary sector and toward the federal government went nowhere even when Democrats controlled the House and had a supermajority in the Senate. It's anathema to many Democrats and just about all Republicans.

For conservatives, the revenue lost on charitable deductions is a small price to pay to be able to limit the scope and power of the government by allowing charities to provide services instead (usually more efficiently and at a lower cost as well). But we should be more open to changes in the other big ticket deductions.

The home mortgage interest deduction may seem similarly sacrosanct. But the fact that the vast bulk of the "tax expenditures" -- the money the government doesn't receive because taxpayers deduct mortgage interest payments from total income -- goes to high earners with big, expensive houses.

Traditionally it's been argued that government should provide incentives for homeownership because homeowners more than renters have a stake in their community. But it's obvious now that we have over-incentivized homeownership, with government encouraging loans to noncreditworthy borrowers.

At the same time, high earners don't need an incentive to buy a home. If we limit the mortgage interest deduction to some amount near the median housing price, some folks will still buy $1 million homes, though they may finance them a little differently. And the government can get more revenue without an economy-crushing tax rate increase.

This proposal wouldn’t eliminate the mortgage interest deduction, but rather limit it. And it’s something that could be phased in so that those who purchased homes (and budgeted) under the assumptions that the current deduction would continue wouldn’t be adversely impacted.

Similarly, what about a cap on the state and local tax deduction? Initial conservative reaction will likely be hostile: Why increase some people's federal tax bills? Isn't that attacking a core Republican constituency?

Actually, it's not and not. The state and local tax deduction is worth a lot more to high earners than to modest earners, and it's worth nothing to the nearly half of households that don't pay federal income tax.

But it's worth the most to high earners in high-tax, high-spending states. Those people are more likely to be Democrats than Republicans. The 2008 exit poll tells the story.

Nationally, voters with incomes over $100,000 voted 49 percent to 49 percent in the presidential race. Those with incomes over $200,000 voted 52 percent to 46 percent for Barack Obama.

In high-tax, high-spending states, Obama did even better with high earners. He carried $100,000-plus voters with 55 percent in Connecticut, 56 percent in New York, 52 percent in New Jersey, 55 percent in Maryland, 54 percent in Illinois and 57 percent in California.

All those states have high state income taxes except for Illinois, and it increased its income tax rate by two-thirds earlier this year. And those states contain a huge share of the nation's highest-priced housing.
In contrast, in low-tax, low-spending states with relatively inexpensive housing, $100,000-plus voters favored John McCain, who won 65 percent of their votes in Texas, 55 percent in Florida and 61 percent in Georgia.

It is no coincidence that the high-tax, high-spending states tend to have strong public employee unions. In effect, the unlimited state and local tax deduction is a federal subsidy of the indefensibly high pay, benefits and pensions of public employee union members. Limiting the state and local tax deduction would create a political incentive to hold those costs down.

Talk about getting the most bang for your buck. You not only bring in revenue to help offset the need to raise taxes elsewhere, you also ratchet up the pressure on states to reduce their unsustainable expenditures on salaries and benefits for public employees. A true win-win for conservatives.