Tax Reform – Giving up old friends

In my defense, such as it is, I can say I added fewer tools to my workshop than Congress has added to the tax code over the same time.  But like Washington, I have a lot of trouble taking anything out of the system.  Old tools are like old friends; it is just plain hard to let go of them. 

 

When Congress turns to tax reform, it should ask two questions about each rule it considers reforming or repealing.  First, what would we do if we were designing an income tax where none existed before?  And, second, given the system we have, what would a fair transition to a reformed code look like? 

 Much of the coming debate will be about the first question.  We will talk about whether particular deductions properly reflect a taxpayer’s ability to pay, whether something subsidizes personal expenditures, and whether an item encourages activity that contributes to the greater good.  But, the second question, that of transition, is every bit as important.  If Congress decides to remove or restrict particular exclusions, deductions, or credits from the law as part of tax reform, it also will also have to decide how to do so fairly.   

 

Current tax reform proposals focus on delivering dramatically lower tax rates. They pay for these lower rates by taking away various exclusions, deductions, credits or other preferential treatment known as tax expenditures.  In speeches and reports, these are often described as wasteful, inefficient, special interest or disguised spending.  Never are they call old friends, which is what they are to many taxpayers.  Retirement savings incentives and the exclusions for employer-provided and other healthcare benefits, as well as the deductions for home mortgage interest, state and local taxes and charitable contributions, account for nearly half of all of the individual tax expenditures.  Necessarily, a tax reform discussion is a discussion about repealing or substantially reducing these benefits.  If these items are not on the table, then the discussion may be about tax changes, but it will not be about tax reform.   

 

If some or all of these rules are to be repealed or limited, Congress will have to confront the issue of transition.  It could do what it largely did in 1986 and decide that the rate reduction benefit is so great that taxpayers should not complain at an absence of transition relief.  Such a decision may make sense from an overall point of view.  It would enable the maximum rate reduction.  It would quickly remove tax influences on personal and marketplace decision making. 

 

For affected taxpayers, however, the ride may be pretty rough. Consider just a few obvious concerns.  The tax cost of tax-favored retirement savings is driven by the amount already invested in these plans.  Would old savings continue to receive benefits or would tax deferral have to come to an end?  The U.S. healthcare delivery system is heavily influenced by employer-provided programs; they cover more than half the population, while private insurance covers less than 10 percent.   Would ending the exclusion accelerate the decline in employer-provided coverage? 

 

How would home values, new housing starts and related industries react to a loss of the home mortgage interest deduction and the local property tax deduction?  How long would it take to establish equilibrium after the change?  Would charitable giving drop, at least temporarily, if the deduction for contributions is eliminated? 

 

When I think about clearing some old tools out of my workshop, I start by trying to let go of the past.  Old friends are hard to give up, but in pursuit of an efficient workshop, it has to be done.  What I try not to do is to give away tools that work well before I have finished using them or have made a plan to do without them. 

 

Reformers have started asking us to consider giving up some old friends in the tax code.  We should demand not such a discussion of their merits but also of a plan to minimize economic disruptions and to ease the burden on taxpayers during the transition.