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  • Writer's pictureOren Levin-Waldman

If Only We Had a Meaningful Discussion About Taxes

As we move into the two final weeks of the 2020 election, we are once again hearing about taxes. The Trump people claim that Biden will raise everybody’s taxes, and Biden claims that Trumps tax cuts need to be repealed because they have only benefitted the wealthy. Well they are both right and wrong. As much as taxes make for nice slogans, as a policy matter it is much more complicated.

Taxes should be about raising revenue to pay for the functions of government. Because it has in recent years become a tool for social engineering, the code has been littered with an array of deductions intended to affect behavior at both the individual and firm level. Unless we allow firms to depreciate plants and equipment, the argument goes, they won’t make any further investments back into their enterprises, thereby resulting in possible job loss. And unless homeowners get mortgage interest deductions, the argument also goes, they simply will not buy houses. But in order to pay for either of these deductions, the effective tax rates are forced up.

Biden is correct when he says that the Trump tax cuts didn’t have the effect they were supposed. Yes the wealthy got bigger cuts, but they also pay more. Firms seeing their corporate taxes and capital gains taxes go down, didn’t necessarily take the savings and invest to create new jobs or raise wages. Rather they assumed that because workers were having less taxes withheld, their workers were effectively getting a raise because their after-tax income was now higher. In this vein Trump too was correct: the average workers was seeing more money in his/her paycheck.

Therefore, to repeal them means workers’ taxes will increase, especially if it means they have less money in their paychecks. To raise taxes during a pandemic when unemployment is high might strike many as odd. If the goal is to get firms to invest and create more jobs, raising corporate taxes is not necessarily the best approach.

Good tax policy should be guided by both efficiency and equity considerations. It has become too easy in politics to promise voters goodies which will have to be paid for, either through program cuts elsewhere or tax hikes. From an efficiency stand point, the goal should be to finance government operations without putting a drag on economic activity. This is the main reason many economists favor either simple flat taxes with no deductions or a consumption tax in lieu of an income tax.

Equity usually requires that tax rates be set on the basis of an ability to pay. Those with higher incomes usually pay more because they can. Simply put, that is where the money is. To use the language of “fair share” is nothing more than an appeal to class warfare which only ends up alienating many. The problem with a tax code that allows for a myriad of deductions is that those with the means can always find ways to avoid taxes, because enough deductions means that their effective tax rates will be less. Consequently, raising marginal tax rates to finance new programs because it is considered to be fair only becomes highly inefficient.

If it is the case that lowering the capital gains tax has not had the intended benefit, then make the cut a targeted one. That is, only those firms that will either use the savings to increase their workers’ real wages or invest in new plants and equipment for purposes of expansion and job creation should receive the tax cut. Those that do not, i.e. they use the savings to invest in more shares, should pay a higher rate.

An efficient tax code which is also equitable would consist of three or four relatively low rates without deductions. Those earning more would, of course, pay more because they do in fact have more to pay. Because there would be no deductions, the tax rates could be kept relatively low, thereby putting more money in people’s pockets. More money in people’s pocket also means that they can demand more goods and services because they effectively have greater purchasing power. This is but one of the reasons why many economists believe flat rates can possibly fuel greater job creation.

It would be ideal if we could truly have an honest discussion about taxes and meaningful tax reform. The problem is that we are an interest group society, whereby different interests seek to gain advantage and serve their interests through provisions in the tax code. Because politicians seek both contributions and votes from interest groups, they naturally aim to please.

Mortgage interest deductions for home buyers serves three principal interests: the real estate industry, the mortgage and lending industry, and of course home buyers. It isn’t really clear that eliminating this deduction would necessarily lead to fewer sales of houses. At this point, the concept of home ownership is so ingrained in the American psyche that most people living in houses would continue to be owners. After all, home ownership is still an investment that often goes up in value, and as such represents savings. But to satisfy these interests, we all pay more taxes through higher tax rates.

Arguably we all derive some benefit, if we are all homeowners, but renters do not, and those who have paid most of their interest down do not. Politicians assume that unless incentives and disincentives are built into the tax code, investors and consumers simply will not behave correctly. Is this not an elitist view of the world which assumes that the public is simply incapable of making decisions for itself? And yet, the nation’s founding principles are grounded in the concept of human agency. It is the idea that we are all capable of making rational decisions for ourselves and pursuing our interests accordingly.

Perhaps the main difference between Democrats and Republicans in today’s political universe is that Democrats promise programs without any serious discussion of how we will pay for them, while Republicans promise putative programs through the tax code. In both cases, the result is more interest groups distorting the political system. It is because we have a complicated tax code that we have the proliferation of interest groups that we do.

Ironically, these interest groups will prevent attaining any meaningful reform. Instead we get the usual platitudes and bromides about taxes whereby one side promises to lower taxes and accuses the other of raising them, and the other side simply accuses the wealthy of not paying its fair share. Alas, tax policy isn’t about anything more than whipping up a frenzy and drawing political lines in the sand. Imagine what it could be if it were actually about policy.

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