To Get Policy Gains From Personal Income Tax Reform You Have To Eliminate The Popular Deductions

The saddest thing in Washington is to watch politicians start talking about tax reform—raising revenue without raising tax rates—and then immediately turn around and clarify that they’re not talking about axing the really popular deductions. So no home mortgage interest tax deduction, no large group health insurance exclusion, no charitable deduction, etc.

The problem is that if you’re not talking about the big popular deductions, you’re not talking about the big policy gains.

The smallest issue here is that you can’t raise very much revenue without tackling the big deductions. But that’s actually a small point. What gets people excited about tax reform in the first place is the idea that the reform as such is good public policy. The existence of loopholes and deductions distorts people’s decision-making in ways that reduces the long-term productivity of the American economy.

Saying that your income is taxed if it comes in the form of money but not taxed if it comes in the form of health insurance, for example, encourages people overconsume health care services. That bids up the price of services that are really needed, and also means that investment in the United States is biased toward creating too much output of health care services and not enough output of other things. The mortgage deduction is an even bigger deal in this regard. People need to buy housing as a consumption good, but homeownership is also a leveraged investment. Creating a large tax preference for one particular form of leveraged investment—invested in a house you live in—encourages people to live in bigger fancier houses than they would otherwise want. What’s more, it’s a bad investment strategy. If you live near Minneapolis (which you should) you’re already exposed to a lot of Minneapolis-specific economic risk through your participation in the Twin Cities labor market. Investing a large share of your net worth in the house you live in doubles down on your exposure to Minneapolis-risk when you ought to be diversifying.

The small deductions, by definition, just aren’t that big a deal economically. Housing policy and health care policy are really important, so reforming tax distortions in those areas can create big policy wins. When you leave that stuff off the table, then you’re really just talking about tiny issues that aren’t very important.