The Best Policy

Close the Loopholes! (Just Not Mine.)

Can the budget crisis be solved without eliminating the mortgage-interest and charity tax deductions?

House for sale. Click image to expand.

One of the magic tricks that is central to all the debt compromises being discussed is this: We can lower marginal rates and raise more revenue if we only close those awful tax loopholes! This grand bargain manages to get us revenue and fairness and avoids the politically hazardous third rail of raising taxes the traditional way by hiking marginal rates. That’s the theory. Or should I say: That’s the hope.

Everyone preaches the doctrine of closing loopholes. The president embraced the notion in his deficit speech; Bowles-Simpson made it the centerpiece of their revenue plan; the Gang of Six relies on it. The nascent agreement between President Obama and Speaker Boehner uses the loophole manifesto to reconcile dogmatic GOP opposition to any new revenues with the recognition that some new revenues are needed. (Both as a matter of math and a matter of political calculus, Democrats require that the total savings come roughly in a ratio of 3-1 cuts to revenue enhancement.)

Here’s the catch. Nobody has yet had the guts to name a single loophole that all could agree to close that would have sufficient impact to be more than an asterisk. After all, one person’s loophole is another person’s “critical investment incentive,” or another person’s cure to a major inequity.

“Tax expenditures,” as loopholes are often called by the wonks in D.C., are just as much a form of spending as direct government expenditures. They total over $1 trillion a year. That they are hidden in the crevices of the tax code changes not a whit the reality: They represent public money being used for legislated purposes. (See a very good report from the Center for American Progress on the need for greater transparency in the realm of tax expenditures.)

Until now, we didn’t know what the real cost of these many loopholes was. But a new online source, the Pew Charitable Trust’s, gives us an amazing window into the vast array of tax expenditures that are there to be cleaned out. Or to be defended.

In the abstract, making loophole closings a fulcrum of the deal is easy. But until we put a few of the largest on the table, start talking explicitly about taking them away, the deal is amorphous at best. If we are to get $100 billion annually in savings, we are going to have to make a serious dent in the biggest of the tax expenditure items. And $100 billion a year is what is needed to get the $1 trillion over 10 years that is being discussed.

So here are a few numbers to ponder:

In the housing arena, three tax expenditures jump out because of both size and political sensitivity: deductibility of mortgage interest on owner-occupied homes, deductibility of state and local property taxes on owner-occupied homes, and the exclusion from taxability of imputed rent on owner-occupied homes. They come in at about $79 billion, $29 billion, and $27 billion annually ($135 billion total). These are some of the biggest tax expenditures out there.

Given the tumult in the housing sector right now, the centrality of home ownership to the “American dream” of home ownership, and the tremulous nature of state and local finances, doing anything fundamental in this area is almost inconceivable. Housing prices and the entire market would be hit too hard if the mortgage deduction were eliminated. Given the foreclosure rate, and the percentage of homes already “underwater” in terms of the debt they carry, can you imagine now effectively increasing by a significant rate the cost of every mortgage? No way!

And state finances would be devastated if state taxes were no longer deductible, since the effective rate of state taxation would jump immediately, causing political mayhem.

The deductibility of charitable contributions costs the federal government about $60 billion a year. So how about scrapping or altering that line item? Can you imagine the shrieking from every charity? The cost to donors of charitable contributions would jump significantly, and the expected size of contributions would fall correspondingly, leading to a significant shortfall at not-for-profits. Hence, the vehement opposition of the charitable world to any changes in this domain. It would be an easy PR campaign: We are balancing the federal budget—by destroying our charities!

The point is not that there isn’t room for serious discussion here. But until we are clear what loopholes we are really talking about, the mere invocation of the word “loophole” bypasses the difficulty of getting agreement on where and how to cut.

Aren’t there some loopholes that are easier? Sure. The president loves to talk about the oil and gas subsidies hidden in the tax code, and the foolishness of adding tax subsidies to the already considerable profits of the energy companies. But the favorite—immediate expensing of exploration and development costs—comes in at only about $1.6 billion per year. Not really big stuff, even if it were totally eliminated. And all the tax subsidies for the fossil fuel industry total $3.2 billion—again, a big number, but not big enough to go very far.

So until we hear an awful lot more about which loopholes will be closed, the entire conversation we are having about tax expenditures as a magical elixir is not a whole lot more helpful than the generic instruction that we need to do something about. It’s all theatrics until you know whose ox is going to be gored.