Personal Finance: Devil in details in ending tax loopholes, deductions

Personal Finance: Devil in details in ending tax loopholes, deductions

November 14th, 2012 Christopher A. Hopkins CFA in Business Diary

At last, our elected representatives appear poised to commence serious negotiations on reforming the distended tax code as part of an effort to avoid the fiscal cliff. Rhetoric from both parties since the election has been encouraging, leaving open the possibility of a sensible and economically productive compromise that constrains entitlement spending and augments revenue.

On the income side, a workable and politically feasible approach should avoid raising marginal tax rates, but must result in more net tax revenue through the reduction or elimination of a variety or tax loopholes and deductions. As far as it goes, this seems eminently sensible and would no doubt elicit broad support. But the devil is always in the details, beginning with an understanding of just what the tax loopholes are.

Most, it turns out, are aimed squarely at the middle class.

Loopholes are technically referred to as "tax expenditures" by policymakers and represent lost revenue to the government due to specific provisions in the tax code that favor one party or class over another. For fiscal year 2014, the tax code includes nearly 200 tax expenditures, but the top 20 comprise 90 percent of the estimated $1.1 trillion in lost tax dollars.

The biggest single loophole is the exemption of employer-paid health care benefits from income taxation, costing the Treasury $164 billion next year. This tax break is a relic of post-World War II wage and price controls, but after 65 years has become institutionalized and is now viewed as practically incontestable.

The benefit was a rational response by employers prohibited from giving raises in the 1940s, since at the time the cost was quite low. Few anticipated that health care spending in the U.S. would balloon from 4.5 percent of GDP in the 1940s to well over 18 percent. The benefit now disproportionately favors middle-income taxpayers with employer coverage at the expense of workers without an employer plan, retires, and those who purchase private health insurance.

Number two on the loophole hit parade is the tax deferral of pension and retirement plan contributions, adding another $163 billion to next year's deficit. Next in line are the home mortgage interest deduction ($100 billion), the exclusion of Medicare benefits from income taxes ($76 billion), and preferential treatment of capital gains ($71 billion).

One might well observe that a loophole is in the eye of the beholder (or beneficiary). Nevertheless, a productive debate over tax reform must begin with a more informed understanding of our present situation. Tax expenditures create economic distortions, resulting in less efficient allocation of resources and slower overall economic growth. They also redistribute income from one group to another, a proposition typically resisted by many of us unless we are a recipient of the redistribution. As usual, it depends upon whose ox is being gored.

Lower marginal tax rates and fewer tax expenditures are desirable if we are to promote a more robust economic recovery. But an informed discussion of the way forward requires a more complete understanding of our starting point.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfree press.com.