Personal Finance: Why is tax reform so hard?

Christopher Hopkins
Christopher Hopkins
photo Christopher Hopkins

President Trump and the Republican Congress have made tax reform a central item on the 2017 legislative agenda. And while virtually every taxpayer supports a cut in their own rate, the devil is in the details when it comes to who foots the bill. Here is a quick look at why it's so hard.

The last major reform of the U.S. tax code was undertaken in 1986, under the aegis of President Ronald Reagan. One obvious hint as to why the current effort is so difficult: lack of any semblance of bipartisanship. The reform known universally as the "Reagan tax cut" was actually sponsored by two congressional Democrats: U.S. Sen. Bill Bradley, D-N.J., and Rep. Dick Gephardt, D-Mo. The overwhelmingly Democratic House voted 292 to 136 in favor, while 33 Senate Democrats joined 41 Republicans in the upper chamber. No significant legislation is ever durable without such binal cooperation.

The act reduced the top marginal tax rate from 50 percent to 28, on the heels of a 1981 law that cut the rate from 70 percent. But in order to attain the requisite support, the measure included some essential but notably unpopular fundamental reforms. Numerous loopholes and deductions were eliminated to the howls of their beneficiaries. Nonetheless, the deed was done and supporters from both sides could rightly accept plaudits.

Whose ox will be gored in 2017 to accomplish a similar feat? It is hard in the current climate to imagine a similar coalescence of right and left. While the 1986 measure accomplished much, it failed to address some of the distortions in the fabric of the U.S. tax code that today stand as major obstacles to fair and effective reform. Many of the current accommodations disproportionately benefit upper-middle and high-income taxpayers, but are often not recognized.

The single largest tax-deduction hole in Uncle Sam's revenue stream is the exemption of employer-paid healthcare insurance. Roughly half of Americans get their medical coverage through their employer, but pay no income tax on this substantial non-wage benefit. Enshrined in the IRS code in 1956, this regressive benefit costs the Treasury around $240 billion in annual revenue. A remnant of wartime labor price controls, the U.S. system of dependence upon employers for healthcare distorts economic incentives, exacerbates income inequality and complicates healthcare reform. But most taxpayers don't recognize that after-tax insurance benefits represent a significant tax giveaway.

Next in line is the long-term capital gains tax rate of 15 percent. The tax reform of 1986 reset capital gains equal to ordinary income rates, but the years have seen special interests successfully lobby for special treatment of profits from investment versus labor income or rents, costing taxpayers $110 billion annually.

Employer-sponsored retirement plans also enjoy tax-deferred status, costing the federal treasury approximately $140 billion each year. And the semi-sacred home mortgage interest deduction is a $68 billion upper middle-class entitlement that has been perennially exempt from scrutiny.

Added together, those tax expenditures account for over a half trillion dollars in preferences primarily benefitting the upper half of the income distribution. The home interest deduction, for example, essentially dictates that renters, or homeowners with no debt, agree to subsidize the mortgage payments of more indebted and generally higher-income Americans able to itemize deductions. Likewise for most of the other tax expenditures enumerated above.

Serious tax reform must begin with a sober assessment not of marginal rates, but of the preferences in the tax code that distort economic incentives and bestow favors disproportionately. As we enter a national discussion on the subject, it is essential that we engage in an earnest and rational debate that is fully informed.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

Upcoming Events