While no one likes making out a check to Uncle Sam, economists have yet another reason to feel pain come April 15. Professional number-crunchers are acutely aware of missteps, loopholes, and boondoggles that cost the federal government literally hundreds of billions each year — bits of misguided or poorly executed policy of which most Americans never know the impact.
Read on for the details of some of the biggest tax-code doozies and why they aren’t going away any time soon.
Ethanol credits: Energy policy in the United States is a crazy quilt to begin with, and factoring in the carrots and sticks of tax incentives makes it exponentially more complicated. There’s a lot of room for politically motivated legislation and for unintended consequences to crop up.
Ethanol was pitched as a kind of energy panacea back when President George W. Bush signed the Energy Policy Act of 2005, mandating an increase in the use of the corn-derived biofuel. Generous credits doled out to manufacturers and producers accelerated industry’s initial embrace of ethanol, but the skeptics have gained the upper hand in this argument. Ethanol production has been fingered as one of the culprits in the spike in food prices a couple of years ago (tariffs kept the United States from using sugarcane-based ethanol from Latin America), and it turns out that making the stuff consumes a lot of the nonrenewable fuel its use was supposed to conserve. Nonetheless, alcohol-fuel credits will burn through some $12 billion between 2007 and next year.
A related energy subsidy meant to encourage the burning of biomass misfired even more spectacularly. Papermaking companies have always burned as fuel a byproduct of paper pulp-making known in the industry as “black liquor.” They wound up netting some $6.6 billion to throw some diesel into the mix, an unintended consequence of a 50-cents-per-gallon tax credit given to companies that blend renewable fuel sources into carbon-based ones. In some cases, the money paper companies got from the credit was more than the money they made manufacturing. In this case, Congress has been working overtime to scrap this provision; they added verbiage ending the paper industry’s windfall into the health care bill that was recently signed into law.
Exemption for inherited stock-gains: Say, like Forrest Gump’s buddy Lieutenant Dan, you had the foresight to buy Apple stock when it went public in 1980 at $22 a share. If you died last week when the stock was at $230.90 a share, whoever inherited it wouldn’t have to pay capital gains on the increase, even if they turned around and sold it on the way to your funeral. To economists, this makes no sense, because if you’d sold that stock the day before your death, you would have had to pay capital gains. Tax planners even encourage elderly investors not to sell stock solely for the tax benefit it confers to their heirs.
This exemption isn’t chump change; it’s predicted to total about $280 billion between 2011 and 2015. Proponents of the exemption counter with that the estate tax takes care of these windfalls; in reality, though, the estate-tax exemption is large enough that it misses a lot of these capital gains.
Mortgage-interest deduction: This one is almost universally decried by economists. The bigger the homeowner’s mortgage, the bigger the deduction. This has the effect both of tacitly encouraging people to buy as much (or more) house than they can possibly afford, and it rewards McMansion owners far more richly than it does those who own more modest abodes. The wealthy get a windfall, while renters, whose median income is half that of homeowners, according to 2007 Census Bureau data, aren’t even invited to the party. From a macro standpoint, economists also fret that the deduction leads people to invest more heavily in housing than they otherwise would at the expense of other sectors of the economy.
Of course, the deduction is also universally loved by homeowners and thus by the members of Congress they elect. And no wonder: Next year alone, homeowners will get to keep roughly $104 billion as a result of the deductions. Any lawmaker who would propose its repeal would be committing political suicide, which is why President Obama’s plan to reduce the size of the deduction even slightly has been a nonstarter in Congress.
Exemption on employer-provided health insurance: This one is not without its share of controversy, as evident by the term “Cadillac plans” and the intensely heated rhetoric around the health care reform bill. Why would anyone want to tax what we have collectively come to think of as a national right?
For starters, there’s a ton of cash at stake. This exemption is the largest by far in the federal tax code. According to White House budget projections, it’s going to cost the government more than a trillion dollars between 2011 and 2015 alone. (While the new health care plan does call for taxing some employer-provided insurance, it doesn’t kick in until 2018 and won’t apply to all plans.)
Our de facto system of employer-sponsored health insurance began during World War II. Hiring managers, restricted by wage controls, embraced health insurance as an alternate method for recruiting workers. At the time, the impact of the exemption on the federal coffer was minimal, and no one imagined health care would grow to become the fiscal black hole it is today.
The status quo makes economists crazy, because the tax-free status gives insurance companies less incentive to compete on price. Also, companies have no disincentive to pick the most expensive plans and may prefer to offer pricier insurance in lieu of higher wages, on which they would have to pay payroll taxes and on which the employee would be taxed. Workers at companies that don’t offer health care and part-time employees who don’t have access to their employer’s plan miss out doubly: They don’t get that tax-free benefit, and if they buy their own private insurance, they do have to pay tax on that. According to some economists, this results in an exemption that benefits better-compensated workers, similar to the way the mortgage-interest deduction delivers a bigger break to people who own larger houses.
Municipal-bond-interest exclusion: Unlike the mortgage interest or health care plan exemptions, the big cheerleaders of this loophole are state and local governments. Groups like the Government Finance Officers Association hate the idea of letting the federal government tax municipal bonds, and so far their view has prevailed. Unfortunately, the perception of big savings is a shell game that benefits bondholders more than the local municipality, while the federal government takes it on the chin.
Cities and states can issue bonds with low interest rates because the buyers know they won’t pay taxes on the interest, but the math doesn’t justify the exclusion. The vast majority of muni buyers are individuals in the top tax bracket of 35 percent. Meanwhile, municipal bond rates are generally between 10 percent and 15 percent lower than those on corporate bonds. So for a 10 percent to 15 percent haircut, the buyer gets to avoid a 35 percent tax. The result? The revenue that’s lost by Washington is greater than the money local governments save by pricing their bonds at below-market rates. When the Tax Foundation turned its attention to this issue five years ago, it calculated that this structure cost the U.S. Treasury $20 billion a year. (It’s on Page 9 of this report.) The organization argued that directly funneling money to municipalities via grants would be a more effective way to help states and cities fund projects without benefiting wealthy investors at the same time.
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