John Hood: To get many happy returns ...

Mar. 18, 2013 @ 07:24 PM

RALEIGH — Whether the setting is Raleigh or Washington, the tax reform debate will inevitably come down to one Big Question: Are you willing to trade current tax preferences for lower tax rates?
Most economists think yes is the obvious answer. But to some taxpayers, revenue-neutral tax reform that offers to trade lower rates for fewer preferences may lack appeal. If you work in a sector that benefits from special treatment, such as high-end real estate or wind energy, those breaks may well be more valuable to you than lower rates or compliance costs.
Still, the system has a whole desperately needs reform. Our effective tax rates on corporate income and capital formation are among the highest in the world. They reduce the competitiveness of our economy and reward current consumption over long-term, productivity-enhancing investment.
The key to unlocking the tax-reform door is to recognize that it isn’t really all about marginal tax rates. The best-available tax system isn’t the one that tallies up everyone’s gross income and applies a tax rate to it. Yet some descriptions of “tax expenditures” assume exactly that. They list both the mortgage-interest deduction (which truly is a special-interest tax break that disproportionately benefits upper-income taxpayers) and the deduction for deposits into IRAs and 401ks (which is a policy for making taxes neutral with respect to current vs. future consumption). Such a description is utter nonsense and unhelpful to policymakers.
You have to start with valid definitions. Income isn’t just transferring cash from one pocket to the other. It is best understood as a monetary return on some prior investment – a return on financial or physical capital, in the case of dividends and capital gains, or a return on human capital, in the case of wages. If government taxes the resources taxpayers spend to accumulate and deploy that capital in the first place, such as deposits into investment accounts or the rearing and education of future workers, then it shouldn’t also tax the return on those investments. Otherwise, its tax code discourages long-term investment in favor of short-term consumption. The results are complexity, unfairness and weaker economic growth.
So a properly structured tax system would retain tools such as generous personal exemptions (especially for children) and savings deductions. These tools shield capital formation from tax at the front end, since the returns on that capital are taxed later. Reformers shouldn’t try to persuade or compel taxpayers to give up these safe harbors in the tax code.
On the other hand, narrow tax preferences for housing debt, municipal bonds, eco-friendly projects, or non-wage benefits favor some forms of capital formation and maintenance over others. Any sensible tax reform ought to reduce or eliminate them, in exchange for lower rates.
In reality, most households and small businesses take standard deductions and forego complex tax filings. They do prefer simplicity to preferences, and form a large consistency for tax reform. They deserve to get what they want.

John Hood is president of the John Locke Foundation and author of “Our Best Foot Forward,” a book on North Carolina’s economy. It is available at Representations of fact and opinions are solely those of the author.