What about middle-class loopholes?

Copyright 1997 by Liberty Issues and Michael J. Hihn. All rights reserved.

"I don't begrudge anyone a tax break, especially myself.  So why are these loopholes destructive?"

"What size will government become, if a voting majority doesn't pay a dime toward the programs they demand?" 

(Updates/Revisions, June 2005:  Added links to all sources, minor text editing.)

We deal again with the most destructive myth in American politics:  that the middle class is overtaxed, caused by hefty loopholes for business and the rich.

The opposite is true.  Tax loopholes targeted at the middle class (listed below) total one trillion dollars per year. That's 1/3 of all personal income, 1300% greater than so-called Corporate Welfare, and 200% greater than corporate profits.  Middle-class loopholes are greater than all reported personal income above $90,000 per year.

We already know that runaway middle-class entitlements are the biggest problem with federal spending.  Less well known are runaway loopholes, also for the middle class, on the revenue side. 

I don't begrudge anyone a tax break, especially myself.  So why are these loopholes destructive?

They distort the economy, retard economic growth, punish the poor, and make it difficult to reduce government spending.  Increasingly, voters get to support Big Government without having to pay for it. 

Most voters pay income taxes, of course.  We hear a lot about a ''fair share'' of those taxes -- whatever that means. 

As I've documented elsewhere, the actual share of taxes for a median income family of four, for all levels of government, is over 70% of their total income -- of which they pay only a small fraction.  It's only the top 10% of all taxpayers who actually pay their own way.  To illustrate, see the following Table -- a graphic version of data published here in February.

It's not the interest deduction.  The loophole is the rollover/exemption of capital gains taxes on home profits.  Middle-class homeowners are the visible beneficiaries.  But the powerful real estate lobby profits less visibly.

Real estate agents are those people in matching blazers, chanting in unison, ''Now is always the best time to buy.''  For them it is.  They get commissions of 7% or more on every transaction.  For most homeowners it means a lifetime of crushing mortgage payments, as tax gimmicks reward us for trading up to ever-more-costly homes.

Home prices generally increase faster than inflation.  As shown later, the tax code stimulates artificial demand and artificially restricts supply - the classic formula for higher prices.  You've probably seen this advice a hundred times:  ''Leverage your investment by trading up, with the largest mortgage you can afford.''  Without the tax gimmick, few people would be dumb enough to do that. 

But on average, people keep a home less than ten years.  Let's trace the consequences.

Imagine a single neighborhood, perhaps your own, which follows the national averages.  Every ten years the entire neighborhood turns over ... new owners carry higher mortgages than the old owners ... thus requiring ever-increasing amounts of real capital ... capital that creates nothing.  No new jobs.  No increased productivity.  Nothing.

Expand that for the entire economy.  We start from a low savings rate, which retards the creation of new capital.  Then we divert ever-larger amounts of scarce capital to financing used homes, instead of jobs and productivity.  This causes higher interest rates (including mortgages), because we must then compete to attract foreign capital. 

It's the classic statist delusion:  visible benefits with invisible consequences.  When our son has difficulty buying a house, one obstacle will be his parents' tax loophole.

This loophole traces to the 1950s, the migration to suburbia.  Prior to that the family homestead was rarely sold; it was bequeathed.  Selling a home triggered the capital gains tax.  Even then, accumulated inflation could be a major portion of that gain, if not the entire gain.

For existing homeowners, the capital gains tax was a barrier to buying that suburban home. Working and middle-class families felt, for the first time, the pain of paying taxes on inflationary gains.  That was the time to index capital gains for inflation.

Instead, government and the real estate industry conspired to create a tax loophole.  Government kept its tax on phantom profits in the stock market.  The real estate lobby removed a major obstacle to selling new homes.

When selling a primary residence, capital gains are ''rolled over'' (deferred) if you buy a home of equal or greater value.  If you keep trading up, the rollovers accumulate.  At age 65, you get a ''lifetime exemption'' (now $125,000) from your combined rollovers.  Congress keeps increasing this exemption to include a majority of middle-class voters.  The exemption is a loophole.  The cap on that exemption targets it to the middle class.

If you need more evidence, consider tax proposals to defer taxes on investment profits.  Gains would be rolled over if they were reinvested in the market.  That's identical to the tax treatment on middle-class homeowners, without the exemption at retirement, but is assaulted as a loophole for the rich. 

You can see, I think, how the residence loophole stimulates demand, artificially.  It also reduces supply. 

Homeowners can be locked into more home than they need, typically after the kids move out.  Couples don't buy smaller homes until age 65, to avoid the hefty tax on a lifetime of inflationary gains.  This artificially restricts the supply of ''family homes'' on the market, thus creating artificial demand for building new ones.

There are two opposing solutions to this mess, political versus economic.

Economically, indexing capital gains would remove the excuse for a residential loophole.  Then, taxing home profits would help pay for the indexing.  (We'll ignore for now that indexing would probably pay for itself.  I prefer Phil Gramm's approach:  ''If revenues increase, cut taxes again.'')

That's a classic supply-side solution:  close loopholes and cut taxes.  So why aren't ''supply-side Republicans'' proposing this?  Politics.

Politicians seek a different type of balance, a balance of special interests.  Rewarding one constituency means bribing another group into supporting the scheme.  So instead of matching tax cuts with spending cuts, they match tax cuts with … other tax cuts.  You've just seen it happen.

Bob Dole proposed the worst possible economic solution (Forbes and Kemp again).  He wanted to cut capital gains rates and expand the residential loophole!  (Dole, and later Clinton, proposed a total exemption for capital gains on primary residences.)

Another solution is to repeal the capital gains tax.  But critics are correct; that would cause home values to plummet.  Think it through.  Current tax policy stimulates demand and restricts supply,  the classic formula for higher prices.  Kick the props out and demand will fall while supply increases, the classic formula for falling prices.

Repealing capital gains also fails politically.  The middle class already has almost total exemption.

Capital gains taxes are paid mostly by the rich.  But only because middle-class gains are largely exempted.

I reported the truth on capital gains in 1994, the very first edition of Liberty Issues. I also showed  where to easily find the raw data.  (See ''Journalism:  What Went Wrong'' on the Web site.)  That was a debunking of a best-selling book, America:  What Went Wrong?, which used 1989 data.

Less than 1/3 of reported capital gains were earned by low and middle-income taxpayers.  But if we include unreported and untaxed gains, then the middle-class share leaps from 32% to 82% of the total -- on employee pension funds alone.

You read that correctly.  Employee pensions are a middle-class loophole.  The exemption excludes savings and investments by the so-called rich -- and is not available to workers without a company pension plan (mostly low-wage, non-union).

Pensions are a loophole, unless we repeal or defer all taxes on capital gains, dividends and interest ... and deduct new savings and investment from taxable income.  (The National Sales Tax is a roundabout way of doing the same thing.  But see ''National Sales Tax:  HR 3090'' on the Web site for why it can't work.)

Gains on pension funds are taxed eventually, at withdrawal.  But consider the impact on current revenues.  Using that 1989 data, $409 billion in pension-fund gains were exempted (not even counting tax-exempt contributions).  That was 33% greater than taxable corporate profits.  For the 1980s, net pension assets increased more than $1 trillion, all unreported and untaxed.  (Plus IRAs and 401-K Plans, which I didn't include.)

There's yet another big capital gains loophole for the middle-class.  To see how it works, we must also look at the Estate Tax.

Capital gains are exempted at death.  Heirs start from the asset's value at death, instead of the original purchase price.  This is an exemption on  interim gains.  The exemption applies to everyone, rich or poor, so it's not a loophole -- yet.  But consider that exemption in combination with the Estate Tax. 

For the so-called rich, at death the Estate Tax is even worse than the capital gains tax.  Estate taxes apply to the entire asset values, not just any gains.  If you buy $1 million of Microsoft stock then die immediately, you'd have a gain of zero but the entire million is taxable. (This assumes the $600,000 exemption has been satisfied elsewhere -- point being that the entire asset value is taxed, not just the gain.)

The loophole becomes apparent if we repeal the Estate Tax and eliminate the death exemption.

Why not tax capital gains at death, to the estate, or when heirs sell the assets, based on the original purchase price?  Well, the middle class would start bitching (rightfully) about taxes on phantom profits.  We can't have that get in the way of looting the so-called rich, so Congress created another middle-class loophole.

Employer-paid health insurance is the biggest loophole.  Also the pension plans noted earlier, plus life insurance, vision and even group legal plans.  (It's a loophole because the costs are tax-free unless you pay for them yourself.)

You're probably aware of the most common distortions, especially in health care, so I'll skip to closing the loophole.

In 1994, Hillary Clinton said her committee considered closing this loophole, but concluded it would be too difficult.  Baloney.  It's easy.

First, treat the cost of benefits as taxable income.  Then, increase the Standard Deduction and/or Personal Exemptions by the average cost of the current exemption.  For everyone.  No more loophole.

To illustrate, a family of four might have an additional $4,200 of both income and exemptions -- a wash.  But the exploiters (mostly union workers with plush benefits) would pay higher taxes.  Those now being exploited (mostly the self-employed and the working poor) would get a tax cut. 

Can any reform be better that this:  tax cuts for the exploited, paid directly by the exploiters?

I'll close this section by recalling the biggest recent flimflam caused by the benefits loophole.  In the late 1980s, you may recall that employers wanted workers to share healthcare costs.  The large unions refused to trade tax-exempt benefits for taxable wages.  In other words, those unions chose lower wages.

Since then, the same unions, and many on the left, have been bitching about low wage increases -- the same low wage increases unions demanded (that some even struck for!).  The failure of government regulated health insurance was blamed on a plot by the greedy rich.  As always, Republicans let them get away with it. 

I haven't heard Republicans saying unions chose lower wages.  Have you?

Supply-side conservatives couch their arguments in economic theory.  But most of their policies are crass pandering for middle-class votes.  Even worse, those conservatives (and a few libertarians) are working against limited government.

The Armey/Forbes/Postrel ''flat tax'' seeks to totally exempt most households from the income tax.  Why? 

Taxes hurt.  They are supposed to hurt.  We need them to hurt.  That pain is our best tool against bloated and oppressive government.  What size will government become, if a voting majority doesn't pay a dime toward the programs they demand?  How can liberty ever prevail, when politicians keep shifting the pain away from voters? 

If supply-siders were serious, they'd propose something close to this:

• Index capital gains for inflation.
• Repeal exemptions and deferrals on residential gains, pension funds and death.
• From that larger tax base, cut tax rates to prox 5% on capital gains, interest and dividends ... or cut income-tax rates across the board by roughly 1/3.
• Then throw in the higher exemptions described above, by closing the loophole on employee benefits.
  

What's your choice:  A 5% tax rate on investment and savings, or a 33% overall tax-rate cut, with no preference for savings and investment?

That's how real supply-siders would frame the issue -- a choice between two tax cuts -- and that is what we lose when conservatives instead pander for middle-class votes.

Here's a way to fight ''progressive'' income tax rates, indirectly.  But we must frame the issue carefully.  It wasn't voters  who created this Middle-Class Gravy Train -- it was politicians and special interests.

Despite these massive loopholes, middle-class voters got suckered on the larger issue of big government and high taxes.  We thought we won a tax revolt in the early 1980s.    Instead, politicians learned they could still keep on spending -- as long as the taxes were hidden from middle-class voters.

The taxes have indeed been hidden, but I've described the damage they cause  -- to jobs, to productivity and wages, to interest rates, and to our own children.

The GOP is blowing this issue, big time.  They can easily be shown as groveling and pandering, just like the hated liberals.  That creates an opening for Libertarians and for libertarian Democrats and Republicans.

There are a lot of separate reforms here.  It might be difficult to get them all passed as a package.  It might be easier to start over from scratch ... which is why I created the Liberty Issues Tax Plan.