CHAMPAIGN, Ill. – If a presidential election is looming, it’s inevitable that the law many Americans love to hate – the federal income tax – will come under attack from candidates. While this election cycle is no different, two competing plans from GOP rivals renew an important public policy question: Why have tax deductions at all?
University of Illinois law professor and taxation expert Richard L. Kaplan says that both Herman Cain’s radically simplified “9-9-9” plan and Texas Gov. Rick Perry’s “flat tax” plan aim to lower tax rates dramatically by eliminating most, if not all, of the tax deductions that currently exist.
“These candidates are certainly correct that tax deductions have grown like wildfire, and their proliferation has unduly complicated the tax law,” said Kaplan, the Peer and Sarah Pedersen Professor of Law.
Although the U.S. tax code allows deductions to stimulate saving for retirement and college, to help with the purchase of a home, and to encourage philanthropy, among myriad others, Kaplan says it’s “highly doubtful” that the tax code is the most appropriate policy tool to create incentives for certain behaviors.
“The creation of one special provision acts as a catalyst, stimulating the growth of other, equally legitimate requests, which in turn create their own endless parade of just causes and compelling arguments,” he said. “This raises the question, ‘Why must every economic and social problem of modern civilization find its solution in the tax law?’ “
Kaplan says the metastasizing nature of the tax code is attributable at least in part to the presence of these deductions, which have the unintended effect of raising tax rates to keep a certain level of revenues.
“It is a simple mathematical inevitability – more deductions require higher rates,” he said. “The only way an individual comes out ahead is if that person claims enough deductions to offset the increase in tax rates caused by those deductions. But that means that others will pay more, because not everyone can come out ahead.”
According to Kaplan, revising the tax code and lowering rates for everyone was the signature achievement of the Tax Reform Act of 1986.
“The entire panoply of deductions wasn’t eliminated, but enough were that the 14 tax brackets were reduced to two, and the top rate was lowered from 50 to 28 percent,” he said.
But what modern-day no-deductions proponents usually overlook are the two most significant causes of real world complexity for tax deductions, the first being deductions for business expenses.
“If a small business has sales of $100,000 but incurs expenses of $90,000, would we really assess a 18 percent tax on $100,000?” Kaplan said. “If so, the tax would consume the entire profits of that business. In fact, a tax on gross receipts could be due even if that business had a loss. Not allowing deductions for business expenses strikes most people as unfair, to put it mildly.
“Thus, we will continue to allow deductions for legitimate business expenses – as does every single ‘flat rate,’ no-deductions proposal. The question then becomes how do we define ‘business expenses’ and where will we draw the line? In other words, once we keep business deductions, we forfeit much of the real tax simplification.”
Kaplan says the desire to keep business deductions leads directly to the second cause of real-world tax complexity: documentation.
“Once we decide to allow business deductions but not allow non-business deductions, we must somehow prove which is which,” he said. “Thus, the recordkeeping, the audit hassles with the IRS, and the litigation to define precisely where one category ends and the other begins.”
Nevertheless, Kaplan says, the basic critique remains valid: Even if we cannot achieve significant simplification, we could have lower rates if we had fewer deductions.
“The unassailable truth is that tax rates are artificially high because the revenue base has so many leakages,” he said. “Taxpayers as a whole would be better off, for example, if we eliminated the home mortgage deduction, which fewer than 30 percent of homeowners actually claim. Most taxpayers would benefit from lower rates, if that provision were eliminated and the rate structure recalibrated.”
But don’t look for that to happen anytime soon, Kaplan warns.
“Americans believe that we, individually, are better off with capital gains preferences, home mortgage deductions, charitable contribution deductions, and all the rest,” he said. “More importantly, there is no possibility that 535 members of Congress will voluntarily give up their ability to encourage activities they deem important or discourage behaviors they deem undesirable by refraining from using the tax code for non-revenue purposes. That is what really keeps the tax code persistently complex.”
