Balanced, Fair Tax Reform: Too Much to Ask?

In a rare breakthrough of common sense, President Bush’s Advisory Panel on Federal Tax Reform has produced a balanced agenda for tax reform. It deserves better than the sharp attacks special interest groups are aiming at it.

You may know the salient points already – simplifying income tax brackets, eliminating the increasingly feared “alternative minimum tax,” replacing the home mortgage interest deduction with a much smaller tax credit, taxing particularly generous employer-offered medical plans, and doing away entirely with the deductibility of state and local taxes.

Pot shots are rolling in. Sen. Charles Schumer is warning of unfair “double taxation” if taxpayers can no longer deduct state and local tax states on their federal forms. The realtors, homebuilders and mortgage bankers are claiming a loss of home mortgage interest deductions would drive housing prices down as much as 15 percent.

So does the package deserve the “dead on arrival” tag some are putting on it?

Let’s hope not.

Consider state and local tax deductibility, a sacred cow of many governors and mayors and county executives. A massive concession seems to be in peril.   In 2003, 43.5 million taxpayers deducted $315.7 billion state and local taxes on their returns, saving themselves $88.4 billion in federal taxes. The biggest winners by far were two high income tax states—California and New York—with total deductions of $55.9 billion and $37.6 billion respectively.

But is it true, as Schumer and his allies argue, that revoking the deduction would easily frighten high income tax states into lowering their taxes and services – “a race to the bottom” – in order to retain their high-income households? 

Maybe, but maybe not. Some individuals do shop around for lower tax states, especially for retirement. But these are already relatively high tax states; one suspects they’ve already given up most of their likely tax fugitives. 

And the tit-for-tat arguments miss the big picture: The tax reform panel, chaired by former Sens. Connie Mack (R-Fla.) and John Breaux (D-La.) is not presenting us with a smorgasbord; it’s strongly insisting its proposals need to be seen as a whole, interrelated package leading to simplified, lower tax brackets. Wait to see the bottom line, they plea. 

Consider, for example, the interplay of state and local tax deductibility and the alternative minimum tax. “The AMT is the gorilla in the room,” notes Kim Rueben of the Urban-Brookings Tax Policy Center . With inflation it’s starting to force hundreds of thousands of not-so-wealthy folks to pay the high minimum tax, negating the value of their state and local tax exemptions, even if they claim them.

The even more astounding proposal from the Bush tax panel is the radically reduced deduction for home mortgage costs. Today a taxpayer can deduct up to $1 million for first and second homes, plus home equity loans up to $100,000. The breaks are great for bankers and the McMansion industry; indeed the Washington Post quotes a custom-home builder from Ketchum, Idaho, complaining the proposed changes would “cripple those communities that rely on second homes and vacation homes as a major source of income.”

Pardon us, but are second homes what homeownership tax breaks – $70 billion a year for the mortgage deduction, $19.3 billion for property tax deductions – should be for anyway? How about something quaint like helping people afford a home? Or even having a roof over their heads? The entire budget of the Department of Housing and Urban Development is $35 billion, less than half as much, and its programs touch only a quarter of low-income renters.

A wealthy corporate executive is much likelier to get a home mortgage subsidy than a construction worker or school teacher, notes Peter Dreier of Occidental College , a longtime critic of the subsidy. Some 62 percent of households with incomes over $200,000 now get a homeowner tax break, averaging $7,219. Only 2.5 percent of households in the ,000-,000 range get any subsidy, averaging . 

The real estate industry defends the existing homeowner tax breaks as a bedrock of the American Dream.   But the tax panel looked at countries that don’t allow mortgage interest deductions, among them Canada, Britain and Australia, and found rates of homeownership close to the United States ‘ 69 percent. 

The panel would replace today’s mortgage interest deduction with a far more modest tax credit of 15 percent of mortgage interest actually paid. What’s more, there’d be a cap on the amount of loan eligible for the credit (up to $412,000 in highly expensive markets).   Second homes would be totally ineligible.

President Bush, while endorsing tax reform in general, hasn’t said if he’ll support all or indeed any of the his panel’s proposals. Cynics say he’s too politically weakened to push much through anyway.

But what, if once, this president really went for the high middle ground?   He—and we—might be winners.