That beloved deduction for mortgage interest is a fat target for tax reform.

Photographer: Daniel Acker/Bloomberg

Closing Tax 'Loopholes' Would Choke the Middle Class

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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There’s an easy way to sum up virtually any debate about tax policy: “You call them loopholes. I call them deductions.”

Paying for new spending by “closing the loopholes” is a favorite rallying cry of almost everyone. But rarely are those people picturing giving up their own deductions for mortgage interest, employer-sponsored health insurance, dependent children, or retirement accounts. Why, no! Those aren't loopholes. Those are just the basics of a decent middle-class life. Loopholes are the deductions used by other, richer people who can afford crooked lawyers.

The sad fact is, however, that almost all of the money lost to “tax expenditures” goes to you, Mr. or Ms. Middle American. It cannot be otherwise; you have most of the money. Oh, I know it doesn’t feel like you have most of the money. Didn’t you just read an article saying that the top 1 percent of Americans collect around 20 percent of national income?

Why, yes, you did. But that means the bottom 99 percent have 80 percent of national income. If we confiscated every dollar the top 1 percent made, that still wouldn’t quite cover our national expenditures. And it is not actually practical to take all of it, since the normal response to 100 percent tax rates would be to move or to stop making money.

Because you have most of the money, you collect most of the tax breaks. On an individual level, of course, a very rich person gets much more out of our national tax expenditures than an accounts payable manager in Toledo. But collectively, the vast middle is where most of the money goes.

Here is a complete list, with one exception , of all of biggest tax expenditures in 2015. 

Tax Expenditure

Cost (in millions)

Exclusion of employer contributions for insurance

206,430

Special tax rate for capital gains

85,360

Mortgage interest deduction

69,480

Defined-contribution employer pension plans

68,040

Deferral of income from controlled foreign corporations

64,560

Step up basis of capital gains on death

63,440

Deductibility of local taxes

47,490

Defined benefit employer pensions

44,640

Deductibility of charitable contributions

44,280

Partial tax exemption of Social Security benefits

39780

Capital gains exclusion on home sales

36,930

Deduction for property taxes

33,120

Tax free state and local bonds

31,070

Special tax rate for qualified dividends

26,320

Self-employed retirement plans

25,480

Child Tax Credit

23,900

IRAs

17,240

American Opportunity Tax Credit

15,660

Deduction for U.S. production activities

14,500

Tax-free allowances and benefits for armed forces personnel

13,570

Tax-free interest from life insurance savings

13,100

Tax-free workers' compensation benefits

9,990

(Source: Office of Management and Budget)

Note what is not on that list: things like “carried interest,” “corporate jets,” or tax breaks for oil and gas companies. Those are favorite talking points because they sound bad, but they are dwarfed by something like employer-sponsored health and pension benefits. To be sure, many of these things, like 401(k)s, mortgage interest deductions and self-employed retirement plans disproportionately benefit the affluent, but we’re talking about the merely moderately prosperous, not the Scrooge McDucks rolling around in their piles of filthy lucre. If you’re reading this article, it’s quite likely that you’re taking advantage of many of these loopholes, without any help from shady lawyers.

If you want to pay for any major new program by “closing the loopholes,” it is these loopholes that you will need to close, because the amount of revenue raised by, say, doing away with carried interest treatment of sweat equity partnership stakes works out to a rounding error on the federal budget.

You can make a sound economic argument that we should do away with all these tax expenditures, hopefully in the context of a tax reform that lowers tax brackets to make the change “revenue neutral” -- which is to say that after both changes, we should be raising about as much money as we did before. But “revenue neutral” does not mean “no one gets hurt.” My household, with its dainty mortgage, minimal capital gains, and lack of children or tax-free municipal bonds, would come out greatly ahead in such a reform. Other people, perhaps who have generous health and pension benefits and a heavily mortgaged house to shelter their four children, would be badly pinched. 

Even things that sound like easy ways to hit the rich -- getting rid of the tax-preferred treatment of capital gains, dividends and municipal bond interest -- would do damage well beyond the obvious targets. There is a reason that even big European welfare states don’t try to tax capital gains too heavily; capital is mobile, and more importantly, capital formation is a voluntary decision to save rather than consume. If you lower the returns to saving, you may see substantial declines in the investment needed to make our future more prosperous. Charitable deductions and muni-bond interest, which primarily help the wealthy shelter their income, also provide a substantial subsidy for charities and state and local governments, who would be hard hit if these advantages went away.

There you have it. Suddenly, closing the loopholes doesn’t sound so easy --  politically, or even morally. Perhaps you’re willing to swing the scythe of tax reform through the sacred precincts of the American Red Cross, the state and local bond issues, and the local housing market. But politicians aren't willing to, because they would have to face their constituents -- like the guy who just took out a bit of a stretcher mortgage to get the kids into a decent school district. They would have to tell him why they got rid of the mortgage interest tax deduction. By which I mean: why they blew his family budget to smithereens and lowered the value of his new house so that he can’t even sell it to get out from under his brand new financial problems.

Or perhaps you want a sort of ultra-light tax reform that hits only those terrible-sounding loopholes, like hedge-fund managers getting capital gains treatment for their carried interest, and accelerated depreciation of corporate jets. That’s not an unfair stance to take; symbolism does matter. But you should be aware that what you are doing is making a symbolic gesture, not proposing a serious fiscal policy. Serious fiscal policy is expensive and painful. And that, of course, is why we haven’t had one for decades.

  1. I have taken the liberty of excluding from our discussion imputed rental income for homeowners. This is the sort of thing that makes sense in an economic model, but it does not make sense to the average taxpayer that they should pay the government for the privilege of owning their home, simply because this allows them to avoid paying rent. Also, counting this and the mortgage interest deduction is really double-counting, since mortgage interest would then be an allowable expense against the imputed rental income, cancelling out one of the expenditures.

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