Preferences as Policy

We have seen that tax "breaks" or "loopholes" or, in more neutral tones, "preferences," are both easily criticized and a normal part of government. In addition to (or in place of) raising revenue, tax laws may include provisions providing relief from taxes for people who act in socially desirable ways. Using tax provisions as an instrument of policy, furthermore, may accomplish purposes that other legislation, such as appropriations, cannot. Tax advantages may be used as leverage, attracting

investment or providing the margin that allows a family to buy a home. At the same time, use of the tax code rather than direct spending can have strange consequences. It is hard to imagine housing subsidies that increase with a person's income being approved as an appropriation, yet this deduction costs billions and is politically sacrosanct.

The government manifests its preferences through the tax code as one of a number of instruments of public policy. Nothing wrong (slimy, sleazy, even faintly illicit) there. Tax legislation may suffer even more seriously than other policy making from common difficulties of the legislative process: complexity obscures choice from all but the directly interested; committees are "captured" by special interests; politicians help groups in return for groups helping them.

Although some U.S. citizens say that taxes should be levied for revenue purposes only, other countries do not practice this doctrine. Everywhere, taxes are used to regulate behavior—whether through sin taxes on commodities that elites believe bad for the masses or by exemptions, such as those relating to the arts, that elites believe good for themselves. Taxation is a major instrument of public policy.

Many of the tax code's preferences are based on notions of equity. Imagine, if you will, a simple income tax with no preferences. Taxpayer A is a young man with an income of $20,000 living by himself in a rented villa. Taxpayer B is a blind, old-age pensioner who supports his wife and two disabled children in their family home on an income of $20,000 a year—from disability and pensions. In a nonpreferential system, A and B would pay exactly the same tax. Equity would appear to require not simplicity but complexity so that B ends up paying less than A.

Can the amount of tax expenditures be known? Yes and no. Yes, it is possible to estimate roughly the loss of revenue to the Treasury from provisions such as accelerated depreciation, or deductions for medical expenditures, or not counting fringe benefits as income. No, it is not possible to estimate accurately. When tax process provides incentives, motivations are involved. How is one to know whether the taxpaying entities concerned, once blocked in a certain direction by abolishing or reducing a preference, will not take action to counter the expected loss of income? As the common scare story goes, to cut the mortgage interest deduction will reduce home starts, driving the housing industry and the entire economy into a slump that reduces revenues. Exaggerated, perhaps, but some backfire is possible. To estimate the synergistic effects of preferences on incentives may well be beyond existing capabilities.

Most returns—about 60 percent—do not itemize deductions. Yet in 1984 over 38 million did itemize. Over 10 million, most with incomes under $30,000 per year, claimed deductions for medical or dental expenses. Deductions for other taxes were claimed by 38 million; 27 million

claimed for home mortgage interest; 35 million for charitable contributions. Out of $359 billion in itemized deductions, about $281 billion, nearly 80 percent, were claimed in those categories. The bulk of tax preferences are for categories that are hard to stigmatize as special interests.^[1]

Because preferences are worth more at higher incomes in a progressive tax system, a large part of the deductions goes to a comparatively small number of taxpayers. In 1984, about 12.7 million returns (13 percent) claimed about half of the deductions. They paid a slightly larger share of the taxes.^[2]

No instrument of public policy is good for all purposes. The dilemma involved in extensive use of tax preferences is well known to observers: individual and collective rationality are at odds. Though the vast bulk of tax preferences originates in the desire to achieve some self-evident good—locating industry in areas of high unemployment, increasing the supply of vital commodities, fulfilling the dreams of home ownership—the collective consequences of reducing taxes for these items may be undesirable. The number of preferences, the fact that they have been adopted at different times and hence may work at cross-purposes, and their high rate of interaction with each other and with existing provisions have led to a complex code. The large amounts by which preferences reduce the revenue base require higher marginal tax rates. Worst of all, to the taxpayer this combination of complexity and cost leads to delegitimation of the tax process; most people suspect other people of cheating. The very language used—"loopholes" and "gimmicks"—suggests that it has become morally suspect to make legal and proper use of those statutory provisions deliberately designed to encourage such behavior.

What, in fact, was meant by "reform"? Essentially three things: lower rates, fewer brackets, and fewer preferences. The key words were "fairness" and "simplification." "Fairness" is used in the sense that people would be treated, if not equally, then proportionally to their financial condition. The existing system was held to give some people opportunities that others could not enjoy. Why should cattlemen, or oil drillers, or union members (with good health benefits) get special treatment? To those who disliked a progressive tax, the flat tax—one rate for all—seemed fair. Ronald Reagan had long been in that camp; while lecturing for General Electric in the 1950s, he had described the progressive income tax as "created by Karl Marx." "It simply is a penalty on the individual who can improve his own lot; it takes his earnings from him and redistributes them to people who are incapable of earning as much as he can."^[3]

Fewer brackets—either one (a flat rate), or three (as in the Bradley-Gephardt proposal), or some number much less than the then-existing

fourteen—sounds simpler, as does reducing the number of preferences. Actually, the appearance of simplification was deceptive. In practice, most people calculate their tax from tax tables; and no matter whether the amount owed for a particular taxable income was calculated from three or thirty brackets, the table would look no different. Also, the vast majority of taxpayers were using only a small number of the available preferences, some of which (like nontaxability of fringe benefits) required no individual effort. Yet filling out tax forms was still a bother; people did not like hiring experts to protect them from the IRS. The populist appeal of simplification was power: a simpler system would make people less dependent on experts. Rich people could afford to hire experts; the common man could not. In the same vein, simplification promised openness, a more transparent system. But simplicity and fairness, as tax experts know, are at odds. For fairness requires distinctions that complicate tax returns.

Which was better for economic growth, targeted preferences or lower marginal rates? The theoretical debate—selective versus universal incentives—merged, as usual, into empirical differences: one side found marginal rate reduction to increase individual incentives and the other claimed selective tax preferences to encourage investment to be superior. Tax preferences to aid industry became a contested concept. Some market-oriented politicians began to see tax preferences as subsidies that distinguished unfairly between different industries, a question only market competition should decide. There was no single obvious truth, but multiple truths.