A Fine Mess

by T. R. Reid

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  AN EVEN LARGER DRAIN on tax revenues comes from the several provisions in the tax code that benefit homeowners. Most countries provide some tax relief for homeowners; the United States is the most generous of all in this area. Just like the charity deduction, the homeowner provisions are extremely popular. Economically, though, they don’t make much sense. Like the charity deduction, the benefits for home ownership are strongly skewed to the richest taxpayers. Millions of homeowners—those who don’t itemize deductions—get little or no benefit from the homeowner deductions. Like the charity deduction, they cost a lot in lost revenue; the Treasury Department estimates about $200 billion in 2016. And like the charity deduction, these tax breaks are unnecessary. They are supposed to encourage home ownership, but countries that don’t allow these deductions have ownership rates as high as ours.

  The economists say that the tax code benefits homeowners in four ways.

  The most obscure is something called “imputed rent.” If you live in the home you own, but don’t pay rent to the owner (yourself), economic theory holds that you are earning “income” in the form of free rent. Some countries—for example, Belgium, the Netherlands, Norway, and Sweden—actually compute how much this free rent is worth and tax it as income. In the United States, the Treasury Department lists the non-taxation of imputed rent on its official list of tax expenditures. The United States has never taxed imputed rent, though, and surely never will, because homeowners would explode if any government ever tried it.

  As a general rule, the prices of homes tend to rise over time. When a house is sold, therefore, the homeowner usually gets more than he paid for the house in the first place. This is considered a “capital gain”—a profit on a financial investment. But most people think of their home as a different kind of “investment” from stocks and bonds. And even if a family made a big profit selling their house, most of that money would be needed to pay for the house they had to buy to replace the one they just sold. Accordingly, the tax code reflects that general belief that this is not a typical kind of capital gain. As of 2016, a family paid capital gains on the sale of a residence only if the profit was more than $500,000, so most Americans were exempt from this tax. The Treasury says this cost $39.6 billion in lost revenue in 2016.

  Homeowners who itemize deductions are allowed to deduct the amount they paid on state and local property taxes on the home. Homeowners love this deduction, of course, but most serious proposals for tax reform—including the Bush plan of 2005 and the Obama plan of 2010—have called for it to be eliminated. After all, it gives a significant tax break to homeowners but nothing to renters making the same income. It gives the owner of a million-dollar house, who may not need tax relief, a much bigger tax deduction than it gives to a less wealthy family living in a simpler house. And it encourages states and cities to increase their property tax levels; people who live in high-tax states get a better deduction than those where property taxes are lower. The deduction for property taxes will cost the Treasury some $36 billion in lost revenue in 2016.

  The big gorilla of homeowner tax breaks is the deduction for mortgage interest, which reduces income tax revenues by about $100 billion each year. That is, this one tax deduction costs more than the budgets of the departments of Agriculture, Commerce, Energy, the Interior, and the Treasury combined. Like other deductions, it is a particular boon to those in the upper brackets; about three-quarters of all the deductions for home mortgage interest go to taxpayers making more than $100,000 per year. About half of American homeowners take the standard deduction, which means they get no tax break for paying their mortgage.

  While this deduction is promoted by realtors and mortgage bankers as a boon to home buyers, it is just as likely to make a home purchase more difficult. All studies (except those funded by the real estate industry) find that a mortgage interest deduction raises the price of a house. When the OECD investigated the impact of the mortgage interest deduction in wealthy countries where it is still in place, it concluded that “new purchasers . . . are not necessarily the beneficiaries of these tax provisions,” because the interest deduction forces them to pay an increased price. Whatever benefit a buyer might get from the tax break is just about completely offset by the higher price of the house.11 So the deduction doesn’t do what it is supposed to do—make it easier for people to buy a home.

  Because of the large cost of this tax break and the small impact, Congress has repeatedly tried to take it away. This always fails, because of effective lobbying from realtors and bankers. But Congress has managed to put limits, sort of, on this write-off. It applies only to mortgages up to $1 million, and you get a write-off for the mortgage on only two of your houses, but no more than that. Clearly, these are not limits that touch any average homeowner. Other countries have imposed similar restrictions. Some have made the preference for mortgage interest a credit rather than a deduction, which means everybody gets the same tax break.

  But Australia, Canada, Germany, Great Britain, Israel, Japan, the Netherlands, and New Zealand, for example, have no deduction for mortgage interest at all. Yet eliminating the deduction seems to have no impact on home ownership. In all the industrialized democracies, the rate of home ownership is just about the same. Roughly 65% of families own their home in countries that have the mortgage interest deduction, and about 65% of families own their home in countries that do not.

  Just like the charitable deduction, though, the write-off for mortgage interest is hard to get rid of. It has been part of the tax code for so long (more than a hundred years) that people see it as a basic right. Beyond that, eliminating the deduction would probably reduce the price a buyer will pay—at least in the short run—and reducing the price of houses would depress the value of what is most Americans’ largest investment. There are ways to make the change gradually, so as to protect the investment of current homeowners. Still, anybody who tries to get rid of this tax break faces a severe political challenge.

  Some twenty years ago, however, Great Britain figured out a politically palatable way. Until the 1980s, Brits could write off mortgage interest of just about any amount on any number of houses; just as in the United States, this created a boon to the wealthy and a significant revenue loss for the government. And then, gradually, the Inland Revenue began snipping away at this deduction. At first, the size of the mortgage was limited so that it applied only to mortgages of about $75,000 or less; you could take a deduction for interest up to a loan of that amount but no more. This change cut the deduction for the richest homeowners, but it had only a moderate impact on most British taxpayers. So it was fairly easy to enact. In 1988, the deduction was limited to a mortgage on only one house per family; this, too, had minimal impact on average earners, and it, too, was fairly easy to enact. Beginning in 1992, the government ruled that the deduction could not reduce the tax due by more than 25%. That meant upper-bracket taxpayers got less of a deduction than they had before, but average earners did not. Over the next eight years, the deduction was reduced to 20%, then 15%, then 10%, then 5%. Each change caused a protest, but the bottom-line difference each time was so small for most taxpayers that complaints were muted. Finally, in 2000, the deduction was reduced from 5% to zero. One of the most popular of all tax breaks was completely eliminated.

  Because this change occurred during a decade when home prices were rising in most of Britain, few homeowners saw the value of their investment decline. Indeed, the Labour Party government that presided over the demise of the mortgage interest deduction easily won the next two national elections. And of course, tax policy experts advocating the BBLR principle were thrilled. Paul Johnson, the director of the Institute for Fiscal Studies, a prestigious London think tank, related the whole story to me with a tone of sheer delight. “This was a triumph of tax policy!” he declared. “The fact that it proved possible . . . gradually to phase it out is good evidence that reform really is possible even when the tax break bei
ng abolished is popular and many losers are created.”

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  THE ELIMINATION OF ANY “tax expenditure” will of course create some losers. The beneficiaries, of course, will always make the best case for their particular tax credit, no matter how “ludicrous” it may look to others. One man’s “loophole” is another man’s “essential provision to provide jobs and growth.”

  As a general rule, those who advocate the BBLR approach want to reduce tax rates for everybody. But some economists and political figures favor a different reform: they want to reduce rates, but only for taxpayers in the upper brackets. This concept is called a flat tax, and it has its champions in the United States. During the 2016 presidential primaries, five of the Republican candidates proposed a flat-tax regime. But would it work?

  6.

  FLAT BROKE

  Good King Wenceslas looked out, as the great Christmas carol tells us, on the Feast of Stephen, when the snow lay round about, deep and crisp and even. To this extent, at least, the legend of King Wenceslas rings true. The Feast of Stephen—that is, St. Stephen’s Day in the Roman Catholic Church—is celebrated on December 26. At that time of year, the province of Bohemia—that is, the western section of the nation we now call the Czech Republic, where Wenceslas ruled early in the tenth century—is normally blanketed in snow. And the carol’s story of how the good king trudged through the snowbanks, “though the frost was cruel,” to carry food and fuel to a starving peasant rings true as well, because Wenceslas is remembered as a wise and benevolent sovereign, a saint of the church, and one of the great figures in Czech history.

  Today Good King Wenceslas looks out over a bustling boulevard in the center of Prague known as Václavské náměstí, or Wenceslas Square. As befits a beloved national champion, Wenceslas is honored with a larger-than-life statue at the top of the square that depicts the good king mounted on an imposing stallion. Along the boulevard beneath the stallion’s feet, throngs of people are strolling and shopping and chomping away at the local delicacy, a huge sausage named for the good king: the Wenceslasworst.

  But the Czechs have a mischievous sense of humor, which extends even to the point of making fun of their national hero. There’s a pizza joint on Wenceslas Square, catering to tourists, that features a menu item called the Good King Wenceslas Christmas Eve Pizza. The description: “Deep pan, crisp and even.” A few blocks from that big equestrian statue, there’s a rather different image of the good king. This one is a statue of a horse suspended upside down from the ceiling—with Wenceslas mounted precariously on its belly, just about to fall off.

  “That horse hanging there, that tells you of course something about the Czech sense of a joke,” said my friend Radim Boháček, an economist who learned almost perfect English while a grad student at the University of Chicago. “Like, they take their greatest king and hang him from the roof downside up.”

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  FOR THE CZECHS AND their neighbors in more than a dozen eastern European countries, the whole world turned downside up in 1991, when the Soviet Union fell apart. A cluster of former Soviet republics and Soviet satellite nations suddenly became free and independent countries. The end of the cold war was so quick and unexpected—the experts at the CIA utterly failed to see it coming—that people and politicians on both sides of the former Iron Curtain were left up in the air about its meaning. For one man, that metaphor was literally true: the Soviet cosmonaut Sergei Krikalev, who blasted into earth’s orbit in 1991. While poor Krikalev was orbiting the earth aboard the U.S.S.R. space station, the U.S.S.R. ceased to exist. Suddenly he was a spaceman without a country. When he returned to earth in early 1992, the landing zone that had been the Soviet Union’s space center was in a newly independent nation, Kazakhstan.

  All along the route of the fallen Iron Curtain—from Estonia on the Baltic to Slovenia on the Adriatic—newly installed leaders set about the task of creating democratic governments and capitalist economies. Determined to erase the residue of their dreary Communist decades, they happily accepted all the money and advice they could get from the wealthy members of the European Union to their west. They revamped their banking systems and eagerly sought investors who could create private corporations within their borders.

  In the process, they turned tax policy downside up as well. Over a decade beginning in 1994, most of the newly independent nations of eastern Europe adopted a radical new approach to taxation—a much-debated but little-tested concept known as the flat tax.

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  THE FLAT TAX WAS a new idea that had many parents. Some heavy-duty economists armed with computer simulations promoted this approach, on both sides of the Atlantic. They were joined by politicians, mainly on the right, who sought a tax-reform plan that would appeal to the wealthiest donors and yet sound fair to everybody. In the 2012 presidential campaign, three of the top Republican candidates strongly supported a flat tax; the eventual GOP nominee that year, Mitt Romney, gave it a characteristically Romneyesque endorsement. “The flat tax is an important idea that we will have to consider,” he said, thereby managing to sound positive without committing to anything. Republicans embraced the idea again in the 2016 campaign; the presidential hopefuls Rand Paul, Carly Fiorina, Ben Carson, Ted Cruz, and Rick Perry all came out for a flat rate of income tax for everybody. They didn’t agree on what the flat rate should be—their proposals ranged from 10% to 19%—but they all argued that it would provide a huge boost to the U.S. economy.

  For all this support, though, there is something less than complete agreement about what a flat tax would look like. In turns out that this seemingly simple idea comes in many different flavors.

  At the purest level, a flat tax means everybody pays the same flat amount of tax, regardless of income or circumstances. At first blush, this might sound fair. Everybody pays exactly the same—what could be more equal than that? In practice, however, all countries have concluded that it is inequitable to ask a hotel maid earning $20,000 per year to pay just as much in tax as a hotel owner taking in $2 million annually. One advanced democracy, Great Britain, actually tried this pure form of flat taxation in 1990, when Prime Minister Margaret Thatcher instituted her “Community Charge.” This system, generally known as the “poll tax,” required that everybody in a given community pay the same amount annually for local government services. A tenant in a tiny studio apartment with a bathroom down the hall was expected to pay £250 per year to the city government, and a plutocrat living in a twenty-five-room mansion paid the same £250. Naturally, this system was a big hit with mansion dwellers, but lower-bracket taxpayers responded with outrage. They refused to pay; they threw bricks through the windows of the tax office; they rioted in the streets. Facing this furious backlash, Thatcher’s flat-tax plan was quickly abolished, and the Iron Lady herself lost her job as head of government after a mutiny by members of her own party.

  More commonly, however, the notion of a flat tax means not a flat amount of tax paid but a flat rate of tax; that is, everybody pays the same percentage of his income to the government. In its most ambitious form, the flat tax is a plan that sets the same flat rate for several different forms of tax. A good example was the vaunted “9-9-9” plan set forth in the 2012 Republican presidential primaries by a short-lived candidate named Herman Cain. Cain’s tax proposal called for a personal income tax with a single rate of 9%, a corporate tax rate of 9%, and a federal sales tax of 9%. Cain himself offered no detail on how much money the “9-9-9” tax might raise; the few analysts who studied the plan concluded it would drastically cut revenues and thus drastically increase the federal deficit. With minimal support from GOP voters, Cain ended his presidential campaign six months after it began, and the “9-9-9” plan was not heard from again.

  The most comprehensive and sophisticated blueprint for a flat tax was designed by two respected academics, Robert Hall and Alvin Rabushka of the Hoover Institution, a think tank based at Stanford University. Their plan
combines a tax on corporate earnings with an individual income tax on wages in which everybody pays the same rate of tax (in the latest version of their idea, they set the rate at 19%); it also limits or eliminates some of the most popular deductions and exemptions in our current tax system. The Hall-Rabushka proposal is intricately designed and so complicated that you practically need a graduate degree in economics to understand how it works.1 Accordingly, it has never gained much popular support.

  The form of flat tax that most backers of the idea have in mind is something much simpler. It’s an income tax with a single rate that applies to every taxpayer. The income tax in most countries has a graduated, or “progressive,” rate structure so that high-income people pay a higher percentage of their income in tax than poor people do. In the United States, there are seven different income brackets, with a different tax rate applied in each case. The rates run from 10% for a married couple with a taxable income of $17,850 to 39.6% for a couple when their income exceeds $464,850. That means the rich couple is paying considerably more in tax, but the rich also have much more left over after the tax is paid. A couple who pay 10% on a taxable income of $17,850 will have just $16,065 remaining for all their expenses during the year; the $465,000 couple, even though they will pay tax at a much higher rate, will still have more than $300,000 left to spend after the tax bill is paid.

  The single-rate tax would do away with the seven graduated tax brackets and their seven different rates. It calls on the millionaire and her maid to pay the same percentage of their income in tax. Flat-tax backers say this is eminently fair; after all, everybody pays the same rate.

  Advocates also argue that the single rate makes taxpaying simpler; you avoid the pesky business of figuring out which bracket you fall into and which rate you have to pay. But this argument for simplicity is something of a red herring. For taxpayers, figuring out what rate to pay is a tiny part of the complexity of filing a tax return. The hard part—the job that takes days or weeks of digging through W-2s and 1099-Bs and multiplying by 0.159, unless line 16 is greater than line 42(q)—is figuring out what your taxable income is. Once you get that number and enter it on line 43 of Form 1040, the task of determining your tax rate, and how much tax you have to pay, is a cinch. For most people, a computer makes the calculation in the blink of an eye.