David Frum: The GOP’s Strong Arguments in the Income Tax Battle

November 16, 2012: President Barack Obama, accompanied by House Speaker John Boehner of Ohio, speaking to reporters in the Roosevelt Room of the White House in Washington, as he hosted a meeting of the bipartisan, bicameral leadership of Congress to discuss the deficit and economy in Washington. Carolyn Kaster / AP

The fiscal-cliff negotiations are driven by politics, and not very inspiring politics at that. The reelected president wants to bend congressional Republicans to his will. Republicans don’t wish to be bent. Yet behind the dominant political story there happens to be some actual policy ideas that deserve more of a hearing than they’re getting.

Question: if the United States needs to raise more revenue from the federal personal-income tax, how should that revenue be raised? By hiking tax rates or by reducing tax deductions? Democrats prefer higher rates; Republicans prefer reduced deductions. Each side may have its own cynical motives. The Republicans happen to have better arguments.

Almost every economist who studies the issue agrees that higher tax rates harm the economy. The Tax Foundation is the group whose study demolished the Romney tax plan—and was quoted in tens of millions of dollars of pro-Obama advertising in 2012. Here’s its assessment of the effect of higher tax rates: They “discourage work, saving, and entrepreneurship. They also encourage taxpayers to rearrange their tax affairs to receive more of their compensation in less heavily taxed forms and to take greater advantage of the myriad tax preferences in today’s tax code.”

Republicans, on the other hand, have taken aim at tax preferences that are almost uniformly harmful.

The biggest tax preference in the individual tax code is the treatment of employer-purchased health-care benefits. An employee who earns $60,000 and receives a health-insurance policy worth $8,000 pays income tax on the $60,000 but not on the $8,000. This exclusion has thrust employers into the role of main buyers of health insurance. It hides the costs of health coverage from employees and thereby makes it easier for health providers to raise fees.

The exclusion is such a bad policy that we should want to get rid of it, even if doing so wouldn’t raise a dime in extra revenue. But as it happens, the exclusion costs the Treasury an estimated $130 billion a year, only a little less than the entire cost of the U.S. Navy. And because low-wage workers often receive no health coverage at all while high-wage workers receive ample benefits, elimination of the exclusion for people earning more than $250,000 would recoup a very big part of that $130 billion.

Another large tax preference is the home-mortgage-interest deduction. This preference is justified by the claim that it promotes homeownership. Yet Canada, which doesn’t have the preference, has roughly the same home­ownership rate as the United States: a little over 60 percent.

Rather than put more people into homes, the deduction puts the same number of people into more home: before the Great Recession hit, new homes in the United States averaged 2,300 square feet; new homes in Canada, 1,800 square feet.

That’s bad economics: Americans end up borrowing more to buy houses and then cutting back on other forms of saving to make up for it. The deduction is also bad for the environment, because it encourages Americans to commute farther to bigger houses that require more heating and cooling.

Here’s the good news: the deduction has already been trimmed over the past generation. Americans can claim a deduction only on their principal residence and only on a mortgage of up to $1 million. Time to reduce that cap again.

Finally, there’s the deduction of state and local taxes against federal income tax. That costs $80 billion a year, or about the same as the federal Department of Education.

Why doesn’t it trigger a revolution when California raises its state income tax past 10 percent? Or when suburban communities around New York City hike property taxes to an astonishing 8 percent of median local annual income? The short answer: the people who pay the most local taxes also receive the biggest relief on their federal taxes. Ironically, as federal tax rates rise to 40 percent, the highest earners will receive an even bigger subsidy on their local taxes.

frum-co03-second "Home-mortgage-interest deductions do not promote home ownership, rather, they encourage the purchase of a larger home." Scott Olson / Getty Images

By cushioning the shock of local taxes, federal policy induces local governments to spend irresponsibly. New York state, for example, with almost exactly the same population as Florida, spends literally twice as much.

If New Yorkers had to absorb the full cost of their state and local governments’ decisions, they might well demand more frugal decisions from their state and local governments. I’m a resident of Washington, D.C., myself, and would feel this particular reform painfully. But I promise, when I feel it, I’ll make sure my often feckless local government feels it too!