Why Our Tax Code?

By James Kwak
In honor of the deficit commission, Ezra Klein is running a number of posts about the commission’s proposals and our tax code, including one about the mortgage interest tax deduction. Although this is often defended as a middle-class tax break, on a percentage-of-income basis it mainly benefits people between the 80th and 99th income percentiles; above that they make so much money that they can’t buy big enough houses to keep up. (On a dollar basis, of course, the correlation between income and tax savings is perfect.)
This should not be surprising, since like any itemized deduction (a) it’s worthless if you have a small house and take the standard deduction instead, (b) it’s proportional to the size of your mortgage, and (c) it’s proportional to your tax bracket. Klein says, “I’m not really clear why we’re giving people making hundreds of thousands a year large subsidies to buy a house, but I’m sure there’s a good reason.” I’m sure he knows the reason, but I’ll spell it out anyway.
This issue comes up occasionally in my tax class, where I have a long-running but mostly silent debate with my professor. When he asked why we have some quirk in the tax code (I forget which), I said, “It’s a political economy thing: it benefits rich people, and they have more political power.” He said something like, “Maybe, but that argument proves too much, because the rich do pay taxes, and if they really called all the shots they wouldn’t pay any taxes.” Which is a reasonable point, so I’ve mainly let the issue lie.
But if you are the rich people in a democratic society where most people believe in reduced inequality, what kind of tax code do you want? You want to start with an overall progressive structure (so the people won’t revolt), and then you want a boatload of exceptions to that structure that (a) favor the rich and (b) can be individually defended on plausible (and sometimes even reasonable) grounds. Which is what we’ve got:

• Mortgage interest tax deduction
• State and local (property) tax deduction
• Charitable deduction
• Lower rates for capital gains and dividends
• Exclusion (or tax deferral) for retirement and educational savings accounts
• Exclusion of capital gains on home sales
• Ability to donate appreciated assets to charity and deduct appreciated value without paying tax on appreciation

As I said, you can defend most of these individually without being laughed at. But the net effect is to water down the progressivity of the system without admitting that that’s what you’re doing. And instead of ordinary people revolting against the rich, this year we had (some) ordinary people revolting in favor of cutting taxes for the rich.