The current U.S. tax code represents decades of political manipulation rather than any grand design, and can certainly be improved upon, but only a tax neutral pro-growth tax reform can prevent the deficit from spiraling out of control. Hence tax reform should favor saving over consumption and productive work over leisure, but otherwise be neutral, allowing capital and labor to flow to their most productive use.
But the ongoing political debate between advocates of "fairness" and economic growth will likely prevent comprehensive reform, resulting in selectively plugging unpopular loopholes.
The mortgage interest deduction perhaps best illustrates the pitfalls to this piecemeal approach. The 2013 budget as well as the president's Simpson Bowles Commission recommends phasing out the mortgage interest deduction, opposed by the right as unproductive because it directs capital toward big suburban McMansions instead of smaller rental flats and by the left as unfair because only the top third of households itemize.
But the "tax loophole" is not the mortgage interest deduction, it's the failure to tax "imputed rent" from homeownership, i.e., the value of rental services the homeowner receives — done only in Belgium, the Netherlands and Switzerland. This has never been seriously considered in the U.S. because the political, conceptual and methodological problems of taxing farmers for consuming their home grown food — as the U.S. has done — are much greater for homeowner imputed rent.
There is no convincing evidence that eliminating the mortgage interest deduction now would free up capital for more productive investment. To the extent it historically induced people to become homeowners and invest more in housing, it likely also increased household saving (that's why they were called savings and loans) for a down payment — a requirement that should be re-instated — by as much or more as the increase in investment.
Whether eliminating the mortgage interest deduction is "fair" is also problematic as wealthy households, some with multiple houses, won't be affected because they often don't have mortgages and if they do they can sell stocks — avoiding the increase in the capital gains tax — to pay them off.
Perhaps most important in the current market, the tax savings for owner housing is likely captured in the property value as it was for income property in the 1980s.
When the "tax incentives" for income producing real estate passed in 1981 were redefined as "loopholes" to be plugged in 1986, commercial property prices plummeted — reflecting the higher tax burden — providing what may have been the fatal blow to the saving and loan industry with significant commercial real estate exposure.
Similarly house prices for homeowners with enough income to itemize deductions but not to pay off their mortgage — likely a "jumbo" held by a bank or credit union — could decline by about 20%, the approximate value of their lost mortgage interest deduction, exacerbating bank foreclosure losses.
One irony is that the revenue from eliminating the mortgage interest deduction won't fund even half the cost of the capital subsidies currently propping up house prices. Another is the potential collateral damage to new business formation and job growth, as homeowner equity has traditionally been the single biggest source of start up capital. Policies that lower before-tax mortgage costs before the election while raising after-tax costs after the election reflects politics, not principles.
Plugging tax "loopholes" sounds better than raising middle-income taxes for more government spending, but these policies won't solve the looming fiscal crisis and may do more harm than good.
Will the fiscal year 2013 budget promote economic growth as promised, helping banks recover from the Great Recession, or will growth be sacrificed to "fairness"? Or can we have both, as promised in the 1984 Treasury Department Report "Tax Reform for Fairness, Simplicity and Economic Growth?"
The proposed increases in corporate and household taxes in the 2013 budget reverse previously enacted pro-growth incentives in pursuit of a more "fair" tax code. The projected deficit of $1.3 trillion for the 2013 fiscal year and about $5 trillion for the first term in spite of these tax increases is optimistic as the economy will grow more slowly than projected as a consequence of these policies. Banks will start paying savers positive real returns once again when international investors find acceptable substitutes for U.S. treasury securities. The increase in treasury borrowing costs will then cause the same downward spiral that trapped the economies of Greece and Southern Europe by reducing tax revenues faster than expenditures, resulting in ever-rising deficits.
In Europe the crony capitalist and state controlled banks were "encouraged" by politicians and their regulators to buy much of this low-yield debt at par, now worth only a fraction of that — hence the ongoing financial crisis. U.S. Government investment in banking during the financial crisis of 2008 was unprecedented because such investments are rarely benign. Politicians will rationalize: we saved you, now you save us!
Kevin Villani was senior vice president and chief economist at Freddie Mac from 1982 to 1985.