Posted by Bob Lord
The Romney tax plan would exempt from income tax all investment income of those whose total income does not exceed $200,000. So, if you have a $200,000 salary and I have a $100,000 salary and $100,000 of interest income from by bond portfolio, I’ll pay a lot less in tax. That part’s easy. But what if we both have a $100,000 salary and I have my $100,000 interest income? Are our tax liabilities about the same? If you said yes, you’d likely be wrong. My liability likely still is much lower than yours. Because I have that extra $100,000 of income, I’ll spend more, and in all likelihood I’ll have more itemized deductions. I’ll have a larger mortgage; I’ll give a little more to charity; my property tax bill will be a bit higher, and so forth. So, even though I make twice as much as you, my tax bill will be considerably lower. Fair, huh?
Paul Ryan would add interest income to the types of income that are taxed at a lower rate. That is not entirely illogical. If you’re taxing some forms of investment income, capital gains and dividends, at a lower rate, it makes sense that all investment income at a lower rate. The problem lies in the deductibility of interest by many people of the interest they pay. I borrow from you to start a business. As I deduct my interest expense to reduce the taxable income of the business, my tax liability is reduced at ordinary income tax rates. You, however, pay tax on the interest you receive from me at reduced, preferential rates. In the process, the public fisc is whipsawed. Every time money is borrowed, total tax revenues decline. The borrower’s tax is reduced at ordinary rates, while the lender’s tax is increased at preferential rates.
George W. Bush passed legislation that allowed the cost of trucks used in a business to be written off over a short period. So, doctors who make hospital calls, lawyers who drive to court, and realtors who schlep their clients bought new SUVs that fit the definition of “trucks.” Good for the oil industry perhaps, but not good for a country dependent on foreign oil and a world struggling to contain climate change.
Fifteen years ago, we created Roth IRAs. You don’t get a deduction from income for the contributions you make (up to $5,000 per year) to a Roth IRA, but the money you pull out is not taxable, no matter how large the IRA grows. Many wealthy taxpayers have gamed the system. I don’t know how they did it, but we have folks who have turned their $5,000 yearly contributions into tens of millions stashed into Roth IRAs. And all of the income that accrues to those IRAs will be forever exempt from tax.
The bottom line: More often than not, tax preferences have insidious side effects. If we eliminated them overnight, the disruptions to the market would be horrendous. But we’d be better off they were phased out.