Tax deductions and tax reform

<p><em>Romesh Vaitilingam interviews James Poterba for Vox<br />
<br />
January 2009<br />
<br />
Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/3597</em></p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam and today's interview is with James Poterba who is professor of economics at MIT and president of the National Bureau of Economic Research. Jim and I met at the American Economics Association's annual meeting in San Francisco in January, 2009, where we spoke about tax reform in the United States, focusing particularly on his research on tax expenditures. I began by asking him to explain exactly what they are.</p>
<p><strong>James Poterba</strong>: Tax expenditure is the phrase that's used, at least in the US, to describe the wide array of deductions that families are allowed to claim under the US income tax schedule for everything from the mortgage interest they pay to the property taxes they pay on owner occupied homes to the charitable deductions they make to the Red Cross or other charities to medical expenditures that they incur above typical levels of such outlays. And the consequence of having a wide set of deductions is that the income tax base in the United States is substantially smaller than it would be otherwise. To raise a given level of revenue we need to set tax rates at a higher structural level than we would otherwise. At least in the US at the moment, tax increases are nowhere near the near term agenda.</p>
<p>The clear objective of force is going to be near term stimulus. And although president elect Obama talked about allowing 2001 and 2003 tax cuts to expire in significant part, and even about the prospect of a hike of tax rates on the highest income household in some stage, at least in very near term those actions are likely to be postponed while we work on trying to help restart the US economy with tax relief of various kinds.</p>
<p>But I think the longer term issue for the US in terms of tax policy will involve a question of structural tax reform and how to think about the design of the income tax.</p>
<p>Some recent research that I was involved with on home mortgage interest deduction in US and a collection of other researchers under the NBER umbrella, we're looking at a variety of other deductions at the moment, really trying to understand what the economic consequences of some of these tax expenditures provisions are, to what extent do they really change tax payer behavior.</p>
<p>They all were introduced with some way or another with an objective of encouraging some type of activity, whether it would be homeownership or charitable giving or providing some relief for households that might have high medical outlays, to what extend do these tax expenditures achieve their initial goals and to what extent did they actually cut into the revenue take of the current income tax structure.</p>
<p>My own work on the mortgage interest deduction which was done in tandem with Todd Sinai, who's a professor at the Wharton school, University of Pennsylvania, and is also an NBER affiliate, showed was that the current mortgage interest deduction structure which allows households to claim, to deduct their mortgage interest payments from their income tax liability, their measure of taxable income, that has the effect of giving a larger subsidy to a household in a higher marginal of income tax rather than a lower one.</p>
<p>So this turns out to be a somewhat regressive subsidy in the sense that if you are a middle household income with 15 per cent or 25 per cent marginal tax rate, your savings per dollar of mortgage interest deduction is going to be smaller and if you are 35 per cent high income household facing a higher tax bracket.</p>
<p>So we provide a larger incentive for extra housing consumption for those at the top end of the income distribution relative to the lower levels. At the same time we end up distorting the total level of housing consumption. The mortgage interest deduction per se is not really the source of the trouble here.</p>
<p>Really the problem is that we don't tax the imputed income that people earn on their house. Essentially when you are a renter, you pay rent to the landlord, the landlord pays tax on the rent that he/she receives from you and consequently we tax that component of income in the economy.</p>
<p>If you are an owner occupant, you live on your own house in some sense you pay rent to yourself but we never tax that rent transaction. And the consequence is there is a built in incentive of tax system for people to own houses and to rent them to themselves relative to renting them from somebody else.</p>
<p>That tax incentive matters in terms of owner occupancy rate in a country like the United States, it matters in the housing that gets consumed. And what Todd and I found is that the consequence of those provisions is a substantial distortion in the effective cost of purchasing housing leading us to have a larger housing stock and have probably a higher homeownership rate that we would in the absence of these deductions.</p>
<p>It raises of course the question for an economist interested in efficiency in the way we raise revenue, maybe we want to think about changing some of those rules. There are two difficult issues with doing that.</p>
<p>One is perennial question the other is one that is particularly opposite at the moment. The perennial problem is that homeowners who already benefit from the mortgage interest deduction would be very concerned about changes in those rules that would have the effect of probably reducing the demand for their homes reducing their home prices.</p>
<p>The immediate problem is that this is hardly the moment to be pursuing a policy that would have some adverse effects on home prices, given the 18 per cent decline in US house prices that took place in calendar 2008 and the central role of the housing market declined in setting off much of the global financial crisis that we've seen in the last 18 months.</p>
<p>So the challenge, I think, is to figure out a way both with respect to the mortgage interest or treatment of owner occupied housing, and with many of the other tax deductions that are currently allowed to think about long term perspective which is potentially to broaden the income tax base, which is just a code word for to limit some of these deductions.</p>
<p>But to probably do it in a gradual way that phases them out over time because that is likely to have less of a near term dislocation than simply announcing that we are going to change those policies next week.</p>
<p>So I don't have a particular suggestion to offer here, but I think that the research that is like the work that I have done suggests that there are some efficiency costs of the current provisions, the way to begin thinking about one might address the underlined tax policy issues here almost surely involves a long term perspective and putting in place some changes that would gradually take effect as opposed to having large overnight dislocations in the economy.</p>
<p><strong>Romesh</strong>: Did you think that this moment is an opportunity to think about these sort of long term structural tax reforms?</p>
<p><strong>James</strong>: I think potentially the next couple of years will give us a chance to do that. The US is already on track for the expiration under current law of a number of important tax provisions that were enacted in 2001 and 2003 and will expire in 2010. Partly because some of those provisions I think there is likely to be demand to extend and partly because the default is that the tax system changes as a result of these pre-enacted expirations. I think that will put some pressure on the political system to think a little bit about tax reform issues, although I think it is going to be on the back burner in 2009, since I think stimulus policy is going to be the first thing that people get going on.</p>
<p><strong>Romesh</strong>: And how these complications, if you like, of the US tax system like the tax expenditures, how they compare with other countries say in Europe, in the UK? In the UK, for example, we no longer have mortgage interest tax relief, that was something that was phased out some 10 15 years ago. Is it much more of a cluttered system? Is it much more structural reform is needed?</p>
<p><strong>James</strong>: The big difference between US structure and that of most of our major industrial counterparts is not so much the structure within the income tax, which does vary a lot from country to country, but it's the greater reliance in the US on the income tax as a revenue source relative to value added tax. The US does not have a VAT, and as a consequence the rates at which we collect income tax tend to be somewhat higher and the share of revenue that we collect from the income tax is higher than in most other developed nations. And that tends to put more pressure on these tax expenditure type provisions because the amount of revenue at stake is larger that it would be if the whole rate structure was lower.</p>
<p><strong>Romesh</strong>: Jim Poterba, thank you very much.</p>