I’ve brought up the issue of tax deductions before, but Robert Wenzel has provided me with the perfect example to illustrate my argument. To recap: my argument is that loopholes are distortionary, therefore, assuming “revenue neutrality,” a loophole-free tax code is preferable to a loophole-ridden tax code. Another way of putting it: ‘X’ amount of taxes without loopholes is preferable to ‘X’ amount of taxes plus ‘Y’ amount of loopholes (X + Y > X). When Daniel Mitchell makes the same argument, though, Wenzel accuses him of being “captured by inside the beltway thinking.”
If we decompose Mitchell’s argument, and really think about it, though, I think he’s right and Wenzel is wrong. Mitchell is basically saying that taxes are bound to increase, and so its preferable that taxes be increased by reducing certain loopholes, rather than by increasing marginal tax rates. We can break it down, and make it easier to understand, by using simple arithmetic. Say X is the current level of taxes, Y is the current level of revenue lost through loopholes, and Z is the future level of taxes. Further, let’s assume that whether we decrease loopholes or increase marginal tax rates the future revenue level will be Z regardless. If we eliminate loopholes, the level of revenue will be Z, meaning that Z dollars are likely to be misallocated. Yet, if we don’t eliminate loopholes then we’ll have Z dollars misallocated through public spending, and Y dollars misallocated as a result of the incentives created by loopholes. Z < Z + Y.
I agree that Mitchell’s example was probably not the best one: “This particular loophole doesn’t distort the economy the way it’s intended to, so we should eliminate it.” But, getting beyond this bad example, I think Mitchell’s case is reasonable — and be reassured, I haven’t been “captured” by “inside the beltway thinking.” As a side note, a lot of Wenzel’s insults are honestly out of place, because Mitchell explicitly writes that the last thing he wants to do is increase government revenue. But, the reality is one in which tax revenue is going to rise no matter what Mitchell, or Wenzel, want, and so one form of revenue increase is preferable to another.
All this being said, there is one case where loopholes may be preferable. Let’s say that our ultimate goal is to reduce taxes as much as possible. It may be more realistic to reduce revenue through loopholes than legitimately peeling back the size of marginal and average tax rates. I’m not too convinced by this line of reasoning though: there have been dramatic reductions in marginal tax rates in the past. Usually, no less, loopholes are introduced with the intention of making some kind of distortion (e.g. increase mortgage-related borrowing), not to reduce taxes per sé. But, I don’t think this is what Wenzel has in mind, anyways. Although, what he could have in mind is that a reduction in loopholes would lead to both this and rising marginal rates, meaning that revenue would actually exceed ‘Z’ from our model above. This is a legitimate argument — and it may be correct —, but it’s an example of “inside the beltway” thinking, since it’s about practicality (and it doesn’t directly address what Mitchell actually has in mind).