The Mises Institute has recently had some good material on tax loopholes, spurred by the putatively bipartisan drive to close tax loopholes (I use the word “putatively,” because I’m not entirely up to date with Washington politics and I’m sure different politicians have different loopholes in mind). Daniel J. Sanchez has three posts for Circle Bastiat that give us some insight on on how Rothbard, Mises, and Hazlitt approached the issue: “Supply Sider Fetishes,” “Yes, Rothbard Covered That” (includes excerpts written by Mises), and “Hazlitt on Loopholes.” There is another Circle Bastiat post on the topic by Joseph Salerno, and on Thursday Mises Daily ran a piece by Rothbard, “Long Live the Loophole.” They’re all straight to the point, and well worth reading.
The argument against closing loopholes, illustrated in all the posts linked to above, basically boils down to the fact that less taxes are preferable to more taxes, and in a world where government continues to raise tax rates, loopholes provide breathing room for the economy by allowing savers and entrepreneurs to retain their incomes. While the argument seems simplistic, I’m sure that economists like Rothbard and Mises did consider the issue in depth — making uncomplicated statements is oftentimes a reward for doing the complicated research: getting an idea of the “big picture” and being able to condense the gist of something to provide non-experts with accurate, but easily digestible, popular essays. I certainly see the merit in the case for loopholes, but there’s still something gnawing at my brain, urging me to consider the topic further.
The reason I ask is because loopholes makes up an important chunk of Stiglitz’ The Price of Inequality, which I’m going to review in the near future. In general, it’s easy to disagree with Stiglitz, because ultimately he advocates increasing taxes for the upper income quintiles; not just closing loopholes, but increasing marginal tax rates, as well. But, he also considers loopholes as being distortionary, and this is what is making me double think my position. There’s very little economics in Stiglitz’ book, meaning that he spends little time really defending his positions. Rather, he asserts them, and he has the tendency to depict anybody who disagrees with him as people in cahoots with “the rich.” But, because I haven’t spent a lot of time putting loopholes within the context of the “big picture,” I still recognize an element of reasonableness in Stiglitz’ discussion. I need to straighten myself out before I review the book.
I don’t know the tax code all too well, so I’ll have to rely on hypothetical examples to make my case. Suppose that entrepreneurs are subject to an across the board average tax rate of 20 percent — one fifth of their income becomes tax receipts. However, there are loopholes available (let’s say, enough to reduce the average tax rate by five percent) to entrepreneurs who invest their, and borrowed, capital into certain avenues of production. As a result, entrepreneurs begin to flood into these industries, and away from the investments they would have otherwise made. Is this misallocation of capital worth the loophole? Similarly, imagine a loophole available for mortgage owners who owe on a mortgage valued at higher than $500,000. This pushes prospective homeowners to forgo cheaper housing, opting for real estate valued equal to or greater than the minimum value to earn the related tax credit. Again, is this misallocation worth the loophole?
Let’s frame these questions within the context of the inefficiency of public expenditure, as I explain it in my Mises Daily “Government Spending is Bad Economics.” We know that, because government lies outside the process of profit and loss, its expenditure patterns aren’t subject to market discipline, meaning bad investments can persist where they otherwise wouldn’t. Further, because of a lack of competitive pressure, neither does government tend to continuously push for higher profits. As a result, the probability that the average government investment is worse than the average market investment is very high. But, in the case of loopholes and subsequent resource allocation, we more-or-less know that we suffer an economic (opportunity) cost, as a result. Are loopholes still worth it?
I understand the moral case for loopholes: it’s better to allow someone to retain their income, than to redistribute it by taking it away from one person and giving it to another — especially if the probability of misallocation is high in both cases. To downplay the moral argument a bit, I agree that the less total taxes are, the better off society is. But, if we are to be nuanced, wouldn’t it be better to close certain loopholes, and reduce marginal tax rates? This way, total tax revenue falls, but the distortions caused by loopholes are eliminated.
What is some of the more detailed Austrian, or generally free market, literature on tax loopholes? If available, I’d also be interested in reading counterarguments. I note that chapter sixteen of Rothbard’s Power and Market has related material — I’ll have to give it a read. What else is out there? The more detailed the better, because then the less broadly I have to read (the less non-detailed writing I have to go through). Otherwise, what do you think? I’m not so sure the issue is as straightforward as any side of the debate believes.