Tax Loopholes

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 DailyGovernment 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.

11 thoughts on “Tax Loopholes

  1. Stadius

    The UK government’s insistence that it’s determined to close tax loopholes, especially those exploited by large multinationals, has been interesting (if not entirely convincing). It’s an easy bit of point-scoring with a public unhappy about spending cuts; after all, how can you justify cuts on the basis deficit reduction if you’re letting billions of pounds worth of tax revenue slide?

    A comparison with their effort to drive down benefit payments, however, leads one to doubt their sincerity:

    Year’s estimated excessive benefit payments: £1.5 billion.

    Staff dedicated to reassessing benefit payments: 3,000

    Year’s estimated tax revenue lost to tax loopholes: £123 billion

    Staff dedicated to closing tax loopholes: 8

    … politics.

    Reply
  2. Dan(DD5)

    ” But, he also considers loopholes as being distortionary, and this is what is making me double think my position. ”

    Stiglitz (and you since you’re not catching the fallacy) is ignoring the unseen in his analysis. In this case, it’s the government spending part of the tax. By focusing only on the revenue collection process, he shows you the distortion of having one industry gaining a competitive advantage relative to other industries due to an industry specific tax credit. This is true, but it’s only half the story.

    If you take away the tax credit, the extra revenue collected will be spent by the government benefiting who ever the money is spent on. So either way, there will be a favorite group or groups receiving the unfair competitive advantage. It is clear then that the distortion originates from the tax and not the tax credit, for the tax credit itself does not introduce any more distortion (although it may shift it to different areas of the economy) then was before the tax credit. Also, by no means does this mean that the result of this analysis is neutral with respect to what’s produces more distortion. All things being equal, the government loses revenue (relative to private sector) after the tax credit. More money is kept in private hands and less in government hands. It’s obvious that if this trend would continue (more and more tax credits), that there would be less distortion and not more.

    a side note: You should not only research the topic in Power & Market, but you should take the opportunity to finally read the entire masterpiece of MES. You would have a much easier time criticizing nonsense such as Stiglitz. No, not because Rothbard is God and never wrong, but because he will force you to logically struggle with almost every single part of economic theory. You will understand economics much better no matter what your current level is.

    Reply
    1. JCatalan

      Thanks for commenting. I generally agree with you, including your criticism of Stiglitz. I don’t think I made that mistake in this post, though, since I do have a paragraph that tries to weigh the distortions of tax loopholes against the distortions of government spending. Now, if you were to argue that such weighting is futile, in the sense that there’s no consistent function by which we can really gauge relative misallocations, I might agree with you. In any case, this is a major reason behind why I propose that if we were more nuanced it may be preferable to close tax loopholes, but reduce marginal and average tax rates (maintain or lower total revenue collected, but reduce distortions caused by uneven taxation).

      I’d love to read all of Man, Economy, and State, but I just don’t have time. I’ll have to see what my course load is next semester, but otherwise it’ll have to wait until, at least, the summer. Otherwise, I have less time to read shorter books that I really want to get to. This doesn’t rule out reading it in pieces here and there, though.

      Reply
      1. Dan(DD5)

        Well the main point here is that the common objection to loopholes (often even made by alleged free market champions) on the basis of markets being distorted is simply false. A tax system with loopholes doesn’t distort anymore then a system without a single loophole. The critics ignore the distortions created by government spending. They treat taxes (especially flat taxes) as neutral. There is no such thing.

        You seem to kind of agree at first, but then you make a statement that simply contradicts what I just wrote:

        “maintain or lower total revenue collected, but reduce distortions caused by uneven taxation”

        You still maintain here that a system with loopholes causes distortions due to “uneven taxation”. So again, this seems correct at first glance, but only because taxes (government spending) are treated as neutral. Since they are obviously not, then you can’t seriously argue that Mr. Government spending $1000 LESS by letting Jon keep $1000 more of his money and have him spend it instead is somehow more distortive. ?? It doesn’t matter that others weren’t allowed to keep their $1000. Mr. Government spending Jon’s $1000 cannot possibly be any less distortive. If anything it’s more distortive (or would tend to be more distortive) because more money was expropriated out of the private sector.

        Reply
        1. JCatalan

          There’s two arguments,

          1. The main argument: $1,000 of revenue without loopholes is better than $1,000 of revenue with loopholes. In the former, you have $1,000 misallocated; in the latter, you have $1,000 misallocated, plus the misallocations caused by the loopholes (whatever dollar value those loopholes add up to);

          2. An auxiliary argument that’s “experimental” (a mental exercise meant to explore an interesting idea): it’s possible that $2,000 worth of government spending is less distortionary than $1,000 worth of government spending + $1,000 of misallocated revenue due to incentives caused by loopholes. Like I said, I think this line of reasoning is a bit too loose to really make such a concrete claim (it could even be that $2,000 of government spending is worse, if all that spending is committed towards something that destroys value, while the $1,000 misallocated by the private sector might create something of value, even if there’s an opportunity cost).

          Even if #2 is wrong (which it could be; I understand how flimsy it is), the most important argument is #1. It’s better to have lower average and marginal tax rates and eliminate loopholes, meaning that total government revenue doesn’t increase, than to have higher average and marginal tax rates, but with loopholes. This has nothing to do with Stiglitz anymore, who wants to eliminate loopholes and higher revenue.

          Reply
          1. Silvano

            @Dan. The degree of distorsion matters. Let’s say everyone should pay a 10% income tax but 5% if you’re white Don’t you think a marginal flat rate equal for everyone would be better?

          2. Dan(DD5)

            But in the loophole debate, we are not arguing for which method is best to lower overall taxes, as you seem to be presenting here. The assumption is that closing loopholes will increase relative revenue for the government. That is the issue at hand. And under this assumption, it is simply false to argue to eliminate them on the basis of distortion because eliminating them does not eliminate any distortion. It simply shifts it. And perusing a policy of closing more and more “loopholes” (and not reducing taxes by other means to offset) would tend to add more distortion, not less.

          3. Dan(DD5)

            I’ll just also add, that you must be careful not to confuse your ideas of what constitutes as “fair” or “justice” with what’s considered as “even” or “uneven” taxes. I certainly don’t think it’s fair (or could be morally justified) to tax white people less then non-white people as Silvano is suggesting below. But this is a rather false choice: White people can now be taxed like non-white people, and people (of all races) who work for the government or are privileged by the government who did not earn that money will get to spend that money. If you corrected the marginal tax rates in each case so that total government revenue remained fixed, then you could not argue that the former is more distortion then the latter on the basis of economics. Although you could argue that it less fair or unjust according to your personal values, but that is not economics.

          4. JCatalan

            Which debate on tax loopholes are you referring to? The only thing this post brings attention to is the distortionary nature of loopholes, and the idea that a loophole-free tax code may be preferable to a loophole-filled tax code (under the assumption that both revenue streams are the same). I’m not sure why we can’t make that assumption about revenues in order to clarify a point on loopholes.

            I agree the race example doesn’t help much. It’s not as if we can change races, so it’s not as if race based tax systems incentivize distortions.

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