Loopholes, Again

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).

  • Dan(DD5)

    Nice try…yet again! But your “arithmetic” still doesn’t add up even if Z (government revenue) is held constant.

    Say you have a society of 10 people.

    case 1: 7 people are taxed evenly to feed off 3 government parasites officials

    case 2: 6 people are taxed evenly (and more heavily to keep Z constant) to feed off the 3 government officials, 1 lucky guy escapes via “loophole”

    Your idea of market distortion is now that 1 guy was able to escape the thief?

    You have 6 victims instead of 7. The 6 victims indeed are more victimized because they have to pay a higher burden, but by no means is the guy who got away being subsidized or anything like that (not that you have said he was), so buy what standard do you exactly determine that this outcome is more “distortive”? Seems like just a value judgement, i.e., that it’s not fair that one guy gets away. Just because 6 guys are burdened 1/7th more then if no loop holes existed doesn’t mean more distortion.

    All we can conclude from an economics point of view is this: The government still allocates Z dollars worth of resources. That 7th guy doesn’t misallocate anything. He keeps his earnings! Talking about incentives of guy #7 in your analysis is just obfuscating the fallacy in your argument.

    • Dan(DD5)

      Here is another example:

      You and I are walking in the street when a thief attempts to rob us both. He demands $100 from each of us.

      Case 1: We both lose $100

      Case 2: I manage to get away, but you don’t. The robber now takes $200 from your wallet to makeup for the “lost revenue” of me escaping.

      I think there is no doubt that the two cases represent different market outcomes. Resources will be allocated differently. Yet, according to your analysis, you would have to conclude that case 2 is more distortive on the market.

      • Silvano

        Let’s say My Nice Family wants $5000 per week from the neighborhood:

        a) we steal $100 from hitting 50 people randomly each week

        b) we take away $100 from 50 people because “we care of them”

        c) we take away just $50 form 100 people but they have to buy stuff at our “Grandfather’ shop” (stuff like bred, butter, milk which they are already buying at the same price for the sake of simplicity).

        The neighborhood is worse off for the same amount, but in case c) competition in more affected.

        PS: anyway, normal people (from a statistic standpoint) even when they do their best to minimize the tax burden, perceive a slight difference from a thief and a civil servant (yes even if gvmt spending is bad spending they get something). So if you want to talk to normal people, Joe the plumber included, better suited example are more easy to understand.

        • Dan(DD5)

          The real cause for market missalocation or distortion or whatever you want to call it is indeed coercion. Take away coercion, and you have no argument for missalocation or calculation problem.

          The “normal people” you allude to who will reject the analogy will also reject your fancy calculation problems.

          “The neighborhood is worse off for the same amount, but in case c) competition in more affected.”

          Competition is not really “more affected” because again, you too are ignoring the fact there are no such things as even taxation or fair taxation. There is no 30% flat tax across the board. 30% are tax consumers and not tax payers (in dollars and not in number of people) eventhough you will show me their paycheck and a deduction of %30 even though

    • http://economicthought.net/blog JCatalan

      Your idea of market distortion is now that 1 guy was able to escape the thief?

      Couldn’t you have been a bit more charitable? That loopholes can distort isn’t controversial, so I’m not sure why you start off with the least relevant example. A better example might be a mortgage related deduction, where the size of your mortgage also decides the size of your deduction, leading people (who can afford it) to buy larger homes as a means of reducing their taxes. Likewise, the government can offer a tax deduction to a company which invests in “green” technology, leading people to allocate their capital towards these investments, rather than the investments they would have otherwise made. These are the type of things I have in mind when I talk about distortions and loopholes.

      Instead of accusing me of “obfuscating the fallacy in [my] argument,” or telling me that my “‘arithmetic’ still doesn’t add up,” can we please actually engage what I have in mind?

      Tax loopholes are meant to set up incentives. These incentives are what push people to misallocate capital. Loopholes don’t exist willy nilly or ad hoc, out of failure of the tax code.

      • Dan(DD5)

        You article says that keeping government revenue fixed, a system with loopholes still distorts more then without loopholes:

        “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."

        Am I missing something here? I certainly don't mean to intentionally accuse you of anything you didn't say.

        "Tax loopholes are meant to set up incentives. These incentives are what push people to misallocate capital."

        Why are they misallocating capital? I grant you the fact that capital will be allocated differently, but why is somebody keeping his own money misallocation?

        Again, you would have to claim that me escaping the thief would result in misallocation (in economics terms). You didn't address the example I gave.

        • Dan(DD5)

          I don’t deny that incentives are being altered. Incentives are changed when I escaped the robber and you didn’t vs the situation where we both got robbed. Incentives changing can’t be your basis for the misallocation, otherwise, you’d have to claim that a tax break would also “missallocate” capital.

          • Silvano

            Tax loopholes are meant to alter trade off between existing choices considering your existing preferences (something a robber do not care). They are designed to redirect resources in a way shaped by a political process. They are not a “spot event” like a robbery.And if you “escape” the robber you are simply avoiding taxes, you are not exploiting a loophole.

          • Dan(DD5)

            They are exactly the same. The robber can have a thing for Engineers, and so if he encounters Engineers, he lets them go. So now we have incentives introduced in favor of engineers.

        • http://economicthought.net/blog JCatalan

          Why are they misallocating capital? I grant you the fact that capital
          will be allocated differently, but why is somebody keeping his own money
          misallocation?

          Because that person is being allowed to “keep his own money” only if that money is spent through specific channels. A similar allocation of resources would be accomplished if the government closed these loopholes and spent the money on the same things. In this sense, tax loopholes act as indirect government expenditure, because it’s providing you an incentive to invest (or consume) where the government wants more investment (or consumption) to occur.

          The robber analogy isn’t entirely suited, because the robber’s intentions are to allocate resources in accordance with his own utility function and constrained by the market process, so to speak. We’re not talking about this kind of robber, but about government. Government allocates resources — apart from wages — towards public goods and other expenditures that target specific industries and people within the market. Tax loopholes are a way of providing tax reductions to people who spend their money where the government wants them to. In other words, tax loopholes change the institutional structure of the market in such a way that undermines an “efficient” allocation (I use “efficient” just to distinguish).

          • Dan(DD5)

            In other words, tax loopholes change the institutional structure of the market in such a way that undermines an “efficient” allocation”

            It’s not the loopholes. It’s the taxes! We’re back to square one. The point is this:

            The moment taxes are introduced, you have unevenness because some will gain (tax consumers), and some will lose (tax payers), regardless of the fact that everybody will surrender, say, 30% of their income. You’re simply not seeing this – tax consumers and tax payers is by definition, an uneven pay system.

            The behavior of market participants has already been changed “unevenly” or in a distorted fashion due to taxes – even flat taxes! And it’s because not everybody is really a net tax payer, although they think they are . You’re assuming everybody can (in theory) pay taxes evenly, and so you can talk about how “uneven” taxation distorts market allocation. Your reasoning ignores the fact that all those people on the market receiving income due to government spending are really tax consumers and not tax payers, In many cases it’s partial income due to government spending e.g, government consumes paper, so at least part of the paper industry is currently a tax consumer! All these people on the market have their incomes already distorted due to government spending. Some of them are doing things they would not have done if there were less taxes (or no taxes).

          • http://economicthought.net/blog JCatalan

            It’s not the loopholes. It’s the taxes!

            Loopholes are part of the tax structure.

            You’re simply not seeing this…

            No, I understand that taxes already distort (and this is mentioned in the blog post, by the way), and have always understood this, but were talking about loopholes (which also distort). My argument is that it’s better to have only the distortion of collected taxes than having both the distortion of collected taxes and that caused by uncollected taxes through loopholes.