As the latest attempts to repeal the Affordable Care Act have recently failed, it seems that Congress is moving on to the next item on their agenda: tax reform. I guess that’s why I keep stumbling on articles suggesting drastic changes to the tax code: like eliminating the mortgage interest deduction.
My main beef is not with any specific deduction in our tax code. (Though the mortgage interest deduction is curious, to say the least.)
Rather, I think our system of deductions runs counter to the goals of our progressive income tax system itself. Looking at most of the incentives, the more you earn, and the more tax you pay, the more you benefit from the programs.
Let’s take the 401k, for example. Anyone making up to $270,000 annually, from the humble custodian making minimum wage to the corporate attorney pulling in a quarter million in salary, can contribute the same amount: $18,000. That $18,000 is shielded from federal income tax.
Our attorney in the 33% marginal tax bracket has a strong incentive to save for retirement: putting in the full amount into his 401k would avoid $5,940 in federal income tax alone (and potentially much more, depending on what kind of match his company provides). He potentially avoids quite a bit more in state income taxes as well by saving for retirement, depending on where he lives.
But our custodian’s incentives are much weaker. Assuming that he works 40 hours a week for all 52 weeks a year, his gross pay is only $15,080: well short of the $18,000 annual limit for 401k contributions. After accounting for the standard deduction and the personal exemption, our janitor still has $4,680 in potential taxable income, to be taxed at a 10% rate. So instead of avoiding 33 cents of tax for every dollar invested in retirement as the lawyer does, our custodian only avoids 10 cents. Investing $1,000 of his income (nearly 7% of his gross pay for the entire year) would only help him avoid $100 in taxes.
“But what about the Savers Credit?” you might ask. You’re right: the savers credit is just the kind of program that creates a real incentive for those who pay less in tax. But our janitor is only scheduled to pay $468 in federal income tax, assuming he takes no other deductions or credits: he cannot even take full advantage of the $1,000 credit.
And if we assume our janitor might owe no federal taxes due to other deductions, his 401k contributions come with no tax incentives whatsoever, as the Savers Credit is not refundable.
A significant problem with our current retirement system is the way tax incentives are distributed. The more taxable income you earn, the greater incentive you have to participate in a 401k. And for those working poor who are putting in long hours at hard jobs but paying no federal income tax, they get no tax benefit by default. Beyond the fact that high earners already have more money to invest in retirement, they also receive greater benefits from the government for doing so.
It’s the same story with other behaviors our tax system encourages. The IRS rewards us for putting money in a Traditional IRA (potentially in addition to a 401k), or saving for future health care expenses in an HSA, for paying mortgage interest on expensive homes (i.e. – those who would pay more than $13,000 in interest annually), or donating to charity. Many states mimic this system, by incentivizing high earners to invest in your children’s education in a 529 with state income tax deductions.
In all these cases, the higher your income, and the higher your tax rate, the greater your benefit when you engage in certain behaviors. Those paying little or no tax have little or no incentive to participate, especially with programs like the mortgage interest deduction which hinge on having an expensive, debt-funded home.
Depending on your political bend, maybe that’s the way you think it’s supposed to work. If some of our citizens aren’t paying federal income taxes, maybe they should not receive any additional tax incentives.
An Alternative Approach
This is not a post arguing to take away benefits from upper middle class and wealthy families. But I’d like to see an alternative tax benefit offered to our citizens who have little incentive to defer income taxes, and have very little money to invest for retirement, healthcare, or college as it is. If we want to encourage these behaviors across all income levels, comparably large incentives should be offered to the working poor as are offered to the upper middle class.
Under such a system, if a working mother of two earned $32,000 a year, she could, instead of putting money in a Traditional IRA for retirement, could invest in a new IRA that provided $1,000 in credits (i.e. offsetting any tax she owed) for the first $1,000 invested, and $500 for the next $1,000 invested. But even if she were paying zero in tax already, she would still receive the credit in the form of a refund after filing.
Similar, refundable credits could be offered for funding healthcare (i.e. – an alternative to the HSA), as well as for paying mortgage interest and charitable giving. If states were open to such a program, something similar could be done for saving for education (i.e. – an alternative to the 529).
In addition to providing comparable incentives to the working poor to invest in retirement, healthcare, and home ownership, these dollars are very likely to be spent and end up back in the economy.
From the government’s perspective, a dollar provided to the poor in credits isn’t dissimilar to a dollar avoided by high earners via deductions. (Though to be fair, income tax that is deferred, as it is with a 401k and a Traditional IRA, will eventually be paid back to the government later in life. Well, usually.)
Still, it should be acknowledged that such a program would have significant costs: albeit potentially smaller than the costs of the existing tax benefits such as mortgage and charitable deductions. I’d propose trying to offset them by adding a new tax bracket on income above $1M, say 44%. (Odd hat tip to Steve Bannon, of all people, for floating a similar idea). Potentially, the federal government could offset these costs by lowering the amount of mortgage interest or charitable contributions that could be deducted.
Regardless, I am no politician or public finance expert, and what I’ve laid out is a half-baked, broad strokes idea. I’m positive that people much smarter than me (than I?) could devise a better plan.
But I believe that we should provide material incentives to our working poor, just as we do with the high earners and upper middle class families. If we think saving for retirement, education, and owning a home are behaviors we should encourage via our tax system, then we ought to extend that fully to people across the income spectrum.
*Photo is from feserc at Flickr Creative Commons.