Tax loopholes defended

President Trump and Congress have enacted sweeping reforms to our tax laws, some of which will take years before the full impact will be felt. Not allowing full deductions for state and local taxes will be a big change, for example. And while the deductions have been simplified for most filers (with higher standard deductions doing that trick), those that pay the most taxes (the rich) will continue to look for ways to save money. This is human nature at work.

The term "loopholes" has become toxic. A tax loophole is thought to be unfairly used by rich people to minimize their taxes at the expense of the rest of us. But I'd bet that just about every loophole had its incubation in a public policy supported by a majority of Congress. Loopholes allow Congress to achieve public benefits without spending money. Instead, they incentivize people to invest their private money differently, achieving a similar result.

Here's a made-up example. Let's say we want orphan children to be adopted into good homes. We can't force people to adopt kids, so instead we give them an economic incentive. So we allow them to deduct 75% of an adopted child's costs from their taxes. They are still paying 25% of the costs from their own pocket, and the deduction typically saves around half of the tax break, so essentially they would get about 40% of the cost as a credit on their taxes. And this saves the state money from having to hire people, pay them, maintain facilities, etc. Instead of having say 10,000 wards of the state, we'd have 1,000.

Now along comes a rich person who lives in a huge mansion. He can adopt and house 100 kids, so he decides to adopt them and take advantage of the tax break. Let's assume one kid costs $5,000 a year in expenses, so 100 kids is $500,000 and the tax break is thus worth about $200,000.

The millionaire might pay $1 million annually in taxes, but let's say he uses this tax break and other tax breaks (equally beneficial to society) to reduce his tax bill to zero. And now along comes journalists, activists, and other partisans who complain that the millionaire is paying no taxes because of loopholes that must be closed. In this example, is society better off closing loopholes and having the millionaire throw those orphans back out on the street? Or, perhaps, is the analysis of the cost-benefit incomplete and misleading if you don't consider the whole picture?

Now let's consider something like the Alternate Minimum tax, which is to prevent millionaires from using loopholes to bring their tax bill to zero. The AMT says that rich people need to pay "something" each year, no matter what or how many deductions and loopholes they have or can find. Sounds like a good idea? It isn't.

Let's say the AMT calculation for the millionaire is that his minimum tax is $500,000. And let's say adopting orphans on his list of priorities is near the bottom. If there is an AMT, the millionaire uses other loopholes to get to his $500,00 in deductions and doesn't do the adoption.

So now the state has an extra 100 orphans it must house, feed, clothe, and be responsible for. It needs to hire people to do so, rent housing, etc. We know it costs "the state" more to do things than it does in the private sector, but even if we take the same $5,000 per kid cost, we are talking about $500,000 in annual expense. So let's go back to the $200,000 the millionaire saved on his taxes, which he will now pay, versus the $500,000 the state saved on caring for orphans, which it will now pay, and the state loses $300,000 a year.

When state budgets go up higher than inflation, and tax revenues do not keep up with rising costs, the state must either raise taxes or cut spending. We can't not pay for the care of orphans, so our taxes go up to cover this extra $500,000 in spending, with only $200,000 in revenue from the millionaire to help offset it.

So "tax loopholes" actually save ALL taxpayers money by reducing the need for higher tax increases to provide all the services we want to provide as a society. If Congress decides that caring for orphans is not one of the functions we should provide, then don't offer that as a tax break. But if the decision to care for orphans is a good one, and offering a tax break saves all taxpayers money, then we should let the millionaire cover it, even if his tax bill ends up being zero.

Why would the millionaire agree to take in 100 orphans at an annual net cost of $300,000? There are many possible reasons. Maybe he really likes kids. Maybe he wants to "give back" and this is something that touches his heart. Maybe he wants to justify living in a 100-room mansion. Or maybe he just wants to have plenty of kids so he can travel to Disney World every week and not feel like a dweeb. We don't need to know his motivations. Why do people buy cars that cost $100,000 when ones that cost $20,000 are essentially the same? Why do people eat out at the Ritz when there is a McDonalds down the street? Why do people pay to fly First Class when a coach ticket gets you there at exactly the same time?

Of course, our elected representatives should examine and review tax loopholes every year, and phase out those that aren't working as designed. But they are not inherently evil. Quite the contrary.

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