- The Washington Times - Wednesday, January 19, 2000

Both Bill Bradley and John McCain have stated that they will close tax "loopholes" if elected president, albeit for different reasons. Mr. Bradley wants the extra money to finance new spending while Mr. McCain wants the revenue to offset part of his tax cut package. Steve Forbes, meanwhile, continues to promote the flat tax, in part because it will clean up political corruption since politicians no longer would be able to trade tax breaks for campaign cash.

The political appeal of being against special tax preferences is obvious, in part because voters inevitably assume loopholes are provisions in the tax code that benefit someone else. Whether they are right or not, ordinary taxpayers resent the idea that wealthy and powerful people can use lawyers, lobbyists and accountants to receive special treatment. This hostility is partly due to the fact that special tax preferences for some probably mean higher taxes for everyone else. Yet there also is a moral component. Recalling Voltaire's famous quote, "With regards to taxation, every privilege is an injustice," most Americans instinctively want a tax code where everyone plays by the same rules.

At first glance, eliminating so-called loopholes should be easy. While all individuals presumably should get an exemption based on family size, any special preferences, deductions, credits and exemptions that shelter income above that level could be considered loopholes.

For business, the definition of a loophole seems similarly straightforward. Taxable business income should be total receipts minus business expenses like wages and other costs in other words, companies should be taxed on their annual profit. A loophole, one might reasonably assume, is a special provision that lets a company understate how much money it made.

While it seems as if it should be easy to fix the mess in the tax code, there are several obstacles to reform. First, it depends on what happens with the money. Conservatives want to lower tax rates with the revenues obtained by closing preferences. Liberals, by contrast, want politicians to keep the extra money and use it to expand the size and power of the federal government. Needless to say, this disagreement does not lend itself to easy compromise, particularly since there are plenty of non-ideological interest groups that will join forces to preserve the status quo.

Another disagreement revolves around the meaning of income. This debate is especially important since the definition of income is what determines whether a provision of the tax code can be defined as a loophole. On one side are those who believe the tax code should tax income only one time (a "consumption-base" tax system). On the other side are those who believe the tax system should tax both income and changes in net worth. This sounds like an esoteric debate, but it has huge implications.

Consider, for instance, the report issued last month by the Joint Committee on Taxation (JCT). Titled "Estimates of Federal Tax Expenditures for Fiscal Years 2000-2004," the report asserts that IRAs, 401(k)s and other forms of retirement savings are tax loopholes that will deprive the Treasury of more than $500 billion over the next five years (as if the money belongs to the government to begin with). Yet this assertion is only possible if one assumes that the government should be able to double-tax income that is saved once when it is first earned and a second time when it produces a return.

By contrast, proponents of a consumption-base tax system (with the flat tax being the best known example of this approach) would not characterize IRAs and 401(k)s as loopholes. It would only be a loophole if the income was not taxed at all, either when first earned or when ultimately withdrawn. Indeed, ordinary savings accounts, which are subject to both layers of tax, should be classified as "tax penalties."

Another example of why it is important to choose the right benchmark is the taxation of capital gains. According to the JCT report, taxpayers will receive almost $200 billion of "tax expenditures" because the capital gains tax rate is lower than the income tax rate. Yet if one does not believe in double taxation, the capital gains tax should be abolished and this so-called loophole actually should be categorized as another example of excessive taxation.

This is not to say there is no agreement between the two measures. Income that is used to purchase health insurance is not subject to tax under current law, for instance, and this would be classified as a tax preference using either standard. Likewise, the tax credit for ethanol would be a clear example of a loophole.

Largely because it uses the wrong definition of income, the JCT estimates that total tax expenditures over the next five years will total nearly $3.4 trillion. Any politician who accepts this flawed measure could wreak real havoc on the American economy. This is why the proper understanding of tax preferences is not an arcane matter, and this also explains why Mr. Bradley and Mr. McCain should be more specific about how they define "loophole."

Daniel Mitchell is the McKenna senior fellow in political economy at the Heritage Foundation.

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