The momentum for tax reform continues to build. Adding to it is former Senator Phil Gramm (R–TX), who wrote an op-ed in The Wall Street Journal laying out a tax reform “game plan” for Congress to follow.
Gramm pretty much nails the most important things tax reform must accomplish to free the economy to grow stronger, create more jobs, and raise wages. He makes just one error.
He writes that taxes should be
neutral in [their] effect on individual behavior. In its purest form, this means no individual deductions, credits or tax expenditures. No matter how committed Americans may be individually to charitable giving or home ownership, the government should not promote those values through special provisions in the tax code.
While wiping out all deductions, credits, and exemptions might sound appealing, such a tax code would thwart the goal of neutrality that Gramm seeks and that sound tax policy should strive to achieve. A neutral tax system requires certain deductions, including the two that Gramm singled out for scorn.
Neutrality dictates that taxes should not influence the decisions of individuals and businesses, either positively or negatively. Properly understood, rather than being incentives that promote values, as Gramm argues, the deductions for mortgage interest and charitable contributions maintain neutrality by preventing taxes from discouraging those activities. As I wrote in a Heritage report:
Without the mortgage interest deduction, lenders would pay tax on the interest they earn and borrowers on the interest they pay. Levying tax on both would create a distortion against investing in housing. The charitable deduction eliminates tax on income that taxpayers earn but do not spend. Taxing them on that income would create a bias against giving and hurt civil society by reducing donations to charities. In this case, the tax preference is not the donation but the tax-exempt status of the organizations receiving donations. Since those organizations are usually nonprofits, they normally do not owe tax on their income. However, the recipients of the contributions—whether employees, suppliers, or consultants—do.
Except for this one hiccup, Congress should follow Gramm’s excellent tax reform game plan. But as the momentum for tax reform builds, it is increasingly important that Congress understand how to maintain neutrality. All tax reform is not created equal. A tax reform plan that ends up harming neutrality by failing to maintain necessary deductions could do more harm than good.