a. Exclusion of employer contributions to medical insurance and health care

The current practice in the United States is that an employer’s contributions to an employee’s health care costs are excluded from individual taxable income, although the contributions are a deductible expense for the employer. The case for modifying or limiting this deduction can be made primarily on efficiency grounds. ^3/

To elaborate, a risk-averse individual facing the possibility of an exogenously given random loss would choose to be fully insured if actuarially fair insurance were available. However, when, as is the case with medical insurance, the extent of insurance coverage affects the magnitude of the loss, the problem is more complex. Specifically, there is a moral hazard problem--while the nature of the illness is exogenous, the quality and the quantity of the medical care an individual purchases is not.

As a result, even before the introduction of a tax subsidy, there is a distortion. The special tax treatment of health insurance is in effect, therefore, a subsidy of a subsidy. In the language of the first section there is a first-order excess burden effect which may well be large relative to the tax subsidy itself. ^1/ The precise magnitude of the distortion is subject to debate. In this connection, the fact that the medical market is noncompetitive complicates matters. ^2/ Related to this is the possibility of an offsetting distortion associated in the public goods nature of biomedical research. ^3/ However, Pauly’s conclusion, that the decrease in insurance coverage caused by a lower tax subsidy would likely be desirable, appears to reflect the academic consensus. ^4/

Since it is in the form of a deduction rather than a credit, everything else being equal this tax expenditure will be more valuable to higher income workers. This suggests that if there is an equity basis for the favorable tax treatment of these expenditures it should take the form of a tax credit rather than a tax deduction. More generally it suggests that the current tax break cannot easily be justified on the grounds that there are externalities associated with improved health coverage--the better-off groups in society tend already to be larger consumers of health services.

On balance, therefore, in light of the need to reduce the federal deficit, there are grounds for limiting or eliminating the exclusion of employer contributions to medical insurance and health care. It may be worth noting in this connection that this was also the conclusion of the 1977 Treasury “Blueprints” Tax Reform document. Further, the Treasury tax reform plan of 1984 (Treasury 1) recommended limits on the exclusion. A final point: while international experience (Table 2) would suggest that this deduction is a popular one, it must be remembered that the other G-7 countries typically exert greater control over the supply of health services than does the United States. In principal, this greater control could circumvent some of the inefficiencies cited earlier and could, in particular, reduce the incentive to acquire private health insurance.

b. Exclusion of employer plan pension contributions and earnings

This tax expenditure raises the more general question of how pension contributions in general are treated for tax purposes. Under current practice, certain employer contributions to pension plans, as well as amounts set aside by the self-employed and individual contributions to individual retirement accounts (IRAs) are excluded for tax purposes in the year of contribution. The most significant recent change concerns the treatment of IRAs. Following the Tax Reform Act of 1986, the full deduction for IRAs is available only for those whose joint return adjusted gross income falls below $40,000 ($25,000 for a single taxpayer). For incomes between $40,000 and $50,000 for a joint return ($25,000 and $35,000 for a single return) the allowable IRA deduction is phased out. Investment income earned by pension funds and other qualifying retirement plans is not taxable.

The principal economic issue underlying the appropriate tax treatment of pensions concerns whether consumption or income should be the base for taxation. The idea of taxing consumption rather than income has a long history, in that it can be traced back, to J.S. Mill. Its more recent proponents include Feldstein and Bradford. ^1/ The efficiency argument supporting this view is that it would remove intertemporal distortions associated with the income tax. While this argument is clear in a world where a tax system is being designed de novo, the matter becomes more complex when it is recognized that a form of income taxation is already in place. This is an example of the practical difficulties that can arise when tax reform rather than tax design is at issue.

Even in these circumstances, however, an argument can be made in favor of a shift to consumption taxation. In a recent paper, Fullerton, Shoven, and Whalley consider the welfare consequences of changing the current U.S. income tax system to a progressive consumption tax. ^2/ They use a general-equilibrium model which incorporates other tax distortions and which allows for a labor-leisure choice, thereby making both income and consumption taxes distortionary. Computing a sequence of single-period equilibria, they find, for a given revenue path, that the discounted present value of the stream of net gains associated with the tax shift amounts to approximately $650 billion in 1973 dollars, a significant saving.

With this background, consider the merits of removing the tax expenditure associated with the exclusion of employer plan pension contributions and earnings. In the years leading up to the Tax Reform Act of 1986, the trend had been toward exempting an increasing proportion of saving from the personal income tax. An example of this was the introduction of the favorable tax treatment accorded IRAs. In effect, the tax system was tending toward a consumption-based tax regime. As the results just reported indicate, this trend would appear to have been appropriate. As already mentioned, however, the Tax Reform Act of 1986 reversed this trend. It would appear that to compound this reversal by eliminating the employer pension contribution tax expenditure would be an inadvisable step. While it is true that the elimination would raise revenue, thereby reducing both the required level of bond finance and the associated distortion to capital accumulation, it would do so in a manner which itself increases the effective tax rate on savings.

c. Deduction of mortgage interest on owner-occupied housing

Following implementation of the tax reform act, interest on debt secured by a principal or second residence was deductible to the extent the debt did not exceed the purchase price of the property and improvements, plus debt for medical and educational expenses. The Omnibus Budget Reconciliation Act of 1987 subsequently limited the deduction of interest on debt to acquire or improve a principal or second residence, or both, to interest on a loan of $1 million: the deduction of interest on other debt secured by a principal or second residence is limited to interest on a loan of $100,000.

It has been suggested that this tax break can be justified on the grounds that higher rates of owner occupation generate positive externalities to society. However, this rationale has not figured prominently in the economics literature on the topic. Instead, focusing on its distortionary implications, the consensus seems rather to have been that this is a deduction which should never have been introduced in the first place. There have been many recommendations to limit this deduction. ^1/ The recommendations have been based primarily on efficiency considerations, with concern over the equity effects (and political realities) restraining the comprehensiveness of the recommendations.

In evaluating the nature of the distortion, the starting point is to recognize that it is not so much the deductibility of interest that causes the distortion as the fact that the imputed rent on owner-occupied housing is not taxed--that is, a deduction is being allowed for an expense where the return to the associated investment is tax free. What should be the optimal rate of tax on imputed rent? In a recent paper, Pines, Sadka, and Sheshinski develop an optimal tax framework in which the crucial allocation decision is between residential and productive capital. ^1/ While the precise outcome depends on the specification of the Social Welfare Function, for the cases they consider the imputed rent should be taxed though not necessarily as heavily as interest income. Note that this outcome holds in a revenue-neutral environment. Presumably, there would be additional welfare gains if the revenue raised by taxing imputed rent were assigned to reducing the deficit.

Other papers emphasize different aspects associated with the housing distortion. For example, White and White argue that there is a serious problem associated with the transfer of resources to subsidized owner-occupiers from unsubsidized renters. ^2/ However, irrespective of the framework employed, the consensus is that current tax treatment constitutes a serious distortion. ^3/ In addition, the revenue loss implied by the distortion exacerbates the deficit.

Taxing imputed rent might appear to be politically infeasible. ^4/ The alternative would appear to be to eliminate the interest deduction on mortgages. Concern is often expressed that this would be inequitable to the degree that the value of the deduction is capitalized in house prices--existing owners would then experience capital losses. However, to the extent that the elasticities of supply of housing are positive, capitalization will be less than complete. Further, the capitalization effects can be mitigated by announcing a phased elimination of the credit. There are also intermediate steps. The deduction for second houses could be eliminated; the size of the deduction could be capped; home equity loans could be abolished. ^5/

A final comment on this section: underlying this specific problem of the treatment of mortgages is a more general problem arising from the fact that the United States can be included among those countries in which borrowing has been substantially subsidized by the tax system. This tax treatment may stimulate consumption in general. Further, given the differential tax treatment of interest income and interest deductibility across countries, there is the potential for a serious misallocation of saving in a world with high capital mobility. ^1/

d. Deduction of property tax on owner-occupied housing

Current practice permits the deduction of property taxes against income tax liabilities. It is difficult to rationalize this deduction in terms of providing a social good. Therefore, the question becomes whether there are any efficiency or equity considerations to justify this feature of the tax code.

The incidence effects of the property tax have been the subject of controversy. The “old view” held that the tax was by and large regressive. That component of the tax levied on land was felt to be borne by landowners given the presumed inelasticity of land supply. That component of the tax levied on structures, because those structures are renewed periodically and therefore the tax would not be capitalized in their prices, was argued to be borne by families in proportion to their purchases of goods and services produced by the taxed structures. This latter component was the presumed source of regressivity.

The “new view” adopted a more general equilibrium approach. ^2/ Incidence of the tax on land was still viewed as being borne by landowners subject to the caveat that in economic terms its supply is not completely inelastic--for example, consider the impact of zoning changes. The view of the incidence of the tax on structures or improvements was however dramatically altered. Conceptually, this component was decomposed into three parts. First, consider the property tax as if it were levied uniformly on all capital goods. Then, for fixed capital supply in the aggregate, the tax would be borne by owners of capitals, and would be progressive. Second, recognize the inter- and intrajurisdictional variations in the property tax rates. With capital and labor mobile between communities, the deviations of tax rates about the average would tend to be reflected in excise effects (i.e., price changes) in the prices of factors and goods specific to the community. For example, land rents and/or the prices of nontraded goods would be altered to absorb the deviations. Third, to the extent that it is a tax on capital as a whole, capital accumulation could be affected and some of the burden would be passed on to other factors, such as labor. ^3/

Empirical work has tended not to validate the existence of excise effects. ^1/ However, the Mieszkowski framework can be altered to accommodate the fact that in the case of property taxation consumers may recognize the links between their tax payments and goods received. In particular, property tax revenue provides local public goods, notably, education. This extension brings the theory of local public goods provision into the analysis. ^2/ While the outcome will depend on the complex interaction of numerous factors, a frequently expressed view is that consumers will move to high-taxed districts if they value the commensurately higher level of local public goods provided. The result remains that the property tax is largely a tax on capital.

To the extent that these locational effects are important, and that therefore the property tax does not greatly alter individual behavior, the excess burden losses may not be very large. It could be argued, therefore, that the property tax deduction leads to a net increase in excess burden--the excess burden increase associated with the implied increase in debt finance could be argued to exceed the reduction in excess burden associated with the implied reduction in effective property tax rates. (This ignores other distortions such as that the tax expenditure might encourage excessive provision of local public goods.) When this result is combined with the presumed progressivity of the property tax (and, therefore, progressivity of the deduction), it would appear that a strong case could be made for abolishing this deduction. This was also the position of Treasury “Blueprints” and Treasury 1.

e. Deduction for state and local income taxes

Current practice permits the deduction of all state and local income taxes against federal income tax liabilities. In this case, the efficiency argument in favor of removing this tax expenditure seems clear. Abstract initially from the possibility that state and local authorities may increase their expenditures and revenues because of the existence of the tax deduction. The deduction, then, in effect represents a reduction in the level of an aggregate income tax defined to be equal to the sum of the federal, state, and local income taxes. ^3/ This implies a reduction in excess burden. However, given the alternative of reducing the federal fiscal deficit, and applying Feldstein’s earlier argument on bond versus tax finance, it would in general be more efficient not to have the deduction with the fiscal deficit being correspondingly lower. The force of this argument may be reinforced by the fact that, when the reaction function of state and local governments is taken into account, there could be an additional distortion associated with the tax deduction subsidizing their expenditures. ^1/ It may be worth noting in this connection that Treasury 1 recommended the abolition of this deduction.

If there is a concern about removing this distortion, it may center on the inter-jurisdictional implications of such a move. The consensus in the literature is that the price elasticity of demand for state and local spending lies between -0.50 and -0.25. ^2/ This is a potentially significant effect which will be more important in states and localities with large government sectors. However, in the absence of inter-jurisdictional spillovers, it may well be desirable that the cost of providing state and local services be borne by the residents and businesses operating within those jurisdictions--the current deduction involves a transfer of resources to jurisdictions with relatively large government sectors and/or high income individuals (with high marginal tax rates). Finally, as already noted above, the United States is unusual in allowing the state and local income tax deductions.

f. Carryover basis of capital gains at death

The specific feature of the tax code that is of interest here concerns the treatment of capital gains at death. Current practice is that when an individual, who has inherited shares, subsequently sells those shares, that individual pays capital gains tax on any gains which have occurred since the date of inheritance rather than since the date of original purchase. As a result, by dying, it is possible for an individual permanently to avoid some portion of capital gains taxation.

The appropriate tax treatment of this matter depends on the resolution of a couple of separate issues. The first of these concerns the tax treatment of capital gains, a controversial area of tax policy. Much of the academic debate has focused on the fact that capital gains taxation has historically been levied on nominal rather than real, and on realized rather than accrued, capital gains. The Tax Reform Act maintained this practice by agreeing to tax capital gains at an effective maximum nominal rate of 33 percent without inflation indexation. The absence of inflation indexation is hard to justify other than as an ad hoc method of offsetting the advantage of deferral of tax payments until a capital gain is realized.

The carryover basis of capital gains at death would appear to compound the arbitrary treatment of nominal capital gains. Further, since all assets are not treated in the same way, excess burden effects are likely. In particular, as individuals age there is an incentive to hold on to shares by first running down bond holdings to finance retirement consumption. ^1/ Efficiency considerations would therefore appear to support the elimination of this tax expenditure.

This conclusion is reinforced by a consideration of the second issue, namely, how should interpersonal transfers be treated? For example, what should be the relative weights attached to estate taxation and inheritance taxation? While a detailed consideration of these issues would be beyond the scope of this paper, it is worth noting that exclusive reliance on the estate tax approach would appear to be undesirable since that would not take into account the family relationship between testator and heirs.

Moreover, and more relevant from the perspective of the issue at hand, estate taxation does not take into account the wealth of the recipient. Returning to the discussion of the first section, if taxes are levied with a taxpayer’s underlying ability to pay in mind, then a case can be made for integrating inheritance (and other transfer) taxes into the income tax structure. In that connection, in the absence of such a comprehensive approach, an argument can be made for eliminating the current carryover basis of capital gains at death. ^2/

In conclusion, there appears to be a strong case for eliminating the tax expenditure associated with the carryover basis of capital gains at death. This case is strengthened when it is again recognized that the additional revenues can be applied to deficit reduction so that any tendency the increased taxation of capital income might have to reduce aggregate private savings would be more than balanced by the direct revenue impact on reduced government borrowing.

g. Exclusion of social security benefits

Under current law, adjusted gross income (the base for income taxation) includes the lesser of one half of Social Security and Tier 1 (Railroad Retirement) benefits, or one half the excess of the taxpayer’s combined income (adjusted gross income plus nontaxable interest income plus one half of Social Security and Tier 1 benefits) over a threshold amount. The threshold amount is $25,000 for single returns and $32,000 for joint returns. These thresholds are not indexed for inflation.

Again, it appears that a reasonable case can be made for at least modifying this tax expenditure. As has been pointed out elsewhere, savings decisions in the United States are distorted, implying that national savings are at a suboptimal level. ^1/ Since the social security system operates from a long-run steady-state perspective more on a pay-as-you-go than on a funded basis, ^2/ there will be a tendency for the system to contribute toward the reduction of national saving. The tax break compounds this effect in that, by increasing the value of social security annuity income, it reduces the incentive for other forms of saving.

This reasoning views the tax treatment of social security income in isolation from the tax treatment of other forms of saving. Extending the analysis in that direction does cloud the issue. For example, full taxation of social security income is not equivalent to the full taxation of private pension annuity income since, in the case of the former, one half of the contributions (the employee’s contributions) are not tax exempt whereas in the case of the latter all of the contributions may be deductible. Therefore, full taxation of social security income might be viewed as taxing that form of saving relatively heavily. However, this concern is mitigated by the fact that the social security system is not a pure pension system. In particular, it is still the case, even if to a decreasing extent, that the current generation of social security recipients stand to receive a very generous “return” on the taxes they paid. This outcome is due to the transitional path associated with the institution of the system. ^3/

In light of all these considerations, this tax expenditure remains on balance a good candidate for modification.