The Real Meaning of Tax Loopholes

James L. Payne is a political scientist specializing in Congress and economic policy. His latest book, The Culture of Spending, sponsored by the Cato Institute, examines congressional confusions about the budget.

Tax loopholes are one of the great mysteries of modern politics. They are wrong, everyone seems to say, and crusades are mounted against them time and again. Yet the evil never gets stamped out, for loopholes keep creeping back into the tax code. What causes this curious inconsistency?

The root of the problem is a misunderstanding about taxpayers. At first glance, taxpayers seem to be selfish individuals who spend their income on their own pleasures. Being preoccupied with their private needs, they ignore the needs of the community. Therefore, government is brought in to reflect those needs. It takes away some of the citizen’s money in taxes and spends it on worthy public purposes.

This all seems logical until you notice one thing: it is based on a distinction between personal and public spending that is largely fictitious, especially today. In the past, when most public spending funded truly public goods like police protection and the judicial system, there was some validity in saying that taxes supported community functions not funded privately. But today, most government spending goes for private goods—things citizens can and do buy for themselves, in other words, government wants for us what we already want for ourselves.

Take housing. The need for a nice home is a personal desire. Yet nice homes for people are also a social good. Hence politicians have set up numerous subsidy programs to help people get decent housing, from government-backed loans to public housing projects.

It’s the same with most other spending programs. Citizen desires for education, opera tickets, quality medical care, or comfortable retirement are private needs. But from the public (governmental) point of view, it is also good for citizens to have these things. Hence the government has programs to purchase them: loan programs to pay for college, subsidies for the arts, payments for medical care, and government retirement programs.

In the business world, we see the same overlap between public and private spending. Take research and development. Companies want to discover new products for a self-oriented reason—to improve sales and profits. But the development of new products is also a public good, since these mean more jobs, more exports, and benefits to consumers. Hence, government has programs to subsidize private corporate research.

Normally, legislators miss the connection between private and public spending. They take money from people who would have purchased housing, and (after losses in the taxing and spending process) give it back to people who want housing. They take funds from college-bound students and their parents, and (again, with waste) funnel it back to them in loan programs and other subsidies. They take money from firms that would have used it for research, and (again, minus overhead costs) channel it back to research through government grants and subsidies.

Every so often, however, politicians notice that people are privately spending money on exactly the same thing that the politicians want them to have. Then they create a tax loophole, now called by its prettier name, a “tax deduction.” They declare that the income spent on the worthy purpose is exempt from taxation. The money you put aside for your retirement—a worthy purpose—is exempt from taxation. The money you donate to charity—a worthy purpose—is exempt from taxation. The money you spend on home ownership (interest) is exempt from taxation. The money a business spends on research is exempt from taxation.

This is not to say that the deductions are always taken in the spirit intended. This is where the negative connotation of “loophole” comes in. As happens with any government regulation, some people extend the interpretation of the law. They get the lower taxes without really doing the socially desired thing. For example, a company might send its scientists for a vacation in Hawaii, calling it a “research conference” in order to take the research tax deduction. As Congress finds out about such abuses, it moves to abolish the deduction. But then it hears about the useful, non-abusive spending of the same kind, and moves to re-establish the deduction. And so we go round and round.

How can we promote socially useful private spending without adding a lot of red tape? The solution is so simple most politicians rush right past it: cut government spending. Stop trying to give people things through government programs that they can buy for themselves. With less spending you can have lower taxes, and people will have the money to buy them!

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