Wall Street Journal

April 16, 2001

Everything You Ought to Know
About the 1040 . . . and More

By DAVID R. HENDERSON

T oday is the day. At least once a year, U.S. citizens must look carefully at a slip of paper and see how much, in total, has been withheld from their paychecks to fund the government. For many it is not a pleasant sight; indeed, it is an appalling one, especially when state and local income taxes are added to the federal number -- and never mind sales taxes and property taxes and all the other levies that diminish individual income still further.

As luck would have it, just as people are signing their tax forms this year Congress is debating President Bush's proposed tax cut. The debate is primarily about how much to cut taxes overall and about whether to cut most the taxes of "the wealthiest Americans," as they are known -- that is, the people who pay the most. Almost no one is talking about the tax code's complexity or about its seemingly arbitrary provisions, which make some items deductible and others not.

In "If Americans Really Understood the Income Tax " (Westview, 344 pages, $30), tax lawyer John O. Fox does in fact talk (with admirable clarity) about the code's complexity, focusing on the various exclusions and exemptions and deductions that make filling out a tax form so maddeningly difficult -- and too often the job of an accountant rather than the taxpayer himself. He argues, essentially, that the government should tax income that is currently not taxed. If it did so, he believes, it could collect the same revenue with a bottom tax rate of 10% and a top tax rate below 30%.

The key idea behind virtually all of Mr. Fox's analysis is what economists call the Haig-Simons view of income, named after the two economists who formulated it in the 1930s. Someone once bluntly summarized this view as "a buck is a buck." In other words, it doesn't matter where taxable income comes from -- income in all its forms, minus the cost of producing it, should be taxed. To put it another way: Any expense that is not part of the cost of producing income shouldn't be deductible.

For this reason, Mr. Fox disapproves of the biggest deduction of all, the mortgage interest deduction on first and second homes. That deduction, he notes, along with the exclusion of the first $250,000 in capital gains from selling a house ($500,000 for a married couple), encourages people to overinvest in housing, which diverts capital away from investment in plant and equipment. Most economists share his criticism of the tax treatment of housing. Mr. Fox also criticizes the provision that allows people to swap real estate without paying capital-gains taxes, noting that this artificially causes people to invest in property they never would have bought otherwise.

Of course, excluding various forms of income from taxation and allowing deductions of various expenditures save taxpayers money. (Such exclusions and deductions partly compensate for the heavy burdens taxpayers face elsewhere. That is one source of the code's complexity.) Mr. Fox shows that in 1997, the top 5.9% of taxpayers, those whose adjusted gross income exceeded $100,000, received 37.7% of the tax savings from special provisions of the tax code. He finds this to be anti-egalitarian.

But Mr. Fox's conclusion ignores two key facts that he himself presents. First, that same 5.9% of taxpayers paid 55% of all taxes. In other words, they paid a higher percentage of taxes than their percentage of savings from tax breaks. For the code to be anti-egalitarian, they would have to get more than 55% of tax savings.

Second, one main reason that high-income taxpayers benefit more from special deductions is that they are in a higher tax bracket. Someone taxed at a 39.6% rate who takes a $1,000 deduction gets a bigger saving than someone taxed at the bottom 15% rate: $396 vs. $150. Cutting the top rate would reduce the high-income taxpayer's saving. Would Mr. Fox therefore call a reduction in the top tax rate pro-egalitarian? I don't think so.

Many Democrats in the current tax debate say we should give tax cuts to those who need it most rather than to those who pay the most taxes. Mr. Fox wants to tilt tax deductions toward lower-income people for the same reason. This in spite of the fact that, as his own data show, the federal income-tax rate for people with adjusted gross income under $20,000 is already 4.4% or less.

Like many others, Mr. Fox favors higher marginal tax rates on higher-income people, but (unlike many others) he at least feels the need to justify such progressivity. How does he do so? Those with high incomes, he argues, have an advantage in every purchase, including housing, health care and education. Let us grant him that point. But don't they get that advantage by producing goods and services that people are willing to pay for?

Mr. Fox doubts that. "Capitalism," he claims, "rewards people who are best able to make money, even when the impact on society may be unfavorable." What he misses is that the people who are best at making money are the ones who are best at producing goods and services that people want, which means their effect on society is, overall, favorable.

Mr. Fox writes: "Schoolteachers play at least as vital a role in the future of our country as professional basketball players and work as hard, but they earn annually less than a basketball star earns for one game." Schoolteachers in total are more important than basketball players in total, and they are paid way more in total than basketball players. But I, a teacher, make way less than the L.A. Lakers' Kobe Bryant because, although I teach economics better than Kobe does (I'm guessing here), I'm not nearly as good a basketball player.

People, including many modest-income people, are telling me, with their voluntary expenditures, that they value Kobe's output more than mine. Go figure.

Mr. Henderson is a research fellow at the Hoover Institution and an economics professor at the Naval Postgraduate School in Monterey, Calif.