Trillions and Trillions of Dollars

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There's rare unanimity in Washington right now. Everyone agrees that our tax system is a wreck. Too many loopholes, too many exemptions, too many carveouts, too much confusion. A friend recently quipped that, as a matter of enlightenment, every member of Congress should be required to do their taxes live on C-SPAN, aided only by a pencil and a calculator. No one leaves until you pass an audit.

Over the coming weeks, a congressional "supercommittee" will try to find more than $1 trillion in deficit savings over the next decade. Part of their job will be -- or should be -- a dramatic overhaul to the tax code. This can be done in a way that appeases nearly everybody. One side says we need lower tax rates. The other says we need more tax revenue. Both can be accomplished fairly easily by eliminating tax deductions and lowering tax rates.

There are literally trillions of dollars in those deductions, which include the ability to deduct mortgage interest, employer-provided health insurance, and contributions to retirement accounts. These deductions are frequently called "tax expenditures." Why? Because distinguishing between a tax deduction and a cash subsidy is difficult. If, instead of allowing mortgage interest to be deducted from taxes, the government wrote homeowners a check based on the amount of mortgage interest they paid, the impact on the economy and government coffers would be exactly the same.

In a report presented to the supercommittee this week, the Congressional Budget Office fleshed out a few numbers about tax deductions. One stat I found interesting: In 2008, total income in the U.S. was $8.4 trillion, yet taxable income was $5.7 trillion. That means over 30% of all income is shielded from tax thanks to various deductions. Just the top three tax deductions will reduce tax revenue by roughly $1.5 trillion between 2010 and 2014. Extrapolate that over the next decade -- as people like to do these days -- and it's many trillions of dollars.

Last year, the chairmen of President Obama's deficit-reduction committee proposed eliminating all tax deductions and drastically lowering tax rates. The rationale for this is simple. First, by widening the tax base, more revenue is raised, lowering deficits. Two, some tax deductions distort the market in incredibly inefficient ways.

On that last point, I've already discussed how the mortgage-interest tax deduction debauches the real estate market. Today I want to talk about downsides of two other top deductions: employer-provided health insurance, and retirement contributions.

The deductibility of employer-provided health insurance is the largest tax expenditure. It's expected to cost $115 billion this year, which, for perspective, is pretty close to what the government spends annually on interest payments for the national debt.

Here's the problem. Health insurance premiums grow faster than both inflation and the economy. By extension, so does the cost of the tax expenditure. In 2000, the deduction of employer-provided health insurance cost $64 billion. This year, it's $115 billion. That's an annual growth rate of about 6%. Meanwhile, the overall economy grew by about 3.5% a year over the past decade. Not only is the deduction expensive, but it gets more expensive (in real, inflation-adjusted terms) every year.

That isn't the least of it. The subsidy increases the price of health insurance, since workers have more money to spend on it. For those receiving health insurance from their employer (the majority of Americans), this isn't a big deal -- the subsidy and the price hike likely even each other out. But for those buying health insurance in the open market, it's awful, since that inflated insurance is purchased with after-tax dollars.

What might that latter group do when insurance becomes too expensive? Drop their coverage. And who picks up the tab for the uninsured when they get sick? By and large, those with insurance, via higher premiums. It's a nasty cycle. Reuters blogger Felix Salmon made a strong point here: "If you want to keep the system fully private, then fine, but don't ask the government for massive subsidies at the same time."

Then there's the deduction for money contributed to a 401(k) or IRA. This is, by most accounts, a reasonable deduction because it incentivizes people to save more for retirement. And that's great!

But the assumption that the deduction causes everyone to save more is misguided. The vast majority of homeowners would still own a home without a tax subsidy. The same is true for retirement savings. As others have shown, there's scant evidence that subsidizing retirement accounts actually leads to more pre-tax savings -- particularly among upper-income earners, where the majority of the tax benefits fall.

And just like the mortgage-interest deduction, those who could use a hand and be incentivized to save more receive the lowest benefit. Since the deduction is based on tax rates, which are largely progressive, low-income workers receive a smaller incentive than those with higher incomes -- someone in the 15% tax bracket receives $0.15 for every $1 saved in a retirement account, whereas someone in the 35% bracket receives $0.35 per dollar. This makes little sense from a policy standpoint, because those with higher incomes have a greater propensity to save as it is, and are likely to save just as much without a subsidy.

Some say we can get around this by replacing the deduction with a matching program. Instead of deducting retirement contributions from taxable income, everyone -- regardless of income or tax bracket -- would receive a set matching contribution from the government. One proposal suggests setting the match at 15%, so that everyone receives $0.15 per dollar contributed to a retirement plan. 15% is undoubtedly less than the average tax rate of most of those currently taking advantage of the deduction, so the proposal would lower deficits, but it would still incentivize lower-income workers to save more.

You'll hear a lot about deficits in the coming weeks and months. The question will be, what can we afford, and what can't we? It would be devastating if we pick apart the insignificants -- NPR, bridges to nowhere, earmarks, waste -- while ignoring the whales in the room. Tax expenditures are one of those whales. And this is a case of killing multiple birds with one stone: The supercommittee can simplify the tax code, raise revenue, lower tax rates, and stop meddling with the economy through subsidies. Let's get it done.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributorMorgan Houseldoesn't own shares of any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.

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