Tax loopholes get a bad rap.
Much of it is deserved, but people who hate on them tend to limit their thinking to the social factors that perpetuate the loopholes (e.g. the influence of money in politics) rather than focus on whether the loopholes are justified in the first place. This is understandable, but (at least partly) betrays a lack oof interest in or appreciation for the arguments in favor (and against) of many of these loopholes, arguments that any critic of tax policy should be able to understand if not address - otherwise, discussion becomes mere populist rhetoric independent of truth.
Nowhere is this clearer than with the "loopholes" that result in lower taxes paid on corporate profits and long-term capital gains. There are arguments for and against these preferential treatments, but they are complex, deeply rooted in rather advanced economic theory (see here and here), and typically not appreciated by laypeople who decide to nevertheless have strong opinions on these issues.
On this page, I'm going to focus specifically on loopholes used by individuals to avoid income tax. I'll be ignoring corporate taxes and estate taxes which are (in my opinion) generally more complicated and less important.
Tax Deductions I - Reduced Consumption
Preferential treatment of capital gains notwithstanding, the justifications for "loopholes" are typically fairly straightforward. Tax deductions, for instance, are typically justified on the idea that one's nominal income can often overstate one's ability to consume.
That's very abstract, so for simplicity, we'll consider three people: Alice, Bob, and Carol. All three worked full-time last year. Alice and Bob made $60k while. Carol made $55k.
- Health Care Deduction - Suppose Alice had to spend $5k in necessary medical bills. This makes her ability too consume more like Carol's than Bob's.
- Charitable Giving Deduction - Suppose Alice donated $5k. In this case, Alice's ability to consume is equal to Carol's, so it seems reasonable to tax her like Carol rather than Bob. As a bonus, the charitable giving deduction boosts charitable giving Peloza.
- Education Deduction - Suppose Alice is simultaneously pursuing a degree and had to spend $5k to cover the cost. Again, Alice's ability to consume is equal to Carol's (not Bob's), so she should presumably be taxed like Carol (not Bob).
- Various Interest Deductions - Suppose Alice is paying $5k in s interest on debt. This, again, reduces her ability to consume by $5k, which again makes her more like Carol than Bob.
- Capital/Gambling Loss Deduction - Suppose Alice makes $10k in capital gains and loses $15k in capital loses. Again, her ability to consume is like Carol's (not Bob's), so allowing her to deduct the $15 from her $60k in income makes some sense.
- Educator Expenses Deduction - Suppose Alice is a teacher and spends $5000 on classroom supplies. This is tragic and should be fixed, but (in the meantime) let's just agree that this reduces her ability to consume and makes her more like Carol than Bob.
- State and Local Tax Deductions (SALT) - Suppose Alice lives in a high-tax state and pays $5k in state income tax while Bob and Carol pay none. Again, in terms of ability to consume, this makes Alice more like Carol than Bob.
- Child and Dependent Care Tax Credit and Adoption Tax Credit - Both of these help the tax system account for the costs associated with children/dependents - as did the personal exemption before it was eliminated.
To be clear, I don't agree with all these deductions. I'm not a fan of subsidizing higher education, think SALT is distortionary on a society-wide level, and have mixed feelings on the charitable giving and mortgage interest deduction. However, to advocate against these "loopholes" from an informed perspective, you need to actually know how they're justified to begin with.
Tax Deductions II - Other
Other tax deductions are justified on other grounds:
- It's well know people don't save enough - both due to cognitive biases and due to incentives created by our society (bankruptcy, reduced welfare, reduced financial aid, etc). To help counteract these biases, the government has created a number of programs to encourage savings such as 401ks, IRAs, and HSAs.
- The residential energy tax credit and the plug-in electric-drive motor vehicle tax credit give money to people who take actions to reduce their CO2 emissions. The justification is just the Econ 101 justification for Pigovian taxes on externalities.
- The Earned Income Tax Credit (EITC) deserves a page all by itself, but basically the welfare cliff is real and the EITC helps reduce it, thereby both helping the very poor while simultaneously encouraging them to work - it's quite beloved by both parties.
- A final class of deductions relate to issues of trying to remove distortions created by the fact that some people work for companies and others are self-employed. For instance, if I use a company car, gas cost is tax-deductible as a business expense. If it wasn't, this would distort the economy by encouraging vertical integration, which is the more general reason why we let companies deduct business expenses and only tax their profits. Likewise, if I use my own car to travel for my employer, I should theoretically be allowed to deduct the cost of gas. Otherwise, we distort decisions by encouraging people to use corporate vehicles even when using their own is more convenient. There are a whole host deductions along these lines including the home office deduction and the self-employment expenses deduction.
You may be tempted to retort that only about a quarter of Americans itemize their deductions, and those Americans tend to be high earners, so these deductions are really just loopholes for the rich.
The thing is, none of that is wrong - it's just incomplete.
Generally the proper response to the rich not paying enough is to advocate for either (1) the raising of tax rates on the rich or (2) the elimination of particular loopholes that have genuinely poor justification. Advocating for elimination of loopholes "in general" sounds good but is vague to point that I can't even consider it a real policy proposal and the fact that the benefit the rich more than the poor is a rather weak argument since it makes no effort to weigh the pros and cons of the proposal.
Second, ignoring all that, the reason a minority of Americans itemize isn't because these itemized deductions are intended for the rich - it's because people complained that taxes were too complicated, which caused Congress to introduce the standard deduction, which is effectively a way for poor people to claim more deduction than is justifiable by the underly theory of tax deductions.
It seems weird and kind of historically ignorant to advocate for the elimination of itemized deductions on the grounds that they favor the wealthy, when the only reason they favor the wealthy is because Congress introduced an artificial progressive deduction that favors the poor so much.
Stepped Up Basis Loophole
Probably the worst loophole is the stepped up basis loophole. Basically, suppose I buy a stock for $100, it appreciates to $300, then I die, and my inheritor sells the stock. In this scenario, zero capital gains taxes are paid. The arguments in favor of this loophole overlap quite a bit with the arguments for zero (or at least lower) capital gains taxes in general. However, none of those argument actually justify this loophole specifically - just less capital gain taxation in general.
Moreover, this loophole is actually significantly larger than it first appears, because when it's paired with other more reasonable loopholes (e.g. tax loss harvesting and equity swaps), it can allow the very wealthy to avoid nearly all income taxes while causing serious distortions in how people invest (there are investment funds whose entire selling point is optimizing for this).
There's a slightly reasonable justification for the loophole: allowing children to keep assets with personal value (e.g. a childhood home) even if they can't afford the tax. I don't really buy this justification, but even if you do the obvious answer is to only apply the stepped up basis loophole to a primary residence and/or only up to some fixed dollar value. (say $2 million).
There's no remotely reasonable justification for the broader loophole, and we should burn it with fire.
Scraping the bottom of the barrel, we have
- shell trust funds