What's so bad about picking winners and losers in the tax code?
Seven possible arguments for tax neutrality
|Scott Greenberg||Sep 9, 2020||3|
The federal tax code is not an impartial document. It is full of provisions that favor particular industries, reward specific actions, and promote certain ways of life.
Many people are unhappy with this state of affairs. For decades, a mantra of the tax policymaking world has been “broaden the base,” a slogan which calls for repealing tax provisions that provide special treatment for certain activities.
Arguments against favoritism in the tax code often invoke the concept of tax neutrality. “Tax neutrality is a widely accepted concept in principle,” writes Jason Furman, who chaired the Council of Economic Advisors during the Obama Administration. “The basic concept is simple: generally the tax system should strive to be neutral so that decisions are made on their economic merits and not for tax reasons.” The Tax Foundation, a center-right think tank, offers a similar definition of neutrality: “Taxes should neither encourage nor discourage personal or business decisions.”
Some readers may be nodding their heads in agreement, but others might not be sold. “Why shouldn’t the tax code simply reward good things and penalize bad things?” — one might ask.
In today’s newsletter, I’d like to survey several possible answers to this question: arguments for why tax neutrality might be a worthwhile ideal. I think that some of these arguments are more convincing than others, but all are worth thinking through when evaluating the advantages (and limitations?) of the concept of tax neutrality.
1. An argument about complexity and administrative costs
One basic argument in favor of tax neutrality is that it helps to keep the tax code simple — which, in turn, helps reduce the costs of tax compliance and tax administration.
Every time lawmakers add a tax provision that favors certain activities over others, it makes the tax system more complicated. New regulations have to be written; new definitions need to be formulated. Taxpayers must pay attention to yet another tax consideration when planning their affairs. IRS agents must examine yet another item in their audits. Inevitably, taxpayers develop strategies to qualify for each new tax provision, and government lawyers respond with guardrails to restrict provisions to their intended beneficiaries. In other words: every time lawmakers move away from tax neutrality, they create compliance costs for taxpayers and administrative costs for the public.
This is a great argument for tax neutrality, but it can’t be the only argument. After all, pretty much everyone agrees that some level of administrative and compliance burden is an acceptable price to pay for a just tax system. (For example: a head tax of $10,000 per person would come with almost no compliance costs — but few would consider this an acceptable form of raising revenue today.) So, count this argument as a partial case for tax neutrality.
2. An argument about the role of the tax code
One argument I often hear in favor of tax neutrality is as follows: “The purpose of the tax system is to raise revenue, so lawmakers should stop cluttering the tax code with unrelated policies that are only meant to favor certain taxpayers over others.” There’s also an obvious retort: “Who’s to say what the purpose of the tax code is? Let’s have the tax code do whatever we want it to!”
I do think there’s something to the argument that the tax code should just focus on raising revenue. The IRS has certain core competencies, like assessing taxpayer income. If you ask the IRS to do more tasks outside of its core competencies, it might do a worse job.
But this argument for tax neutrality doesn’t work in every case. There are some non-neutral policies that the IRS is genuinely in a better position to implement than any other part of the federal government. If lawmakers want policies to encourage certain business investments, it helps that the IRS already collects information about what investments each business makes. And if Congress decides to deliver cash to particular households, the IRS refund system is one ready-built mechanism for making that happen. The argument that “the tax system should just raise revenue” misses that the IRS is sometimes well-positioned to do other things as well.
3. An argument about allocative efficiency
One of the most common arguments in favor of tax neutrality is that non-neutral tax policies create economic distortions, harming allocative efficiency.
That’s a bunch of economics jargon, so here’s the argument in plainer language: People have preferences about how they want to spend their time and their resources. When the tax code penalizes some activities relative to others, this will cause people to spend their time and their resources on things they prefer less. This is generally thought to be unideal.
There have been thousands of pages written about this argument for tax neutrality. Serious thinkers have disagreed about: i) whether the economic effects of making the tax code less neutral are serious or not, ii) whether some non-neutral tax provisions might actually be good for economic efficiency, and iii) whether economic efficiency is even a worthwhile ideal at all. So, while the economic arguments for tax neutrality are quite common, there’s debate about how far they can be applied.
4. An argument about relativism, or about humility
When lawmakers try to use the tax code to reward good things and penalize bad things, one possible argument in favor of tax neutrality is: “Who’s to say what’s good or bad?”
There are different versions of this argument. A strong version: “Individuals should be able to decide what’s good and bad for themselves, instead of being pushed by tax policy to conform to the values of society.” A weak version: “In theory, it’s okay for the tax code to reward good things and penalize bad things. But in practice, many people disagree about what’s good and what’s bad, so let’s be humble and cautious about using the tax system in this way.”
I’m more sympathetic to the weak version of this argument for tax neutrality. It’s understandable that Americans with deeply-held convictions would be interested in promoting the wellbeing of their fellow citizens and the common good of society, using the tax code as one tool to do so. At the same time, lawmakers should always be worried that their value judgments might be wrong: moral reasoning is difficult, and plenty of smart people disagree about fundamental questions. This is one reason to err on the side of tax neutrality: humility about whether lawmakers know the right things to subsidize and penalize.
5. An argument about fundamental rights
Some arguments for tax neutrality appeal to the fundamental rights of citizens — the right to self-determination, the right to private property, the rights of minority interests to be free from majority hegemony, etc. If you believe in strong versions of these rights, you might be averse to a tax system that collects more from taxpayers who don’t engage in socially favored activities.
It’s a little unfair of me to lump all of these rights into one category, because a property-rights-based case against tax preferences can look very different than a minority-rights-based argument. Nevertheless, what all of these rights-based arguments have in common is a sense that the state fundamentally owes its citizens a measure of impartiality and non-interference.
These arguments all make good sense when discussing things like speech and religious practice, but I’m skeptical that they apply with much force when it comes to run-of-the-mill tax preferences. Public life is fully of petty distinctions and impositions which do not feel like violations of fundamental rights. That said, if lawmakers were to enact tax policies of a more extreme nature — such as confiscatory taxes — then these arguments for tax neutrality would become more relevant.
6. An argument about social peace
One speculative argument in favor of tax neutrality is that it could help de-weaponize the federal tax code as an instrument of social conflict.
The argument goes like this: America is divided into factions who would like to use every policy instrument available to help their friends, penalize their enemies, and promote their way of life. The tax code is one of the more potent available weapons, because it can provide material benefits and inflict real harms. But many Americans might be interested in de-escalating our current social conflict: they might think that they have more to lose than to gain. One path to de-escalation would be for all sides to agree to limit the weapons they use — which could involve a commitment to make the federal tax code more neutral.
As I say, it’s a speculative argument. Many of the tax preferences in the current code have nothing to do with factional conflict, and it seems like wishful thinking to imagine that a well-crafted tax reform bill could end the culture war. That said, I think there’s something to the idea that a greater focus on neutrality in every area of policy could help reassure Americans that the consequences of their opponents winning power might not be so dire.
7. An argument about political economy
A final argument for tax neutrality is that most tax preferences, in practice, are simply not worthwhile public policy.
When you see a tax preference, how often do you think, “This is a good faith attempt to further the public interest”? And how often do you think, “Those lobbyists really did their job well”? If the average tax preference does more to further private interests than any conception of the public good, it might be worth adopting a blanket norm against favoritism in the tax code.
The problem with norms is that it’s hard to get everyone to agree. Lawmakers might be wary of committing to forego creating new tax preferences if they didn’t trust that other lawmakers would honor the same commitment.
Tax neutrality is an influential concept in the tax policy debate, though its influence on the actually existing U.S. tax system is more limited. In this post, I’ve tried to survey the main arguments for tax neutrality — though I’ve sure I’ve missed some. (I also haven’t explored all of the arguments against tax neutrality; that’s for another time.)
For my part, I think that a presumption of tax neutrality is a good default approach for thinking about tax policy. If someone offers a tax proposal that favors specific activities over others, I think the burden of persuasion is on them to show why deviating from tax neutrality is worth it.