Closing Tax Loopholes: Obama's Best Shot?

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By all measures, President Obama began his 2012 campaign on Tuesday night. He used big numbers—not just ones with dollar signs attached, but ones that exist only in imaginations: 2035. 2020. 2015. The thinking was grand, the planning long-term, the rhetoric Sputnik-ed.

And yet, one of the president’s proposals in his State of the Union address was all about the fine print: closing tax loopholes. Absent from the speech was a broad-stroke promise to raise or lower taxes. The closest Obama came to doing so was a thinly-veiled threat to eventually let the Bush tax cuts expire for the wealthiest Americans, this after agreeing to extend them only last month.

Regardless of what happens to the top tax bracket, focusing on tax loopholes is a shrewd move politically, particularly with the president’s 2012 reelection campaign now in view. It realigns the tax debate on the minutiae of the federal code, getting away from the same old tax-versus-spend back and forth.

For one, it sounds good. Americans hate taxes, after all. Our nation was founded upon a hatred of taxes. There is something about giving our money to the government that is primordially noxious to our understanding of individual liberty. Even for those who say they don’t mind paying the man, or the few who might freely admit that their taxes could be higher, let’s be frank: we wouldn’t pay a dime if we didn’t need to.

That’s why, politically, Obama picked a great fight. He flirted with class warfare when speaking about the wealthiest Americans, and it only drew a smattering of applause. When he mentioned tax loopholes, everyone in the room applauded. That should tell you something.

That something isn’t just about politics, though. There’s also ample evidence to suggest that raising and lowering taxes isn’t enough in any given situation. You have to tend to the fine print. Consider the case, as so many do these days, of Reagan.

At times lost in the conversation about Reagan’s tax cuts is the fact that they were the product of two distinct pieces of legislation. The Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986 were separated by half a decade and were markedly different in character.

If the first law was Reagan performing surgery on the tax code, the second was Reagan stitching the patient back together. In sum, the first cuts were uncomplicated, amounting to big reductions in marginal income tax rates, estate taxes, and corporate tax rates. The second ones lowered some tax rates and raised others, but were primarily the culmination of a prolonged effort to “fix” the previous legislation: it broadened the tax base, simplified the tax code, and—you guessed it—closed loopholes.

According to Citizens for Tax Justice, a left-leaning think tank, the “huge budget deficits that emerged in the eighties” are a result of the 1981 tax cuts. Revenue from individual income taxes failed to grow with inflation, and revenue from corporate income taxes plummeted. Lower tax rates alone could not cure the economy, and the deficit peaked at 5.1 percent of GDP in 1985. By contrast, the 1986 legislation consolidated tax brackets and lowered some tax rates, but still resulted in higher tax collections. That’s because with fewer ways to avoid or reduce one’s tax burden, more income was exposed to taxation even as rates declined. Reagan ended his presidency with the deficit at 2.8 percent of GDP.

Since 1986, thousands of minor changes to the tax code have allowed a a whole new raft of loopholes to open again. Tax brackets and rates today look very similar to those under Reagan. Collections from individual and corporate income taxes have been stalling or declining for the last decade, and there’s a little thing called the national debt that’s making some people really upset.

All of this warrants attention to loopholes in 2011 and beyond. It could be the easiest way for Obama to bring in more tax revenue without having to steamroll Republicans. Such policy enjoys bipartisan support—as it did with the 1986 tax legislation—satisfying the right’s appetite for a less intrusive bureaucracy and less burdensome demands from the government, while also throwing a bone to the left by offering a more egalitarian approach to taxation.

Consider this argument made by economics professors Richard Vedder and Lowell Gallaway in a 1998 Joint Economic Committee Study. Using the example of two adult couples with equal incomes but different lifestyles, Vedder and Gallaway construct a situation in which, as a result of excessive rules, distortions and loopholes in the tax code, one pays far less in taxes than the other:

While the two couples have equal earnings, are the same age, have the same number of children, etc., the unmarried big spending couple faces an annual federal income tax liability that is more than $6,000 less than the couple that married, lived conservatively, and got out of debt.

Granted, this is an uncommon and hypothetical comparison, but it illustrates a point about taxation that's sure to strike a chord with voters. Vedder and Gallaway ask plainly of their scenario, “Is that good social policy?” A vast majority of Americans, if not all of them, would probably say no. President Obama would do well to keep this question in mind. If he doesn’t, it’s entirely possible that America will answer the same way when he asks for four more years.