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February 19, 2015

A tax code for a different time

February 19, 2015

With a new Congress and fresh talk of (unlikely) base-broadening tax reform, legislators may find it useful to remember the distant origins of some popular tax provisions and ask whether they’ve kept up with the times.

Three of the largest and most popular tax provisions—the mortgage interest deduction, tax benefits for employer pensions, and the exclusion for employer-sponsored health insurance (ESI)—took root in the early days of the tax code, but not for the purposes their champions claim today. When first introduced or implemented, they affected very few households, addressed a small portion of the economy, and reflected very different realities in housing, health care, and retirement. Decades later, these three provisions alone cost over $500 billion a year and influence some of the economy’s biggest sectors.

Let’s start with some background. The mortgage interest deduction was born with the modern income tax code in 1913, which allowed for broad deductions for consumer interest. Though the precise intent behind the deduction is uncertain, it appears to have been mostly an administrative provision: at the time, mortgage and other consumer interest payments were relatively uncommon and difficult to distinguish from the legitimately deductible interest expenses of farms and small businesses.

Tax provisions for employer pensions were codified in the 1920s through more deliberate legislation that clarified the tax treatment of deferred income; they may even have been aimed at encouraging employers to adopt pension coverage for workers. However, over this period, only around 15 to 20 percent of private-sector workers were covered by pensions. Even when pension overhauls were introduced in the 1970s and ’80s, only about half of private-sector workers were covered, similar to the share covered today.

Last, the early tax code exempted employer contributions for accident and health insurance plans, but today’s tax-free treatment for work-based health plans was formally codified into IRS rules in the 1950s, after a brief dalliance with attempting to tax them.

None of these provisions were enacted as major social policies. After all, less than 10 percent of Americans, mostly high-income families, even paid income taxes in those days. It wasn’t until World War II and the post-war years famously transformed the income tax from “a class tax to a mass tax” that tax policy became a mechanism for providing benefits to a large share of the population. Rising tax rates and wage caps imposed to combat wartime inflation made employee benefits, exempted from wage controls, useful to employers for attracting workers and keeping taxes low. Unions also were happy to encourage these new tax-free perks.

As more families owed income taxes, these initially minor tax provisions morphed into popular middle-class entitlements, even as the economy changed in ways that could not have been foreseen when these provisions were introduced. The housing market transformed with the creation of new federal housing agencies and a large expansion of consumer credit. New (and expensive) medical treatments became available. Life expectancy and years in retirement increased, and traditional defined benefit pensions were replaced by 401(k)-type plans.

Despite the political appeal of these provisions, evidence of their effectiveness as social policies is severely lacking. As deductions and exclusions, their design still favors the well-to-do because their value increases with the marginal tax rate. Plus, few moderate-income households claim enough deductions for the mortgage interest deduction to have much value. As a result, roughly two-thirds of the mortgage interest deduction and major retirement subsidies, and about half of the value of the exclusion for ESI, flow to the top 20 percent of earners.

Other countries maintain similar homeownership rates without a mortgage interest deduction, while the US subsidy has been linked to less affordable housing for lower-income Americans, bigger houses for richer Americans, and more debt. Open-ended tax subsidies for health care push health costs higher. And there is little evidence that current tax subsidies for retirement saving actually encourage new saving; instead, they give the largest subsidies to people who would likely have saved anyway.

Attempts at reform often leave the door open for these subsidies to grow back. The Tax Reform Act of 1986 reduced the value of the mortgage interest deduction by lowering tax rates and boosting the standard deduction so fewer homeowners itemized their returns, but it left the subsidy in place. The Affordable Care Act imposes surtax on “Cadillac” insurance plans to curb the ESI tax benefit, but at the same time it reinforces untaxable ESI as the cornerstone for insuring middle class families. Recent expansion of 401(k) plans has been accompanied by a decline in defined benefit pension plans, whose benefits seem to have been less concentrated among higher-income workers. And as automatic enrollment in 401(k)s becomes a popular tool for getting workers to save, retaining the existing subsidies will only reinforce their ineffectiveness.

Leaving these subsidies on autopilot is a recipe not just for bad tax policy, but also for bad housing, retirement, and health policy. If Congress is serious about reform, it’s time to give these provisions another look.

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