The Democrats' never-ending search for tax loophole closers

Senate Democrats are circulating a list of a dozen tax “loopholes” they’d like to close as part of a budget package. It is unlikely that Republicans will agree to any of them except as part of broad tax reform, but it is worth taking a quick look at a few on their merits.

Some represent good tax policy and should be approved, regardless of what happens to the budget talks. Others sound good but won’t accomplish much after the tax lawyers root out new ways around them. And some are little more than headline-mongering.

As always, I wish lawmakers would stop calling them loopholes. Most are, in fact, explicit subsidies approved by Congress with full knowledge of the consequences. They are not the sort of accidental tax breaks that “loopholes” implies.

One of the best ideas on the Democrats’ list is taxing derivatives contracts on a mark-to-market basis, thus making investors pay tax on annual returns even before they sell these securities. This is sensible, easily done with today’s technology, and would reduce the deficit by about $16 billion over 10 years. House Ways & Means Committee Chairman Dave Camp (R-MI) raised this idea in an early tax reform draft, though he got lots of pushback from the financial community. 

There are a couple of proposals that make sense at first blush but are unlikely to accomplish much in the real world. One would tax the compensation of private equity managers (carried interest) as ordinary income. Another would end the practice called check the box, where firms can choose their legal form for tax purposes by, yes, simply checking a box on a tax form.

Carried interest is now taxed as capital gains. It ought to be treated as ordinary income since it is nothing more than another form of compensation. The private equity industry has been fighting this change for years, but seems pretty blasé about the shift these days. I suspect that’s because they’ve already figured how to restructure compensation to avoid expected new rules.

Check the box is a similar story. Originally created to simplify the choice between corporate form and partnerships for domestic firms, in recent years it has gained enormous popularity among multinationals as a mechanism to avoid U.S. tax on their foreign subsidiaries.

Eliminating check the box would reduce the deficit by $80 billion over 10 years, according to an official congressional estimate. More likely, it would give lawyers lots more lucrative business. Given the money involved, many firms would pay for the extra paperwork. Besides, check the box is going nowhere absent broad international tax reform.

Then there are the tax-the-rich proposals. For the most part, they won’t raise much money but sound good to the Democratic base. These ideas include: Imposing less generous depreciation rules on owners of corporate jets (an idea that has been in every Obama budget since he moved to the White House), eliminating the mortgage interest deduction for second homes, and limiting corporate deductions for very generous options payments to senior executives.

The deduction for options is a great example of how piecemeal changes to the code do little more than encourage new ways to avoid tax. Years ago, Congress limited deductible executive compensation to $1 million. But it didn’t take long for the lawyers to figure out the rule applied only to cash comp. Curbing the deduction for options would close that loophole (yes, this one qualifies for the “L” word). But don’t be surprised if firms find other ways to deduct the pay of their top execs. 

Finally, the Democrats’ list includes a couple of individual tax changes that are long past due. One would limit the use of mega-IRAs for estate planning (a gimmick that got Mitt Romney lots of unwanted attention). Another would bar business owners from characterizing income as profit rather than salary (a trick to avoid payroll tax that surfaced in the tax returns of Newt Gingrich and John Edwards).

Power washing many of these from the revenue code is a perfectly fine idea and ought to happen sooner rather than later. But it isn’t likely to occur as part of the ongoing budget talks.