Bush’s tax panel calls for sweeping reforms

With his second-term domestic agenda stalled, President George W. Bush has been casting about for new initiatives. The panel he appointed to recommend simplifying the labyrinthine US tax code handed him a huge one on Tuesday, recommending sweeping changes to the US taxation system.

The panel intends to call for the capping of tax deductions on interest for home mortgages and employer-sponsored healthcare, eliminating the deduction for state and local taxes, and overhauling tax reductions for popular retirement savings schemes. In exchange, it will recommend abolishing taxation of dividends, cutting personal and corporate income tax rates, and ending the worldwide taxation of US corporate earnings.

The most controversial of its recommendations is likely to be reducing the mortgage interest tax deduction, which allows taxpayers to write off their annual interest payments on home loans of up to $1m.

Even before the panel’s final report has been published,the powerful home-building industry has been lobbying to kill the proposal.

The industry might not need to work too hard. Fresh from his defeat over social security, many doubt Mr Bush has the inclination or ability to push through such a contentious reform.

When he launched the commission last January, Mr Bush cautioned the nine-member panel to “recognise the importance of home ownership” in US society. But faced with the requirement that any changes to tax policy should be revenue-neutral, the economic logic of the proposal is compelling.

Each year the loophole costs about $75bn in lost tax revenue, making it the second most expensive deduction on the tax code behind employer-provided healthcare contributions, at $125bn a year, which the panel also suggested restricting.

The federal government desperately needs new measures to raise revenues if, as the panel suggests, Congress is to abolish the Alternative Minimum Tax a parallel tax for the wealthy that is expected to yield about $1,300bn over the next decade.

Many economists argue that the loophole does little to promote home ownership as about 55 per cent of the benefit goes to households with incomes of more than $100,000 a year that is, to those who would own homes regardless of a tax incentive. Households earning less than $40,000 a year receive just 5 per cent of the tax benefit.

“What you end up with is a tax system that encourages bigger houses with more bathrooms, rather than more home-ownership,” says Wayne Brough, an economist at the Freedom Works. There is even evidence that the tax break locks poorer Americans out of the market by pushing up prices.

Ironically, the National Association of Homebuilders, a strong supporter of the tax deduction, concurs with this view. Curbing the tax benefit would cause house prices to fall, it says. “We are not just talking about slowing the growth of house prices,” says Jerry Howard, chief executive of the association. “We are taking about house prices diminishing.”

That argument is likely to prove politically decisive.

When the tax break last came under threat in 1995, the National Association of Realtors claimed that reform would cause house prices to fall by 15 per cent, wiping $1,700bn off homeowners’ equity.

If the deduction is threatened again, the housing industry would most likely produce even more shocking figures.

The NAHB says the housing market has already started to slow and any tinkering with the tax code would be extremely risky. “This is the primary source of wealth for most Americans, and many have been counting on the value of housing for their retirement,” says Mr Howard.

The tax panel, acutely aware of such concerns, has suggested phasing in reform over several years.

Even so, fear is likely to trump economic rationality, argues Bill Archer, former chairman of the tax-writing Ways and Means Committee in the House of Representatives.

“It is not so much a matter of whether it makes economic sense,” he says. “A lot of legislation that makes economic sense goes down because of fear. In this case the fear would be that any reform would have a chilling effect on the economy.”

If anything, the housing industry is more powerful than it was in the 1990s. About 40 per cent of all new private-sector jobs over the past four years have been created in construction, mortgage-broking and other businesses related to housing. Paradoxically, the very ambition of the tax panel’s recommendations might be the only hope for eliminating the mortgage deduction and other popular tax breaks. “If you are going to take away something from these higher-end homeowners, you need to give them something back,” says Mr Archer.