Targeting Gimmicks is a Distraction from Genuine Tax Reform
Short-Term Giveaways Are No Substitute for Long-Term Growth
In a recent policy brief, we outlined a framework for broadening the tax base, proposing reforms to make the tax code neutral, simple, and fair. The current U.S. tax code is riddled with tax expenditures—special deductions, credits, and exclusions that reduce taxable income for individuals and businesses. These carve-outs reduce revenue to the benefit of special interests while requiring tax rates to be higher than they would otherwise be.
Last year the President promised several different groups of workers tax cuts for specific types of income. Now we’re starting to see the emergence of legislative bills that aim to deliver on those campaign promises.
While renewing expiring provisions under the Tax Cuts and Jobs Act (TCJA) should be a priority for policymakers, these additional proposals amount to short-term political gimmicks: popular-sounding giveaways that narrow the tax base, overlook our dire fiscal trajectory, and substitute targeted exemptions for real reform.
Take, for instance, no tax on overtime pay. Legislation introduced in the Senate would allow workers earning overtime pay to claim a new deduction of up to $10,000 ($20,000 for married couples) on their overtime earnings. An analysis by the American Action Forum estimates that this tax break would benefit around 13 million workers.
The French government did something similar in 2007. A 2014 article in the Journal of Labor Economics focused on this reform in France and found that “detaxation of overtime hours has not, in fact, had any impact on hours worked.” The study also notes how high earners were able to game the system, noting that the reform “had a positive impact on the overtime hours declared by highly qualified wage earners because of the leeway they have to manipulate the overtime hours they declare in order to minimize their taxes.”
The authors conclude: “while the wage earners concerned have indeed benefited from a spike in their remuneration thanks to detaxation, that has not, on average, come about through working more. Detaxation is a costly measure for the public purse, without any ascertained impact on hours worked.”
The authors were right to point out that this tax reform is costly for the public purse. The lower-bound estimates for this tax proposal range from $680 to $866 billion lost tax dollars over the 10-year budget window.
Another popular tax reform gimmick is “no tax on tips.” Legislation introduced on this front includes the creation of yet another new deduction of up to $25,000 for income through tips. According to the Yale Budget Lab, this would benefit about 4 million workers, or about 2.5% of the workforce, and only 5% of workers in the bottom 25% of the income distribution.
Aside from being badly targeted, the proposal to exempt tips from taxation could lead to significant behavioral changes among service workers and industries. The unequal treatment of income would incentivize more workers to move from wage to tip-based compensation, with the possibility of more service industries adopting the voluntary tip approach of the restaurant industry.
Exempting tips from income tax would cost roughly $118 billion over a decade. Accounting for behavioral effects and subsequent increases in tip income, the cost could rise to $300 billion or more.
Not taxing tip income while taxing wage-based income also violates the principle of horizontal equity. A cash register worker earning $30,000 in wage income and a waiter earning $50,000 in combined wage ($25k) and tip income ($25k) would be subject to very different tax burdens. In this instance, the cashier making $30,000 would owe $1,616 in federal income tax, while the waiter earning $50,000 would owe just $1,040. It is hard to justify a system where a service worker earning $20,000 less ends up with a larger tax bill.
A final tax gimmick that has been widely floated is the proposal not to tax Social Security benefits. This would benefit the almost 57 million retirees aged 65 and over claiming an average retirement benefit of almost $2,000 a month.
The Tax Foundation estimates that exempting Social Security benefits from income tax would cost the U.S. roughly $1.19 trillion over 10 years.
The most immediate practical obstacle to this proposal is that taxes from these benefits are used to fund the Social Security trust fund, which makes it off limits for budget reconciliation. Another obvious issue is that depriving the already shrinking trust fund of revenue income would mean the very benefits policymakers are attempting to exempt from taxation will instead have to be cut when the trust fund dries up.
Given Congress's limited authority to eliminate taxes on Social Security benefits, lawmakers are instead likely to propose raising the additional standard deduction claimed by people 65 and over. One such bill has already been introduced aimed at raising the deduction from $1,950 to $5,000 ($3,200 to $10,000 for married couples).
In sum, these tax proposals, collectively costing over $1 trillion, are crafted to win over specific voting blocs. Genuine tax reform that drives economic growth and improves the livelihoods of American workers should instead focus on making the tax code simpler, neutral, and non-distortionary.
Every new tax exclusion shifts more of the tax burden onto those that don’t qualify for special tax breaks and undermines the goal of moving the tax base towards a simplified and neutral system. If the goal of tax reform is to raise worker wages and employment opportunities, then policymakers should focus on renewing expiring TCJA provisions. Full and immediate expensing should be a central goal, as well as faster write-offs for investment in residential and non-residential structures and lower rates on corporate income and capital gains.
Real tax reform isn't about carving out favors—it’s about creating a system that works for everyone. Lawmakers should resist the lure of targeted giveaways and return to the harder, but more rewarding, task of building a broader, simpler, and more growth-oriented tax code.