Tax loopholes are not mistakes. Loopholes are incentives designed into the tax code to encourage behaviors that the government prefers. Home ownership is considered a good thing, so the interest on a home mortgage is a tax deduction. That makes owning a home more affordable, so home ownership is encouraged. The mortgage deduction is a loophole. The pattern of all loopholes is that they cause economic decisions to be altered away from some things and towards others. The tax code has over 60,000 pages, with each loophole designed to favor something deemed good, at least by the Congressman who managed to get the loophole included.

Loopholes are behavior incentives

One way for the government to influence your life is by directly commanding you to do something, like buy health insurance. The gentler approach is to provide you with a financial incentive. There is no point in providing an incentive to get people to do what they do without an incentive. An incentive provided by a tax deduction is a loophole. The loophole makes it cheaper, so people who are near the border of deciding get the extra push needed to make the decision. If you are deciding whether to rent or buy a home, the tax deduction for mortgage interest can have a major impact on the calculation. If renting were 10% cheaper than buying before the deduction, then after the deduction, buying might be 10% cheaper.

The taxes on the people who don’t use the loophole must be higher to make the same total revenue. So renters are in principle paying more to subsidize homeowners. I’ll put aside the question of whether that is good for society as whole. Either way, the mortgage loophole and all other loopholes affects economic decisions and shifts the tax burden.

The mortgage interest deduction is atypical, because everyone knows about it and it’s often discussed. To date, there is majority agreement that it is a good idea. Most of loopholes are not so well known. They start out in the tax laws passed by Congress. The Treasury Department provides an official interpretation of the tax laws in Part 26 of the code of Federal Regulations. It’s available on line Estimates of the number of pages in the tax code vary considerably. One estimate in early 2008 had it passing 67.000 pages.

Loopholes are central to American business

Loopholes are an industry unto themselves. This past year General Electric made $14.2 billion in profits worldwide, including over $5 billion in the United States. Thanks to a corporate strategy of lobbying for loopholes and cashing in on them, GE paid no US income tax. That’s despite the US officially having, at 35%, one of the highest corporate income tax rates in the world. In general, corporate success in the US depends upon playing the loophole game well, in addition to providing a product or service.

Complex tax laws are inherently wasteful because capturing the tax benefits is non-productive. GE had to file 24,000 pages of tax returns in order to pay no taxes. The people who prepared the returns might have done something productive instead, like making light bulbs — if that were still allowed.

Loopholes steer money away from investments that make the most economic sense on their merits towards less logical investment choices that yield tax benefits. That means overall productivity is less.

Loopholes reward those who can get them enacted. That discourages foreign companies from establishing businesses in the US, because they see the 35% tax rate and feel uncertain of their ability to avoid paying it.

Loopholes produce inefficiency

Loopholes also explain why raising tax rates on the rich does not produce the amount of revenue that simple percentages suggest. If the corporate tax rate were raised from 35% to 40%, GE would still have paid no taxes.

In 1916 there were 206 people who reported annual taxable incomes of one million dollars or more. But as tax rates rose to 73% in 1921, the number of millionaires fell to 21. As tax rates were cut in the mid-20s, the number of individuals reporting taxable incomes of a million dollars or more rose again, to 207. It made more economic sense to pay the lower rate than to use loopholes to avoid paying.

High tax rates were re-enacted in World War II and kept high for decades. The high rates produced little revenue. Back then the tax code was simpler than today, only 8000 pages, but there were enough loopholes to avoid taxes.

Eliminating loopholes

The number of loopholes can be reduced significantly by changing the tax system to a flat tax. As proposed, there is a personal exemption and exemptions for dependents, but above that few exemptions. The tax rate is proposed at a flat 18%, or thereabouts. There is an argument that charitable contributions would rise, even though contributions would not be deductible.

Short of enacting a flat tax many loopholes could be closed to simplify the system. That would reduce cost of compliance and restore some economic efficiency. There is one loophole that cannot be closed, and it’s an important one. Money can be moved offshore for investment, and the profits kept outside of the United States. Taxing money in another country is a violation of the country’s sovereignty.

If a person is getting their income from local job or small business, the out-of-country tax option depends upon moving out. However, rich people are likely to have financial investments and bank accounts that can be moved without a physical presence. For large corporations, foreign operations are difficult to manage and the local infrastructure in a foreign land many be lacking. In the global economy, more companies are able to cope with those disincentives. In a global economy with internet communications, it’s easier than ever before. We should expect high tax rates to chase money across the borders.

It’s time to rethink the loophole approach to taxation.