Tax Expenditures: A Way to End Budget Gridlock?

Back in 1987, the very first issue of my own Journal of Economic Perspectives had a symposium on the just-passed Tax Reform Act of 1986, which famously (among economists, at least) reduced various exemptions, exclusions, deductions, and credits in the tax code, and then used the extra money to reduce marginal tax rates. In that issue, Nobel laureate James Buchanan offered a trenchant analysis of the political economy behind such legislation. He argued that politicians love to hand out tax breaks to specific groups, but as they do so, it becomes necessary to raise tax rate on remaining income that isn\’t getting a special break. Eventually, the tax rates get so high, and the tax breaks get so numerous, that Congress girds up its loins and passes a bill like the Tax Reform Act. However, Buchanan continued, it would be imprudent to view this bill as proof that Congress actually believe in a simpler tax code with lower rates. Instead, it is just politically necessary to pass such a bill from time to time, so that the political cycle of more tax breaks and higher rates can unwind again.(My journal is freely available on-line back to 1994, but the first issue is not yet freely available. However, it is available through JSTOR, and many academics will have access in that way.)

In our current impasse over crafting middle-run and long-run ways to reduce budget deficits, many conservatives would like to have a tax code with lower marginal tax rates and with fewer government efforts to micro-manage aspects of the economy, while many liberals would like to have a tax code that raises more revenue–in particular from those with high incomes. Reducing the reach of tax deductions, credits, exemptions, and exclusions–which collectively go under the name of \”tax expenditures\”–could offer a way to provide some satisfaction for all sides.

Daniel Baneman, Joseph Rosenberg, Eric Toder, Roberton Williams discuss \”Curbing Tax Expenditures\”  in a paper just published by the Tax Policy Center. They point out that a George W. Bush tax commission back in 2005 proposed limits on tax expenditures, as did more recently President Obama\’s President Obama’s National Commission on Fiscal Responsibility and Reform  and a commission from the Bipartisan Policy Center.

Tax expenditures comprise large sums. The authors of the TPC paper point out: \”Despite significant variation over the years, tax expenditures impose substantial costs on the federal budget and will continue to do so. In 2011, they were projected to cut revenues and raise outlays by $1.1 trillion, more than we collected from individual income taxes and nearly half of total federal revenue collections for the year.\”

Of course, the problem with altering tax expenditures is that people are used to them, and don\’t want to see them disrupted. By far the biggest tax expenditure is the fact that employer-provided health insurance isn\’t taxed as income: if it was, the U.S. Treasury would collect about $174 billion per year more. The second-biggest tax break is the deductibility of mortgage interest, which costs the Treasury about $89 billion per year. Other big-ticket tax expenditures include deductibility of state and local taxes, deductibility of charitable contributions, lower tax rates for capital gains and dividend income, and others. You can make all the tough-minded policy arguments you want about how in a U.S. economy where rising health care costs are a major policy concern, maybe having a $174 billion tax break subsidizing health insurance isn\’t the best idea, or in a U.S. economy that has just seen the destructive power of a housing price bubble, maybe a tax break to make it easier to spend more on houses isn\’t a great idea. But it\’s tilting at windmills to attack these sorts of provisions one at a time.

Instead, the TPC authors point out:  \”While an ideal tax reform process would comprehensively evaluate each tax expenditure on its merits, eliminating some and restructuring or retaining others, broad-based limitations on tax expenditures may be easier to enact and would still produce net benefits. This paper examines alternatives for implementing across-the-board limits applied to a selected group of the largest and most widely utilized tax preferences.\” Thus, they offer proposals like converting most tax expenditures into a single tax credit at a 15% rate, or putting a cap (as a share of income) on the total tax expenditures that could be claimed on any tax return, or even just reducing the cost of all tax expenditures across-the-board by a fixed percentage amount. In other words, don\’t tackle individual tax expenditures head-on, but instead try to rein back on many tax expenditures all at once.

Such proposal would mostly affect the tax bills of those with high incomes, because tax expenditures mainly flow to those with higher incomes. On their calculations, 41% of the total value of tax expenditures goes to the top 5% of taxpayers by income, and 24% of the total value goes to the top 1%. Remember, those in the upper part of the income distribution are far more likely to itemize deductions. And because those with high incomes face higher marginal tax rates, the amount of taxes they save from tax expenditures is also higher.

The next figure shows effective (that is, average) tax rates for different income levels, and then shows what the tax rates would be without tax expenditures. The federal income tax is progressive: on average those with higher incomes do pay a higher share of income in taxes than those with lower incomes. But at the upper income levels, the presence of tax expenditures reduced the extent of that progressivity.

Reducing tax expenditures would arguably reduce certain ways in which the government is influencing economic outcomes. It would free up revenue both to pay for reducing marginal tax rates, and also to pay for some reduction of long-germ budget deficits. I believe there is a deal waiting to be cut, although I\’m admittedly dubious as to whether the current crop of politicians can achieve it.

For a previous take on tax expenditures with some additional background and argument, see my post of last August 3, \”Tax Expenditures: One Way Out of the Budget Morass?\”

How Much Revenue from Limiting Deductibility?

One unattractive aspect of having certain expenditures be deductible in the U.S. tax code is that any deduction is worth more to someone in a higher tax bracket. Thus, when it comes to typical deductions like the mortgage interest deduction, the deduction for state and local taxes, the deduction for charitable contributions, or the deduction for large out-of-pocket health care expenditures, someone in a 35% tax bracket saves 35 cents off their tax bill for each $1 of deductible expense, while someone in a 15% tax bracket saves only 15 cents off their tax bill for each $1 of deductible expense. Of course, the two-third of taxpayers who don\’t have enough of these specific expenses to make it worthwhile to itemize their deductions just take the standard deduction, and get nothing extra off their tax bill for these expenses.

Proposals are always kicking around to reduce deductibility, by limiting the tax savings from a deductible expense to say, 28% or even 15%. How much revenue might such proposals raise?

What about limiting deductibility to 28%?
Daniel Baneman, Jim Nunns, Jeffrey Rohaly, Eric Toder, Roberton Williams estimate the revenue to be raised from a proposal to limit deductibility to 28% in a recent paper for the Tax Policy Center. They write (footnotes omitted):

\”To measure the revenue and distributional implications of these proposals, the analysis considers two baselines: current law and current policy. “Current law” is the standard baseline that official revenue estimators at the Joint Committee on Taxation use to score tax proposals. It assumes that tax law plays out as it is currently written. Most important, that means that the 2001–2010 income and estate tax cuts expire at the end of 2012 and that temporary relief from the alternative minimum tax (AMT) expires at the end of 2011. The “current policy” baseline assumes that Congress permanently extends all provisions in the 2011 tax code (except the 2 percent reduction in Social Security payroll tax) as well as AMT relief, indexed for inflation after 2011. …

[A] proposal from the Obama Administration … would limit the benefit of itemized deductions to 28 percent. ..  Thus, for example, an additional $100 of itemized deductions would save a taxpayer in the 35 percent bracket only $28 rather than $35. The 28 percent limitation on itemized deductions would raise an estimated $288 billion over the next ten years compared with current law …  Relative to current policy, the proposal would raise $164 billion.

The 5.3 million affected households in the top quintile would see their taxes go up by an average of about $2,900. The average tax increase for the 697,000 affected households in the top 1 percent would be about $13,300. Almost all of the tax increase—99.8 percent—would fall on households in the top quintile of the income distribution—those with cash incomes greater than $111,000. …  The top 1 percent would bear 61 percent and the top 0.1 percent would pay a little more than one-third.\”

What about limiting deductibility to 15%?
The Congressional Budget Office does a regular report called \”Reducing the Deficit: Spending and Revenue Options.\” In the March 2011 report, Revenues–Option 7 is \”\”Limit the Tax Benefit of Itemized Deductions to 15 Percent.\” CBO estimates that this change could raise $1,180 billion over the next 10 years relative to current law, which is roughly four times as much as the 28% limitation would raise. The CBO doesn\’t do a distributional analysis, but this change would only affect those who already itemize deductions, and would have by far its largest effect on those with higher incomes.

Of course, there are justifications for the existing tax deductions, and reasons and history behind the justifications, and interest groups behind it all. But in a situation where all the meaningful options for long-term deficit reduction are going to be painful in one way or another, limiting deductibility has some advantages. It would raise revenue from those with higher incomes without increasing the marginal income tax rates, or part of the revenue could even be used to reduce the top marginal rates. Limiting deductibility also reduces the role of the federal government in certain aspects of the economy like providing incentives for greater mortgage borrowing. It should be in the mix of possibilities.

For a related post several weeks ago, see \”Tax Expenditures: One Way Out of the Budget Morass.\”

Tax Expenditures: One Way Out of the Budget Morass?

When seeking to reduce budget deficits, the usual choices are lower spending or higher taxes. But there is a third option, a category-scrambler called \”tax expenditures.\” Basically, this category includes all the ways in which government tax revenues are reduced by deductions, credits, deferrals, exclusions, exemptions, and special preferential tax rates.

Tax expenditures scramble how one thinks about spending and taxes because if they were repealed, they would presumably lead to higher taxes, which seems like a tax increase, but they also would mean that the government is ending a decision to direct resources and intervene in a particular direction, which sounds like a spending cut. Earlier this year, there was a political dogfight over ending the tax breaks for ethanol production: some viewed this as a cut in government \”spending\” for ethanol; others viewed it as a covert tax increase. Because tax expenditures scramble categories, they may offer a politically savvy way to address some of our budget woes. Reducing tax expenditures might offer some revenue to reduce budget deficits, finance lower marginal tax rates, and raise funds for some more important government spending priorities. 

Donald Marron has written a nice overview of these issues in the Summer 2011 issue of National Affairs in \”Spending in Disguise.\” Richard Epstein also takes up this topic in an article in Defining Ideas called \”The Tax Expenditures Muddle.\”

The dollar numbers here are enormous. Each year, the Analytical Perspectives volume of the federal budget presents tables showing the dollar cost of tax expenditures. Here\’s the list from the 2012 budget volume, cropped to include only those provisions which cost the Treasury more than $4 billion in the 2012 fiscal year

There are two obvious problems with using tax expenditures as a policy tool. The first is that the many of the biggest tax breaks are wildly popular. Just look at some of the big ticket items on the list: Exclusion of employer contributions for medical insurance premiums and medical care; Deductibility of mortgage interest on owner-occupied homes; Step-up basis of capital gains at death; Deductibility of charitable contributions, other than education and health; Exclusion of interest on public purpose State and local bonds; Capital gains exclusion on home sales; Deductibility of State and local property tax on owner-occupied homes; Exclusion of interest on life insurance savings; Social Security benefits for retired workers; and so on.

The second issues is that many of these tax expenditures have at least some economic justification. For example, money given to charity can be viewed as not devoted to one\’s own consumption, and thus appropriately outside the scope of taxation. Epstein offers an interesting potential justification for the interest deduction on home mortgages: \”One clear case of a tax expenditure is the interest deduction on a home mortgage. There is no question that interest payments count as expenditures, and thus a reduction to gross revenues. But that expenditure is offset, not quite perfectly, by the consumption value of the home purchased with a home mortgage. A precise economic test would first allow the interest deduction but bring the imputed income attributable from home use into the system, even though it is not a receipt of any kind. But since calculating that imputed income is too costly, the law should follow the simpler rule that treats the consumption enjoyed as a perfect income offset to the interest deduction. In fact in most cases, the consumption value of the home is probably greater than the interest payments on the loan, especially toward the end of the life of the mortgage. Nonetheless, that excess imputed income goes untaxed, because of the insoluble difficulties of its direct measure.\”

Moreover, many tax expenditures are a kind of gamesmanship that can easily go astray. Marron offers a nice hypothetical example: \”Princeton economist David Bradford once offered a simple thought experiment to illustrate how far such games could go. Suppose that policymakers wanted to slash defense procurement and reduce taxes, but did not want to undermine America’s national security. They could square that circle by offering defense firms a refundable “weapons-supply tax credit” for producing desired weapons systems. The military would still get the weapons deemed essential to national security, defense contractors would get a tax cut, and politicians would get to boast about cutting both taxes and spending. But nothing would have changed meaningfully.\”

Despite the political and practical issues, tax expenditures need a close look. They add up to something like $1 trillion each year, which is just too large a total to ignore. Certainly one can make an argument that tax expenditures have contributed to the rapid rise in health care costs over time, because health insurance is for so many people a form of untaxed compensation. One can also argue that tax expenditures have contributed to the roller coaster of housing prices that helped bring on the Great Recession. One can also point out that if the goal is to help people afford health insurance or housing, there are surely more effective and equitable methods than these tax breaks. Granted,  lot of tax expenditures aren\’t attractive political targets, but it\’s not clear to me that they are tougher than Medicare, or defense spending, or tax increases, or any of the other ways of addressing the U.S. budget deficits.