CBPP: Tax Expenditures Are Ripe for the Picking

Tax expenditures have been a hot topic lately as a way to raise additional revenue for a deficit reduction plan that could replace sequestration. Recently, Sen. John McCain (R-AZ) said he would be willing to consider several "revenue closers" (or tax expenditures) in a compromise, and reforming tax expenditures has been proposed by the White House as well.

This isn't surprising given the gains from tax reform. Yesterday, the Center on Budget and Policy Priorities released a new paper from Chuck Marr, Chye-Ching Huang, and Joel Friedman that makes the case for reforming tax expenditures as part of a deficit reduction package. They also go into some specific ways on how it should be done. First, they argue:

Tax expenditures are ripe for reform: they are costly, reducing revenues by over $1 trillion annually, and they are often poorly designed for achieving their desired policy goals. In many cases, there is little difference between benefits or subsidies provided through the tax code and benefits or subsidies provided through the spending side of the budget. So efforts to reduce spending should also address spending in the tax code. Further, tax expenditures tend to provide a disproportionate share of benefits to households higher up the income scale.

Of course, one would find very few economists and tax experts who would disagree with that statement. So what should be done about it?

The authors group their preferred solutions into two types. The first is a broad-based limitation on tax expenditures, similar to ones we talked in a recent paper on raising revenue from high earners. Specifically, they mention limiting the value of deductions and exclusions to 28 percent, limiting the amount of deductions a taxpayer can take, and limiting the value of certain tax expenditures. All three methods would likely represent progressive changes to the tax code -- although that would depend on the design -- but CBPP prefers the first option, since it would maintain incentives at the margin for preferences involved with these limits. We have also talked about ways in which marginal incentives could be preserved in the other two limits albeit at the cost of reduced revenue.

The second solution the CBPP discusses is closing loopholes or reducing tax expenditures that allow high-earning taxpayers to substantially reduce their tax burdens. They discuss in more detail five of these tax provisions:

• Carried interest: Private equity fund managers typically receive a management fee plus 20 percent of the fund's profits (the latter being "carried interest"). The fee is taxed as ordinary income, but the carried interest is taxed at lower capital gains rates. Many analysts would argue that the carried interest is more like ordinary income, since it is compensation for managing a fund rather than the return on capital that the manager has invested.
• Like-kind exchanges: Like-kind exchanges are a way to defer capital gains taxes. If a property is held for business or investment proposes, it can be exchanged for similar property, hence the name "like-kind exchange." For example, almost all land exchanges can qualify as like-kind even if they have very different values. Thus, these exchanges can function as a way of avoiding paying capital gains taxes.
• Valuation discounts: Valuation discounts are used to reduce estate tax liability. They reduce the value of assets that are hit by the estate tax by placing temporary restrictions on their usage. This depresses the value of those assets for estate tax purposes while eventually allowing heirs to make full use of the assets at a later date.
• S corporation loophole: S corporations are a form of corporation that does not pay the corporate income tax; rather, it passes through the income to its owners, who are then taxed at the individual income tax. However, these profits are not hit by payroll taxes. S corp owners are supposed to report "reasonable compensation" to themselves, income that is subject to payroll taxes, but this rule has not seemed to adequately serve its purpose. Proposals to close this loophole would instead subject both compensation and S corporation profits to payroll taxes.
• Inside buildup: Cash value life insurance is a type of life insurance that not only pays out death benefits, but also invests premium payments to build up investment earnings. This "inside buildup" is not taxed until the policy is cashed out and may actually be never taxed if the proceeds are paid out upon death or if they are used to pay the policy's premiums. These provisions offer a distinct tax advantage to these type of life insurance policies.

The authors also mention other provisions, such as international tax loopholes and the tax treatment of derivatives that could be targeted. Many of these options are also ones we highlighted in our large table of revenue-raising options.

We agree with CBPP that tax expenditures should absolutely be part of the discussion. Many of these tax breaks make the tax code complex, economically distortionary, and unfair. There is certainly a lot of room for reform in both the ways they described and in other ways, such as reforming the largest tax expenditures in the code.