Taking a Hatchet to Tax Expenditures

The good folks at the Tax Policy Center have written yet another enlightening report on tax expenditures. This one, titled, "Curbing Tax Expenditures" analyzes the current mess that is the tax expenditure "budget". Tax expenditures -- the various credits, deductions and loopholes that are littered throughout our tax code -- tend to be expensive, regressive, and economically distortionary. Their existence comes at the expense of less debt and lower marginal tax rates.

In their paper, TPC largely focuses on the distributional impact of tax expenditures. They explain that while the average household saved $6,500 in 2011 because of tax expenditures, a household in the top one percent saved an average of $220,000.

This paper then reviews a number of policy changes aimed at cutting certain tax expenditures across the board. Rather than focus on every tax expenditure, TPC focuses on seven of the largest tax expenditures -- the mortgage interest deduction, charitable deduction, state and local tax deduction, deduction for medical expenses, exclusion for employer provided health insurance, and preferential treatment for capital gains and dividends. Together, these tax expenditures account for 40 percent of total tax expenditure costs.

TPC then examines three possible reforms:

• Replacing each tax expenditures with a 15 percent credit (for capital gains and dividends, this would result in a 15 percent rate differential).
• Limiting the total individual value of these tax expenditures to 3.9 percent of income (similar to the Feldstein, Feenberg, MacGuineas Proposal).
• Applying a 39 percent across the board haircut to each tax expenditures.

Each of these cuts are meant to have the same effect on change in tax burden (which is measured statically*), though because of behavioral effects they raise different amounts of revenue. The conversion to the 15 percent credit would have the largest impact over the 2012-2021 time frame ($2,769 billion), followed by the 39 percent haircut ($2,426 billion) and then the 3.9 percent cap ($2,407 billion). On average, these policies would increase revenue in 2021 by about 1.5% of GDP.

TPC also looks at the distributional effects of each of these policies.  Although each plan would reduce average after tax income by about the same amount (on a static basis*), they would have difference effects up and down the distribution ladder. In each case, though, the reduction in tax expenditures falls most heavily on the top twenty percent of earners -- and especially on the top one percent:

Overall, this latest TPC analysis offers even more insight into various ways we can reform our tax code to generate revenue and reduce the distortions created by tax expenditures. Rather than cutting across the board, a better policy would be to completely reform the tax code by making decisions on how to treat each individual tax expenditure -- and using the money to both reduce the deficit and provide rate reduction and simplification. As TPC explains:

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.

Let's hope 2012 is the year for tax reform.

^{*As TPC explains: "Incorporating most forms of behavioral response in distributional estimates of tax changes can misrepresent the actual impact of the changes. For example, a reduction in the tax on realized capital gains would likely induce investors to realize more gains, resulting in their paying more tax than if they did not change their investment activity. A large enough increase in realized gains could result in their paying more total tax and thus appearing to be worse off, despite the fact that a lower tax rate would make them unambiguously better off. Ignoring behavioral change in analyzing the distributional effects thus yields more accurate conclusions."}