Warning to budget mavens: ‘Tax expenditures’ may yield less than expected
“Don’t forget, there are 180 tax expenditures in this tax code, which are really tax earmarks, which are really spending by any other name, and you get rid of those and start picking them off, and you can save billions and billions of bucks.”
— Former U.S. senator Alan Simpson (R-Wy.), Aug. 18, 2011
It’s sometimes seen as the holy grail of revenues — a huge pot of money hidden in the tax code, ready to be exploited to rebalance the gap between spending and revenues.
We’re talking about “tax expenditures,” which include everything from the home mortgage deduction for homes to tax credits for college loans or energy-efficient vehicles. In the past 20 years, scores of such provisions have popped up in the tax code, in part because it has been easier to win approval for tax cuts than new spending programs. Some people, such as Simpson above, argue that these really are spending programs in disguise, though he overstates the case when he calls them “earmarks,” which are generally targeted to a small number of people. Millions of Americans benefit from these provisions.
In fact, one study by the Center for Budget and Policy Priorities concluded that if the estimated $1 trillion revenue loss from tax expenditures were counted as a spending item, then it would dwarf the annual spending for Medicare and Medicaid ($719 billion), Social Security ($701 billion) and national defense ($689 billion).
It sounds like a lot of money. But some caveats are in order before people can put this in the bank, including the new “super committee” of lawmakers tasked to find ways to cut more than $1 trillion from the deficit in the coming months.
Virtually every budget analysis – Republican, Democrat or bipartisan — treats the revenue-loss estimate as similar to spending estimates. But it is a mistake to assume that simply eliminating a tax expenditure will result in that revenue loss being returned to the Treasury. Individuals react to the tax code in different ways, and the elimination of a provision promising tax savings doesn’t mean people won’t find other ways to keep that money out of the government’s hands.
The revenue estimate, in fact, is merely a snapshot of the benefit that taxpayers are getting at that moment. Even if you argue that the tax benefit is a subsidy (the savings on mortgage interest could be seen as a subsidy to encourage home buying) it is still not the same as cutting a check to someone to buy a house.
The nonpartisan Joint Committee on Taxation, in its annual report on tax expenditures, makes this quite clear. We normally do not quote such a long section from a report, but because this point is often ignored, we decided it was worth highlighting.
Tax Expenditures versus Revenue Estimates
A tax expenditure calculation is not the same as a revenue estimate for the repeal of the tax expenditure provision for three reasons.
First, unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision.
Second, tax expenditure calculations are concerned with changes in the reported tax liabilities of taxpayers. Because tax expenditure analysis focuses on tax liabilities as opposed to Federal government tax receipts, there is no concern for the short-term timing of tax payments. Revenue estimates are concerned with changes in Federal tax receipts that are affected by the timing of all tax payments.
Third, some of the tax provisions that provide an exclusion from income also apply to the FICA [Social Security] tax base, and the repeal of the income tax provision would automatically increase FICA tax revenues as well as income tax revenues. This FICA effect would be reflected in revenue estimates, but is not considered in tax expenditure calculations. There may also be interactions between income tax provisions and other Federal taxes such as excise taxes and the estate and gift taxes
In other words, while the revenue loss might be calculated, the revenue gain from eliminating the tax provision is more questionable. There may be less money in these provisions than expected.
This point is also made in one of the most comprehensive examinations of tax expenditures, which was published in the American Economic Review in 2008:
Tax expenditure estimates are “static,” meaning they assume no change in economic behavior if they were eliminated. This means that tax expenditure estimates may be much larger than revenue estimates for eliminating a particular provision. They also could provide a misleading estimate of the cost of a direct spending program alternative because they do not account for the fact that an equivalent spending program would frequently produce income that would itself be subject to tax.
Secondly, the biggest tax expenditures happen to be very popular. Sen. Orrin Hatch (R-Utah), in a series of speeches on tax expenditures in July, produced a chart that highlighted the biggest, based on JCT data. Some 65 percent of the tax expenditures come from the top 10, including employer-provided health care (13 percent), home mortgage interest deduction, exclusion of Medicare benefits (7 percent), earned income tax credit (5 percent) and the deduction for state and local taxes (5 percent). All of these provisions have substantial constituencies and enjoy popular backing, so eliminating them or even scaling them back may be difficult.
Third, there’s the question of who benefits from these provisions, the rich or the poor. Hatch, using JCT data of some of the biggest revenue-losers, produced a chart showing that some (such as the earned income credit, the education credit and student loan interest) went almost exclusively to people making less than $200,000 — President Obama’s cut-off for tax increases.
Others, however, also have crunched the numbers and found that most of the money saved goes to the wealthiest Americans (who pay the largest share of taxes.) That’s largely because wealthier people are in higher tax brackets, so reductions in their taxable income (such as with itemized deductions) result in a bigger windfall than people in lower tax brackets. “Tax expenditures in the aggregate are a larger share of income, but a smaller share of taxes paid, for high-income taxpayers than for those with low incomes,” the 2008 study concluded.
The Bottom Line
All of these factors — the uncertainty of the revenue to be gained, the popularity of the biggest provisions and the need to balance the equity of any cuts — suggests that the potential windfall could be much less than some of the figures tossed out by some public figures. (We aren’t trying to single Simpson out — that’s why there is no Pinocchio Test — but his statement is fairly typical.)
One interesting proposal, advanced by Martin Feldstein, Daniel Feenberg and Maya MacGuineas, would cap the total value of tax reductions that a person could take to just 2 percent of adjusted gross income. Their research suggests that such a cap would raise $278 billion in 2011, and it would encourage 35 million Americans to shift from itemized deductions to the standard deduction, thus simplifying their taxes. It might also be easier to implement than trying to eliminate or scale back some of these popular provisions.