The tax break state

June 1, 2013

Everyone always talks about the welfare state. But to understand who really wields power in Washington and what they actually want, you need to understand the tax break state.

Luckily, the CBO released a major report this week breaking down tax expenditures (which is the boring, but more precise, term for tax breaks). Wonkblog’s Dylan Matthews already went through the major charts of the report (with other, slower Web sites catching up later). But to get a sense of the size and importance of these things, consider this: The top 10 tax expenditures total about $900 billion a year. Over half of them go to the top 20 percent of households. About a third go to the top 1 percent.

The easiest way to understand the tax break state is to think of it in three clusters: (1) tax credits that boost the earnings of those in the bottom half of the income distribution, (2) tax deductions and exclusions that boost the middle class and upper-middle class, and (3) the exclusion of capital gains and dividends from income taxation, which goes to the top 1 percent.

The first group includes the two tax credits that disproportionately benefit those in the lower half of the income distribution. There’s the earned income tax credit (EITC), which boosts the income of low-wage workers, particularly those with kids. Of this expenditure, 51 percent  goes to the bottom 20 percent of households. Then there’s the child tax credit, 77 percent of which goes to the bottom 60 percent.

The second group includes the deductions and exclusions from taxable income that go to the middle and upper-middle class. (I’m using middle class here to denote not the median person, but the college-educated white-collar worker with benefits in the top half of the income distribution.) The big deductions and exclusions are centered on the two staples of American middle-class life: a home mortgage and health insurance through your employers. A third important one is the deductibility of state and local taxes.

These programs become more valuable if you make more money. Unsurprisingly, richer folks tend to have bigger houses, a higher top tax rate and more generous health insurance. The result is that they get more from these tax breaks: Sixty percent of the health insurance break goes to the top 40 percent of households, while more than 70 percent of the mortgage and state/local taxes deductions go to the top 20 percent of households.

The last group is the preferential tax rates on investment income. Income from capital gains and dividends is taxed at lower rates than other types of income. Since the ownership of capital assets is concentrated at the very top of the income distribution, so are the gains. Sixty-eight percent of this expenditure goes to the top 1 percent of households.

Many of the recent policy debates are actually about how and whether to change the tax break state. Take the 47 percent meme. Rather than a random slip by Mitt Romney, the fact that 47 percent of Americans don’t pay federal income taxes is a major concern for many conservatives. But they’ve been freed from the federal income tax in large part by the tax credits that go to the bottom 40 to 60 percent of Americans. Those tax credits were expanded under both George W. Bush and President Obama. And soon there will be even more of them. Starting in 2014, Obamacare introduces new tax credits to subsidize health care premiums; according to the CBO these will equal 0.4 percent of GDP and mostly benefit the lower and middle quintiles.

If you are the type of person who can feel nostalgia for things that just happened, perhaps you remember last year’s Wonkblog coverage of whether Romney’s tax plan could “work.” It was impossible, because there weren’t enough tax expenditures going to the top 1 percent to balance cutting their taxes by the amount he wanted. That was because it excluded the tax expenditures for capital income, or the ones that primarily go to the top 1 percent.

While Romney and Paul Ryan hinted at expanding this tax expenditure that the top 1 percent mostly takes home, Obamacare collapsed it a bit with a new surtax. Starting this year, a new, 3.8 percent tax will be charged on investment income, starting at $200,000 for single filers and $250,000 for joint filers (CBO notes 91 percent of it will fall on the top 1 percent). This surtax, as the CBO notes, “effectively reduces the preferential rate on dividends and capital gains.”

Meanwhile the government is very responsive to the interests of the top 20 to 40 percent of Americans, and so far it has been very difficult to approach scaling back the tax expenditures in deductions and exclusions. Again, since these benefits scale with income, these tax expenditures disproportionately benefit those up the income scale.  Obama’s signature proposal for raising taxes right now is limiting the value of these itemized deductions and expenditures for couples making more than $250,000 a year to just 28 percent.

This, then, is the fight in American politics. Democrats want to expand the tax break state for the poor and cut it for the rich. Republicans want to keep it for the rich, or possibly use it to lower tax rates on the rich, but they’re uncomfortable with the part of the tax break state that benefits the poor. Although shrouded in arcane tax terminology, this is one of the most important battles over who will benefit from our economic progress, and how.

Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.

Correction: The graph that initially accompanied this post was incorrect. It's been fixed.

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