The number of tax breaks has nearly doubled since the last major tax overhaul 25 years ago, with lawmakers adding new benefits for children, college tuition, retirement savings and investment. At the same time, some long-standing breaks have exploded in value, such as the deduction for mortgage interest and the tax-free treatment of health-insurance premiums paid by employers.
All told, federal taxpayers last year received $1.08 trillion in credits, deductions and other perks while paying $1.09 trillion in income taxes, according to government estimates.
Only about 8 percent of those benefits went to corporations. (The write-off for corporate jets equals about .03 percent of the total.) The bulk went to private households, primarily upper-middle-class families that Obama has vowed to protect from new taxes.
“The big money is in the middle-class subsidies,” said Syracuse University economist Leonard Burman, former director of the nonpartisan Tax Policy Center. “You’re not going to balance the budget by eliminating ethanol credits. You have to go after things that really matter to a lot of people.”
These tax breaks weave an invisible web of government benefits that now costs nearly as much as the Pentagon and all other federal agencies combined. But “tax expenditures,” as they are known in Washington, get no routine oversight. Congress and the Treasury Department both track them but use different rules to count them and estimate their value. The congressional Joint Committee on Taxation lists more than 300 breaks, while Treasury tallies 172.
No one regularly assesses whether tax expenditures accomplish the goals they were created to serve. Yet, with the rise of an ideology within the Republican Party that shuns big government and vilifies taxes, they have become virtually untouchable.
For those reasons, the tax code is a popular venue for both parties to pursue costly policy goals.
Edward Kleinbard, a University of Southern California law professor who served until recently as chief of staff to the Joint Committee on Taxation, says tax breaks are now the dominant instrument for creating new spending programs. Policymakers can give taxpayers a government benefit and get credit for lowering their tax bills — a combination lawmakers find “irresistible,” Kleinbard said, because they can portray themselves as tax cutters rather than big spenders.
Every president since Ronald Reagan has learned that lesson. In 1997, after a Republican Congress refused to increase spending for federal student loans, President Bill Clinton turned to the tax code to create a slew of higher-education credits. Initially worth around $10 billion a year to the nation’s college students, those benefits have been expanded to more than $20 billion annually.
Similarly, when President George W. Bush wanted to help victims of the Sept. 11, 2001, attacks, he turned to the tax code. He backed the Victims of Terrorism Tax Relief Act, which wiped out two years of tax liability for survivors and created a continuing exemption for annuities paid to families of public-safety officers killed in the line of duty. Estimated 10-year price tag: $360 million.
In 2009, when Obama wanted to boost the flagging economy, he offered a massive new tax break as the centerpiece of his stimulus package. The Making Work Pay credit put about $60 billion a year in people’s pockets in 2009 and 2010, including $18 billion in “refundable” payments to low-income families whose tax bills were so small that the government had to write them checks to make sure they received the full value.
This week, Obama is expected to offer an outline for revising the tax code to weed out special tax breaks. At the same time, he is pressing Congress to create several more. His $447 billion jobs package includes a $4,000 credit for hiring people who have been out of work more than six months and a $5,000 credit for hiring returning war veterans.
Administration officials say targeted tax cuts are an easy way to quickly put money in people’s pockets. But they also acknowledged the political reality that lawmakers are more inclined to support a plan that cuts taxes than one that increases spending.
Hard benefits to break
Once a tax break is ensconced in the code, it is hard to dislodge. Beneficiaries become fierce defenders, as do anti-tax conservatives, who view the end of a tax break as an impermissible hike in overall tax collections. About 95 percent of Republicans in Congress, and a few Democrats, have signed a pledge circulated by GOP strategist Grover Norquist vowing to “oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.”
The pledge, which Norquist has been circulating for 25 years, promotes “a nonsensical debate that says we’re not going to talk about spending in the tax code like we talk about other spending,” said Eugene Steuerle, an architect of the 1986 tax overhaul while working in the Reagan Treasury Department and now a senior fellow at the Urban Institute. “Spending in the tax code is granted a superior status, and if you get rid of it, it’s called a tax increase.”
Simply limiting the cost of a tax break can be politically perilous. Norquist’s group, Americans for Tax Reform, recently issued what it called a “comprehensive list of Obama tax hikes.” Among the items: The reversal of a 2003 Internal Revenue Service ruling that allowed people to use pretax health spending accounts to pay for over-the-counter drugs. The group has dubbed the change the “medicine cabinet tax.”
Even temporary tax breaks have proved remarkably resilient. Congress routinely passes a “tax extender” bill that renews a host of expiring provisions worth about $30 billion a year. One of the most expensive: a break for residents of states that levy no income tax, including Texas and Florida. Congress has agreed to let them deduct sales taxes instead, at an annual cost to the Treasury of about $1.8 billion.
Congress generally renews the breaks for a year or two, preserving the illusion that they are temporary. But of dozens of breaks created since 1986, lawmakers have permitted just 18 major ones to expire, according to a recent Joint Committee report. Half were stimulus measures enacted by Bush and Obama during the recent recession.
Making Work Pay is among the fallen. But before it expired in December, Congress replaced it with a more generous provision that reduced payroll taxes by two percentage points this year. The payroll tax holiday will put an estimated $80 billion in workers’ pockets — a perk that comes on top of the breaks that reduce their income tax bills.
Combined with traditional rate cuts in 2001, proliferating tax breaks have left people at all income levels paying a shrinking share of their earnings in income taxes, the primary federal revenue source. Nearly half of all households no longer pay any income tax. Meanwhile, a middle-income family of four paid just 4.7 percent of its income, on average, to the IRS last year, according to the Center on Budget and Policy Priorities — the third-lowest percentage in 50 years.
If policymakers hope to raise enough cash from tax loopholes to help tame the nation’s debt, tax experts say individual taxpayers will have to pay more.
Even the Bush tax cuts of 2001 and 2003, while infamous for providing disproportionate benefits to the rich, showered far more money in absolute terms on the middle class. The legislation doubled Clinton’s child credit, wiped out the marriage penalty for joint filers and expanded refundable credits. Of the approximately $4 trillion that would be lost if the Bush cuts stayed in place through the next decade, only about $800 billion would go to the wealthiest households making more than $250,000 a year, according to government estimates.
Georgetown University law professor John Buckley recently estimated that 95 percent of the revenue lost to tax expenditures is concentrated in 10 categories that aid families and advance popular policy goals. The “special-interest stuff,” he said, such as write-offs for corporate jets, is minuscule by comparison — “unless we’re all special,” he said.
In the mid-1980s, Reagan administration officials and a Democratic Congress also confronted a tax code eroded by multiplying tax breaks. They concluded that costly breaks, such as a credit that encouraged people to shelter income in unprofitable investments, were keeping tax rates artificially high for everyone.
The resulting overhaul was the most extensive in U.S. history. It repealed or modified dozens of tax expenditures, trimming their overall cost by nearly 40 percent. The resulting savings were not directed to deficit reduction, but used to lower rates across the board, pushing the top rate down from 50 percent to 28 percent.
Huge breaks survived, however. People could still get health insurance from their employers without being taxed, a benefit that originated with wage controls during World War II. And while taxpayers could no longer deduct interest on credit cards, they kept the break for mortgage interest. Policymakers did not want to hurt the real estate and construction industries, and they theorized that the break would continue to encourage people to buy homes.
Burman, then a junior staffer at the Treasury Department, said he warned that it would also encourage people to shoulder ever-larger mortgages. When the housing bubble burst in 2006, he said, “instead of getting into trouble with Visa and MasterCard, people lost their homes.”
The breaks for health insurance and mortgage interest are the most valuable tax expenditures on the books, worth a combined $260 billion this year. They have soared in value, helped along by the increasing size of mortgages and the cost of health insurance.
But a recent effort to cap the value of the health-care exclusion was abandoned amid complaints from labor union officials, who have for years traded wage increases for richer health benefits. Democrats instead enacted a tax on insurers that sell high-cost policies, a provision some lobbyists predict will be further watered down before it is scheduled to take effect in 2013.
Meanwhile, top tax aides said the new debt-reduction “supercommittee” on Capitol Hill could look at capping the mortgage deduction or disallowing it for second homes. Neither is likely, however, and no one has expressed interest in ending the deduction for the vast majority of homeowners.
Caps on spending
After 1986, the tax code emerged leaner and more efficient. But as Norquist began circulating his anti-tax pledge to protect the changes, Congress decided to tackle rising budget deficits by imposing strict caps on spending.
With no place else to go, lawmakers — particularly Democrats — latched onto the tax code as a vehicle for new initiatives.
Buckley, who served until last year as chief Democratic tax counsel on the House Ways and Means Committee, said it started in 1986 with the low-income housing credit for developers and investors. As Reagan’s budget cutters were slashing direct spending on housing, Rep. Charles B. Rangel (D-N.Y.) won bipartisan support for the credit, which quickly became a primary source of financing for housing construction and rehabilitation.
The trend accelerated under Clinton, who found Republican lawmakers far more willing to finance his priorities in the form of tax cuts than as new spending. While Clinton ended traditional welfare programs, he shifted chunks of the social safety net to the tax code, creating an array of benefits for families, including a new credit for every child younger than 17.
“Politically, it was easier to get tax cuts dedicated to a purpose than to get spending dedicated to the same purpose,” said former Obama economic adviser Lawrence H. Summers, who also served as Clinton’s Treasury secretary.
The child credit and the Earned Income Tax Credit, a break for the working poor enacted in 1975, are now two of the federal government’s biggest anti-poverty measures, far larger than the modern welfare program, or even food stamps.
For Clinton, the Taxpayer Relief Act of 1997 had another advantage. It let him make good on a pledge to cut taxes for the middle class without enacting a more expensive rate reduction, said Eric Toder, who served in Clinton’s Treasury Department and is now co-director of the Tax Policy Center. Other Democrats took note.
“If you look at the [Al] Gore campaign or the Obama proposals, just about all their tax cuts are increased tax expenditures,” Toder said. “They really viewed this as the way to give tax cuts to the middle class.”
Rather than tackling these breaks one by one, experts such as Kleinbard and Harvard economist Martin Feldstein, a senior Reagan White House adviser, last week counseled Congress to eliminate or cap all tax breaks for everyone.
Obama has advanced a similar idea that would limit itemized deductions for families earning more than $250,000 a year. But lawmakers have repeatedly rejected it, fearful of antagonizing the industries and charities that benefit, as well as taxpayers themselves.
Kleinbard calls tax expenditures “the sacred tax cows.” But to tame the debt, he said, at least some of them must be led to slaughter. “There’s just no other way to make the numbers work.”