The other way to look at these credits and deductions is that they’re essentially government spending programs in disguise. After all, if these deductions didn’t exist, then either the deficit would be smaller or everyone else could pay fewer taxes. A tax credit that subsidizes the construction of affordable housing is no different than an explicit grant to do the same thing.
In Washington, however, tax expenditures generally aren’t considered spending programs. They’re considered tax breaks. And, as a new NBER paper by Len Burman and Marvin Phaup details, this view has had enormously perverse consequences over the years. Politicians always prefer tax breaks to new spending programs. So Congress ends up enacting a disproportionate amount of social policy through tax credits and deductions, the paper said, and that, in the end, can actually lead to higher taxes and bigger government than would otherwise be the case.
Burman and Phaup found that total U.S. tax expenditures will amount to $1.2 trillion in fiscal year 2011. That’s much, much larger than non-defense ($671 billion) or defense ($744 billion) discretionary spending. In other words, there’s a huge pool of federal spending that Congress doesn’t even consider to be spending. As the authors noted, “excluding income tax expenditures causes spending to be understated by about one-third.” Here are the 10 biggest tax expenditure programs for fiscal year 2011:
In a phone interview, Burman, a former top tax official in President Clinton’s Treasury Department, laid out his argument at greater length. “The policy process is biased in favor of tax expenditures,” he notes. “The data shows that new programs are more likely to be run through tax expenditures than spending agencies like HHS [Health and Human Services] or HUD [Housing and Urban Development].” And that’s a problem. For one, these programs are often more inefficient than outright grants would be—nonprofits, for instance, often have to work with outside investors in order to collect the credit.
Second, the bias toward making policy through the income tax code means that the IRS now oversees an enormous chunk of the policy process. But, Burman notes, the IRS hasn’t been given the additional resources to handle all this new responsibility. And the IRS isn’t better suited to direct, say, affordable-housing policy than HUD is.
Deficit hawks have often advocated tax-reform policies that would wipe out a lot of the deductions and credits. Some of these programs would no doubt stay. Maybe Congress would keep the mortgage-interest deduction or the tax break for 401(k)s. Fair enough. But there are $1.2 trillion in tax expenditures—if Congress is looking to cut the deficit, there’s no reason we should only be looking at traditional spending programs. The Bowles-Simpson commission found that by trimming a variety of tax expenditures, we could slash the deficit and reduce overall tax rates.
One obstacle, of course, is that Republicans would have to agree that cutting tax expenditures doesn’t entail hiking taxes. The other problem, though, is that tax reform isn’t enough. After all, the Tax Reform Act of 1986 eliminated a wide variety of tax expenditures and lowered overall rates. But the basic dynamic didn’t change. Congress still had a bias toward tax expenditures. “Lobbyists actually love it when Congress does tax reform,” Burman says, “because they have new space to lobby for tax perks.” Indeed, since the 1986 tax reform, Burman and Phaup found, the number of tax expenditures has increased by more than 58 percent.
The only lasting solution, Burman and Phaup conclude, would be to formally count tax expenditures the same way regular spending gets counted. Have the CBO score tax deductions as increased spending. Include credits and deductions on the spending side of the budget ledger. “The ideal thing would be to integrate tax expenditures into the budget process,” Burman notes. When Congress examined housing policy, it wouldn’t just look at HUD’s budget in isolation, but also consider the variety of vouchers and credits and deductions in the tax code that are geared toward housing. “That might be the most controversial thing we propose in the paper,” Burman concedes. But, he adds, the current method of pretending that tax expenditures somehow aren’t really spending makes for a lot of distortions in the policy process.