Spending Through The Tax Code
Bruce Bartlett, 05.28.10, 6:00 AM ET
Conservatives are united in their belief that government spends much too much and that spending ought to be cut sharply. But they almost universally ignore de facto spending through the Tax Code even though many tax provisions are functionally identical to spending. These “tax expenditures” not only hemorrhage revenue unnecessarily, but they distort private decision-making, create unfairness and reduce economic growth.
The problem of tax expenditures was first identified in the 1960s by Harvard law professor Stanley Surrey, who went to work for John F. Kennedy in 1961 as Assistant Secretary of the Treasury for tax policy. At that time the top marginal income tax rate was 91%, meaning that reducing one’s taxable income by $1 saved 91 cents in taxes for those in the top bracket, while earning $1 of additional income netted them only 9 cents. For some people it was worth spending 90 cents to reduce their taxable income by $1, which gave rise to many wasteful tax shelters designed to produce nothing except tax deductions.
Obviously, this not only encouraged rich people to mine the Tax Code aggressively for tax loopholes but also to pressure Congress to enact new ones. As a consequence, effective tax rates–those people actually paid in terms of taxes as a share of income–diverged sharply from statutory rates. In effect, the high statutory rates implied that the rich were being soaked, while the reality was that the actual tax rates that they paid were much lower.
There was a widespread perception that many rich people were paying little if any federal income taxes. A popular book during this era was The Great Treasury Raid by Philip M. Stern, who reported the following cases as well as many others: In 1959 five Americans were known to have incomes above $5 million (more than $37 million in today’s dollars) yet paid no income taxes. In 1961, 17 Americans were known to have had an income of $1 million or more ($7.5 million today) without paying any federal incomes taxes. And Mrs. Horace Dodge had her entire $56 million fortune invested in tax-exempt municipal bonds, which paid her an annual income of $1.5 million (more than $11 million today) that she wasn’t even required to report on her tax return.
Surrey had hoped that Kennedy’s big tax initiative would cut rates in exchange for loophole closing. Indeed, it’s now forgotten that Kennedy’s Jan. 24, 1963 message to Congress proposing a big tax cut also included many reforms that were later dropped from the final legislation, which was enacted the following year by Lyndon Johnson and reduced the top rate to 70%.
Surrey was disappointed at the lack of interest in tax reform. He thought that one problem was that no one realized just how many tax loopholes existed, and he had his staff compile a list. It turned out to be a bigger project than anyone imagined, and it took several years to list every tax expenditure and how much they cost in terms of revenue.
Treasury’s first tax expenditure list was released in the last days of the Johnson administration. Treasury Secretary Joseph Barr presented it at a hearing of the Joint Economic Committee of Congress on Jan. 17, 1969. He punctuated his testimony by revealing that in 1967 there were 155 taxpayers with adjusted gross incomes above $200,000 ($1.3 million today) who paid no federal income taxes, including 21 with AGIs above $1 million ($6.5 million today).
This revelation created a nationwide firestorm, leading Congress to enact the Tax Reform Act of 1969, which sharply cut back tax preferences for the wealthy. Richard Nixon signed it into law on Dec. 30 of that year. Among its provisions that still vex taxpayers to this day was the first alternative minimum tax.
The Nixon administration was not thrilled with the idea of tax expenditures. One fear was that it provided a too-convenient shopping list for members of Congress looking for revenue-raisers. Also, the mere fact that something appeared on an official Treasury list of tax expenditures implied that they are all illegitimate and equally so.
Critics quickly pointed a serious problem with tax expenditures–they necessarily had to be calculated with reference to a baseline. In other words, if there were no tax expenditures at all what would the tax system look like? Surrey implicitly adopted an idealized tax system that had been developed in the 1930s by economists Robert M. Haig and Henry Simons. They said that the ideal tax base consisted of all consumption during a year plus the change in net worth.
The Haig-Simons definition of income still underlies tax expenditure analysis–but not completely. Surrey understood that a pure Haig-Simons tax base was impractical, so he made some exceptions to create a “normal” tax system from which to calculate tax expenditures. Under a pure Haig-Simons definition of income, for example, people would theoretically pay taxes on unrealized capital gains yearly, the imputed rent that homeowners pay to themselves for living in their own homes and other forms of income that have traditionally been exempted from taxation.
Thus, Surrey’s definition of income was essentially judgmental, embodying a liberal concept of the appropriate tax base. Conservatives have long argued that pure consumption can be just as easily justified as the ideal tax base, which would eliminate from the tax expenditures list all provisions that defer taxation on saving such as 401(k) plans, Individual Retirement Accounts and so on. Since a consumption tax would not tax saving, any tax preference for saving would necessarily be part of the normal tax system.
Nevertheless, Surrey’s concept of tax expenditures is the one that was adopted, and the Budget Act of 1974 requires the Treasury Department to produce a list annually, which appears in the analytical perspectives volume of the president’s budget. Congress’ Joint Committee on Taxation also compiles an annual list of tax expenditures that differs slightly from Treasury’s owing to some differences in methodology. Both lists show that the largest tax expenditure is the exclusion for employer-provided health insurance, which will reduce federal revenues by $177 billion this year. The second-largest tax expenditure is the deduction for mortgage interest, which reduces federal revenues by $107 billion.
Unfortunately, it’s not really possible to just add up tax expenditures and arrive at a net revenue gain, because they interact with each other in complex ways. But a recent effort to do so by the Tax Policy Center estimated the total cost of tax expenditures at 5.5% of the gross domestic product.
The real problem with tax expenditures is that they tend not to get the scrutiny that spending programs get. Historically, new tax expenditures became permanent parts of the Tax Code and were seldom reviewed for effectiveness. Also, in recent years both parties have supported the creation of many new tax credits that subtract directly from one’s tax liability. Previously, most tax preferences took the form of deductions or exclusions that reduce taxable income.
Tax credits are really just spending disguised as a tax cut. This is literally true in the case of refundable tax credits such as the Earned Income Tax Credit. If someone qualifying for it has no tax liability against which to use the credit, he or she can get a check from the Treasury for the difference.
To see just how similar a refundable tax credit is to direct spending, imagine that instead of having the Defense Department pay $1 billion to Lockheed Martin for some spare parts for the Air Force, it instead gave it a $1 billion refundable tax credit that was tradable. If Lockheed Martin didn’t have at least a $1 billion federal tax liability, it could simply sell the unused portion to another company that did. Either way the company gets paid $1 billion and $1 billion worth of resources are extracted from the private sector for government’s use.
There’s not a tax expert on the left or the right who doesn’t recognize the illegitimacy, inefficiency and ineffectiveness of many tax expenditures. There is a desperate need to clean up the Tax Code, as Ronald Reagan and a Democratic Congress did in 1986. Unfortunately, Republicans now take the view that eliminating any tax expenditure constitutes a tax increase, and they oppose it because they oppose all tax increases for any reason.
When the time comes, as it inevitably will, when raising revenues will be part of a big deficit reduction bill mandated by financial markets, Republicans will really have only two choices: raise tax rates or restrict tax expenditures. Since many of the latter are conceptually identical to direct spending, the choice should be an easy one. Those concerned about our nation’s fiscal future should be focusing as much attention on tax expenditures as they do on the spending side of the budget.
Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Action and The New American Economy: The Failure of Reaganomics and a New Way Forward. He writes a weekly column for Forbes.