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Thursday, July 14, 2011

Tax Expenditures?

As I wade through all the budget rhetoric of late, a term keeps popping up: “tax expenditures.” Unfortunately, a citizen would be wrong if he or she assumed these were expenses paid with our taxes. Tax expenditure is actually wonky jargon for the opposite.

It is actually tax revenue that is not collected through the provisions of our tax laws that allow deductions, exclusions, or exemptions from a taxpayers' taxable expenditure, income, or investment, deferral of a tax liability, or preferential tax rates. Don’t get a headache; think loophole, but not corporate perks or private jets variety. Here are some commonplace examples: the largest is employer contributions for health insurance and care ($184 Billion), in second place, the deduction of home mortgage interest ($96 Billion), and in fourth, 401K Plans ($68 Billion). For FY2012 the CBO has identified 137 “tax expenditures” and they add up to a whopping $1.2 Trillion in federal revenues forgone. To put this in perspective, the total forecast collections of the federal government for the same period are $2.6 Trillion. Thus, the deductions, credits etc. are not small potatoes; they represent almost 50% of what the net collections are.

It’s easy to see how we got here. If you are a politician with a position that you would like to promote, it’s much easier to sell us on the idea of a deduction or a credit than to tell us that we are going to have to actually pay for your priority.

Let’s look at something close to home: the mortgage deduction. This tax expenditure is regressive and expensive, what is sometimes referred to as an “upside down subsidy” because it helps the relatively well off to reduce their taxes. Much academic research suggests that it does not promote home ownership, instead encourages households to acquire bigger mortgages and larger homes. At some point it might have been a good idea, but how do you withdraw the benefit? Multiply this dilemma 137 times and you start to understand the mess we are in.

A more perverse aspect to this is “tax rate inflation.” Because so much income has a tax preference, what’s left must be taxed at a higher rate in order to raise the required revenues. As rates increase, tax avoidance behavior becomes more rational, adding yet another drag on productivity.

We need more debate about “tax expenditure,” and how we can wean ourselves off this dangerous drug. We need to jettison the confusion in favor of low rates over a much broader income base.  

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