Tax Expenditures

From Leonard E. Burman, Marvin Phaup, “Tax Expenditures, the Size and Efficiency of Government, and Implications for Budget Reform,” NBER Working Paper 17268. (ungated early draft here):

One possible explanation for the difficulty in controlling the budget is that a major component of spending—tax expenditures—receives privileged status. It is treated as tax cuts rather than spending. This paper explores the implications of that misclassification and illustrates how it can lead to higher taxes, larger government, and an inefficient mix of spending (too many tax expenditures). The paper then suggests options for reform to the budget process that would explicitly incorporate and properly measure tax expenditures. It concludes by considering ways to control tax expenditures (and other spending) and the special challenges presented by tax expenditures.

The paper is quite illuminating, even for those of us who know about tax expenditures. The authors note:

Tax expenditures are large relative to other spending. (Table 1). Income tax expenditures
will amount to about $1.2 trillion in fiscal year 2011 based on US Treasury estimates. That is
significantly larger than nondefense or defense discretionary spending. Tax expenditures would
roughly equal total discretionary spending were it not for the extra outlays authorized in an effort
to boost the economy out of recession. Overall, income tax expenditures are one-quarter of total
spending, or about 8 percent of GDP. Put another way, excluding income tax expenditures
causes spending to be understated by about one-third.

There are three main points I want to stress (there are many in the paper that also merit discussion, but these are of greatest interest to me in terms of fiscal consolidation):

  • Total tax expenditures exceed total discretionary spending (defense and nondefense).
  • Total tax expenditures exceed total net individual income tax revenue for FY2011.
  • Exclusions for employer sponsored health care and for mortgage interest are the two largest components of tax expenditures.

    These points are illustrated in these three tables from the paper.


    Table 1: from Burman and Phaup (2011).


    Table 2: from Burman and Phaup (2011).


    Table 3: from Burman and Phaup (2011).

    In this context, it is truly amazed at the recalcitrance of certain policymakers in allowing for some revenue increases. I’m not advocating elimination of all tax expenditures, but one has to consider the implications of retaining the current panoply of measures, given the current state of tax revenues. (Acharya, Richardson, van Nieuwerburgh, and White discuss the the economic implications of the mortgage deduction in an op-ed in yesterday’s NYT.


    Figure 1: Federal current expenditures, line 20, BEA Table 3.2 (red) and sum of Federal tax receipts and social program contributions, lines 2 and 11, BEA Table 3.2 (blue), both divided by GDP. Solid black line is linear trend over period EGTRRA and JGTRRA in place. All raw figures in billions of $, SAAR. Numbers are ratios to GDP for 2011Q1 (2011Q2 tax revenues not available). NBER defined recession dates shaded gray. Dashed lines at 2001Q1 and 2009Q1. Source: BEA, 2011Q2 advance release, NBER, and author’s calculations.

    A realistic approach to dealing with our debt situation requires that increased tax revenues accompany spending cuts.

  • 19 thoughts on “Tax Expenditures

    1. A.West

      Very good. Let’s pare back government to the defense of individual rights, enstate a flat tax or national sales tax, get rid of the incredibly complicated current tax system, and let individuals on the free market choose their own healthcare, eductaion, retirement spending, and pay fees for roads, mail, etc.
      Voila, no more “tax expenditures,” and government would become much more efficient. It may not be a favorable development for state-employed educators who love big government, however.

    2. W.C. Varones

      I agree that loopholes are a big problem.
      So does Krauthammer.
      I would take Krauthammer’s offer of revenue-neutral loophole-closing matched with rate cuts, and then could probably agree to rate increases from there in exchange for real spending cuts.
      It does illustrate rather well how horrible our spending problem is, though, that you could close all ten of those loopholes — including taking away everyone’s 401(k)s, mortgage deductions, and health care exclusions, and you still wouldn’t even cut the deficit in half! That’s how bad the Obama deficits are. Not to mention the contractionary effects of closing all those loopholes.
      What a fine mess these Keynesians have got us in.

    3. Bryce

      The horses are already out of the barn, but it is worth noting that “Exclusion for employer-sponsored health ins” & “Mortgage interest deduction” have played huge roles in creating our grossly distorted situations in healthcare & housing.
      Govt subsidy is so often poison in the fullness of time.

    4. Bruce Hall

      Spending cuts are a euphemism for “spending less than the increases we projected.” Spending cuts will be real when the Federal government spends less… in absolute terms… than it did in 2007 before the recession began.
      The number of jobs is less than 2007. The value of housing is less than 2007. But, for Obamaniacs, the government should tax more to match the spending “decline” from the really great increases they wanted.

    5. Steven Kopits

      The health care exclusion is a bit of policy at the heart of our distorted system. Removing it would be the best way to balance the budget and bring greater efficiencies to healthcare provision.
      Agree to limit Fed govt spending to 20% of GDP, and take away the health care exclusion. That’s a workable deal.

    6. JBH

      By far, the number one way to resolve the debt problem is economic growth. Economic growth will increase only when impediments to growth are removed. There is no other way. The primary impediment to growth is bloated government at all levels. The power of government is no longer benign; it has become intimidating to good ordinary folks and is putrid. Too much government saps the productivity of the private sector. Government regulation has gone far beyond the boundary of sanity. Over-taxation of salt of the earth members of society to employ all too many government bureaucrats, support welfare recipients who are otherwise able to work, and indulge in the myriads of other wasteful programs that – if it were your money it would not be wasted on – are but a start to the underbrush that must be cleared. The animal spirits Keynes so well understood will do the rest when these and other like impediments are dismantled. Remove these keylogs and the entire logjam will flow. There is a tide in the affairs of men. Which, taken at the flood, leads on to fortune. Ill-considered notions like “our debt situation requires that increased tax revenues accompany spending cuts” are part of the detritus that must and will be swept away in this millennial flood.

    7. GK

      The solution is so simple that it is tragic that our country will come to an end for no reason.
      Spending :
      1) Cut ALL spending by 10%. Everything. SS/Medicare/Defense, everything.
      2) After that, debate about which spending should be cut beyond 10%. But the 10% universal cut is set in stone.
      Taxes :
      1) First simplify the tax code. The revenue increase that people want from tax increases will come from simplificaton, as 20% of all taxes go towards auditing, compliance, and processing.
      2) After the tax code is simpler, then we’ll talk about rate changes. Anyone who wants higher taxes now is a fool for not being disturbed by the 20% wasted on tax complexity.
      That is all.

    8. GK

      I would like to point out that the GDP of the advanced economies has barely grown in the last 4 years…
      While the GDP of China + India has grown about 40% over the same period.
      A 40% net overtaking in just 4 years.

    9. Dirk van Dijk

      Not crazy about the flat tax in the personal side, but we could greatly simplify things on the Corporate side. Just get rid of the corp income tax. However qould ahve to make the preferential rate on Cap gains for only really long holding periods. I would say five years to start to get a prefered rate and then a sliding scal down say 2% per year between five and ten. Also tax dividends as ordinary income. Might allow a small amount at 0% tax, say up to $2000. Meanignful to the small investor, irrelevant to the Hedge Fund crowd. No step up of cap gains at death, or make those gains taxable upon death (buy the farm/sell the stocks, at least for tax purposes).
      Clears up who is actually being taxes, shareholders, employees or customers. Corporations only have to keep one set of books, huge savings on accountants and tax lawyers. The can invest based on economics of the project, not the tax implications. Makes people actually invest rather than play the casino.

    10. mclaren

      More honest version of the paper:
      “One possible explanation for the difficulty in controlling the budget is that a major component of spending—military expenditures—receives privileged status. It is treated as `necessary defense’ rather than pork barrel waste on Rube Goldberg superweapons that don’t work, rampant looting by corrupt military contractors and mercs, and unwinnable unnecessary foreign wars. This paper explores the implications of that misclassification and illustrates how it can lead to higher taxes, larger government, and an inefficient mix of spending (too many tax expenditures). The paper then suggests options for reform to the budget process that would explicitly incorporate and properly measure military expenditures. It concludes by considering ways to control military expenditures (and other spending) and the special challenges presented by military expenditures.
      Of course, we’ll never see such a paper, since honesty, to an economist, is “worse than a crime, it’s a blunder.”

    11. jonathan

      I don’t agree with the concept of “tax expenditures.” This is part of doublespeak that entered the language during the Reagan era – before in general but specifically then with regard to taxation. I may run on here, so I apologize in advance.
      In 1982, in the largest tax increase in US history – enacted by the GOP Senate, a Democratic House and RWR – the government inserted itself into private transactions as never before. The one sentence summary is: we moved from taxing the results of transactions, however structured, to examining whether those structures had a “business purpose” to imposing a specific time value on money. No more interest free loans to a child or within a company. Arguably the biggest intrusion of government into private economic conduct, all done when the GOP controlled the flow of legislation.
      Then came the words “revenue enhancement” instead of tax increase. Huge changes to the AMT were revenue enhancers though they were tax increases. That word traces back to the mid-80’s and I remember it in 1986.
      Then came “tax expenditures.” I don’t remember the exact date but the words partially replaced the older “tax preferences” to emphasize that the government was foregoing revenue.
      This really bothers me: the IRC treats all income as taxable – very first sections – and then treats some income as non-taxable and some income as excludable. You eventually reach income that is deductible, meaning it is partially excludable. This all flows from the idea that all income is taxable, which is really nothing more than a way of writing the IRC.
      Tax deductions are mixed in with partly excluded income – see the chart above; it mixes lower rates on capital gains with a deduction for owning a home. This is silly. A tax deduction is a social preference: we have wanted to encourage home ownership and health care coverage. We have wanted to encourage retirement savings – which has value in taking pressure off social security. Lower rates or stepped up death basis are different. I’m not just being pedantic: they come from different reasons.
      The step up in basis came from a bunch of stuff, including a calculation that collections would be greater if the estate were taxed at FMV and the basis was stepped up to that figure rather than taxing at original basis with carryover. If one eliminates stepped up basis, then one needs to tax estates differently.
      Lower capital gains rates were intended to encourage investment but they’re inseparable from the holding periods. The real issue is that holding periods are so short the capital gains tax doesn’t encourage actual long term investment but instead rewards what most people would consider short run investing. (Most argue this is really aimed at lowering taxes in the financial sector.) Don’t confuse lower rates for a purpose with the other factors that vitiate the purpose.
      My feeling is we should raise marginal rates and change the holding periods for capital gains, increasing rates for what are really short term investments and reducing them for genuinely long term investments (like 5 or 7 years). I also think we should run healthcare as a single provider, perhaps with insurers operating under strict guidelines – as in Holland – but that’s separate from the idea of the social benefit of healthcare.
      What really bothers me is the idea that all income is taxable. It’s an artifact from the construction of the IRC. One could rewrite the code to include income bit by bit so there would, for example, be a different marginal rate for homeowners that would serve the same purpose as the mortgage deduction. It is wrong to place so much meaning on the way the IRC was chosen to be written way back when.

    12. Buzzcut

      Another thing to note is that a “tax expenditure” is by its very nature of more value to higher income folks. You need to itemize your taxes in order to take advantage of the vast majority of these items (with the notable exception of the health insurance exclusion). And a deduction is obviously of more value to someone in the 35% bracket than in the 10% bracket.
      So we have the opportunity to address “fairness” as well as efficiency.

    13. colonelmoore

      I was intrigued by Prof. Chinn’s statement that he is not in favor of eliminating all tax expenditures. I would like to know which camel’s nose under the tent he would like to keep. Some tax expenditures favor the less well off and I suspect that these are the ones that he favors.
      I say it in this way because a policy of favoring any tax expenditures leads to clamoring for other tax expenditures. (“Don’t tax you. Don’t tax me. Tax that fellow under the tree.”)
      By the way, Milton Friedman proposed one tax expenditure program – eliminating all anti-poverty programs and the minimum wage (which focuses the greatest expense on the very businesses that create the most entry level jobs) and substituting a flat tax combined with a negative income tax. He then testified against the Earned Income Credit when Congress proposed it without eliminating the minimum wage or any anti-poverty programs. Congress has a habit of robbing Peter to pay Paul so that it can count on the votes of Paul.

    14. Ronald Calitri

      Another point in favor of tax expenditures involves the macroeconomic balance of growth inducements. There are two reasons tax expenditures are greater than discretionary expenditures; one is valid, the other not. For growth and employment purposes, it may be desirable to buttress effective demand in sectors where government cannot efficiently spend in volume. The composition of government expenditures may not be in synchrony with the mixture of expanded consumer surplus needed for full employment. It is traditional in the United States to deploy tax expenditures for macroeconomic control. With control of course, comes control _fraud_, itself a formidable tradition.
      The proposed new employee FICA exclusion is a useful example. Plainly the intention is to increase employment at the margin; but it could also be used in volume to undercut competitive cost structures, encouraging industrial concentration, and ultimately lowering overall employment and wages. I am not expert enough to propose a rule that will prevent control fraud in this area; but plainly there will have to be one.
      So, we should be devoting considerable energy to designing effective tax expenditures, and redesigning those whose effects are no longer palpable. At one time, for example, executive jets were an infant industry; and the economy was better off from tax spending on them. Private jets are mature now; so there may no longer be any positive net social return from public spending on them. At one time, the mortgage interest deduction encouraged home ownership; but eventually its impact on raising mortgage interest rates came to be recognized. Now, bankers pocket the benefits; and it could be desirable to replace the interest deduction with tax expenditures for home repair, maintenance, and improvement. The net benefit to homeowners could remain unchanged while targeting effective demand more productively.
      Basically, I think we are stuck with tax expenditures as a crucial element in U.S. industrial policy. Admittedly, we are treading on dangerous ground; but no real escape is possible; so we should try making the best of it. That will require considerable detailed work at the mesoeconomic level, dirty, unattractive, and dangerous, whose practitioners can expect no profit if it is performed well. Perfect work, in other words, for the Israeli Spring, the Arab Spring, the English Spring, and for members of Economics Graduate classes, whose debts have not yet sprung.
      Although presently mired in the mud, we should remain mindful of the natural seasonal progression. After the mud comes the flies, and then the heat. Hurray!

    15. Jacques

      None of the above posters present evidence that reduction in government spending leads to a more “efficient” economy with higher GDP. All one gets is unsubstantiated claims based on ideology. The United States has one of the smallest governments relative to GDP among other developed countries. In fact, the United States is a weird outlier. In addition, the country is already as unequal as poor developing nations – again an outlier among developed economies. So here we have Social Darwinists who are still unsatisfied, and would rather turn the country into a banana republic.

    16. George N. Wells, CPIM

      I’ve been talking about tax expenditures for some time and I’m hearing more about these as the whole “debt debate” continues in the news. Because tax expenditures don’t show up as outlays in the federal budet these are the preferred way of handing out money for the RNC. They are also the preferred way to achive the redistibution of wealth to the wealthiest Americans because while the purpose of the tax expenditure (health care savings, et cetera) seem universal, the reality is that for the vast majority of Americans have neither the means to use these accounts nor do they itemize their tax returns.
      Looking at the list of the 10 largest tax expenditures in the article, if Harry Potter waved his wand, uttered the magic words, and made them disappear (and that is the only way that could happen) the disapearance would send most of middle income Americans into appoplectic shock. Having to pay income tax on their employer-provided health insurance and losing their and property tax deductions (even if they aren’t currently using them) as well as the rest of the list would cause panic and outrage. Of course, the real impact would be on the top one-percent of the population but middle-income America would feel as though they were wronged; even if their marginal tax rates and the “standard deduction” were adjusted to compensate for the loss of the specific deductions. The problem of the tax expenditures is that we tend to look as them as something of value that, if taken away, makes us smaller.
      What we fail to understand is that while there is a practical and logical argment, the problem is the emotional attachment to the tax expenditure.

    17. 2slugbaits

      Ronald Calitri Along that same line, temporary investment tax credits can have a valid and useful macroeconomic purpose in stabilizing aggregate demand by pulling forward planned investment during a recession. Of course, like a lot of these things, politicians (particularly GOP politicians) inevitably subvert the usefulness of investment tax credits by trying to make them permanent.

    18. Ronald Calitri

      2slugbaits: “For, what was well done for a Time, In half a Year became a Crime” (see below). I quite agree that temporary inducements are quite useful, but should also span the relevant time horizons.
      On the politics issue, neither party, nor occupation nor race, nor sex, stays lobbyists from swift delivery of their appointed contributions. I’m pretty certain that part of the problem _is_ within the Republican Tea Party, though their complaint is hardly parochial, well antedates the American Revolution, and doubtless was ancient when Mandeville wrote Fable of the Bees (1705). Economists in schools interpret Mandeville as having stereotyped the paradox of thrift. Mandeville’s actual words, focus on the paradox of vice.
      “So Vice is beneficial found, When it’s by Justice lopt, and bound.”
      The popular discussion continues on Mandeville’s terms, rather than his interpreters’. Alas, earmarks gone, we have slid the slope towards noble savagery.

    19. PJR

      The entire discussion of tax expenditures has been warped imho by excluding most business expenses. Everyday taxpayers intuitively know that businesses/corporations get all the deductions. Luxurious working conditions, cars, yachts, airplanes, sky box suites at sporting arenas, meals, vacations (errr, attendance at conventions), and more. Also, going further down this road, are those million-dollar bonuses and large corporate board salaries really legitimate business expenses? As for deductions for individual income taxes, one might legitimately argue for lower caps on some deductions (like home mortgage interest) but elimination of smaller deductions when being so generous to businesses is patently wrong.

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