Budget cutting

I once participated in an executive education program in which we were all given a spread sheet of the federal budget and told to balance it solely by eliminating spending.

That was about 25 years ago when the federal government spent a lot less than it does now. Nevertheless, few of us were happy with the process or with the results.

The choices came down to cutting entitlements like Medicare and Social Security or cutting so-called discretionary spending like the national park service, education, or defense.

Of course, raising taxes should have been another option, but for the sake of this exercise, that was taken off the table.

There was a fourth option, though, that no one mentioned,and that I didn't appreciate until recently. In fact, in aggregate, it represents a higher level of spending than any other category, including social security, medicare, or defense.

By itself, it represents almost 6 percent of the country's gross domestic product. If eliminated, it would wipe out 80 percent of the trillion dollar deficits we've been running up lately. Most surprisingly, it's been sitting in the Congressional Budget Office's annual budget outlooks since 1974.

I'm talking about the so-called "tax expenditures" -- all the exclusions, deductions, and credits knitted into the income tax code, often to accomplish some social purpose, like encouraging home ownership, but just as often to satisfy some well-connected special interest.

By law, a tax expenditure is defined as "“those revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”

Most of these tax expenditures go to individuals, not corporations. And the very biggest should be familiar to everyone. I'll mention just a few highlighted by the Congressional Budget Office in its annual outlook (pages 93 - 96).

• Excluding the cost of employer-provided health insurance from incomes is the single largest tax expenditure, equal to 1 percent of GDP by itself. If that cost was also subject to employment taxes, it would represent 1.8 percent of GDP in total.
  
• The deduction for owner-occupied home mortgage payments equals 0.8 percent of GDP. 
  
• The preferential rate given dividends and capital gains equals 0.5 percent of GDP. And allowing inherited assets (e.g., stock) to avoid the capital gains tax equals another 0.3 percent of GDP.
  

There's more. In fact, someone counted more than 170 tax expenditures in the code and that number has increased by 25 percent over the last 10 years. 

If all the tax expenditures were eliminated, there would be no deficit. Don't take my word for it. Here's GOP congressman Paul Ryan, quoted in National Review:

"Tax expenditures have a huge impact on the federal budget, resulting in over $1 trillion in forgone revenue each year. . . . To put that number in perspective, $1 trillion is roughly the total amount the government collects each year in federal income taxes." 

And here is the actual budget impact for the items I mentioned above over the next five years:

• Tax exclusion for employer contributions to health insurance: $659.4 billion
• Deduction for mortgage interest on owner-occupied houses: $484.1 billion
• Lower tax rates for dividends and long-term capital gains: $402.9 billion
• Exclusion of capital gains at death: $194 billion

That's $1,740,400,000,000. Nearly two trillion dollars. By coincidence, isn't that even more than the congressional "super-committee" was supposed to cut as part of the deficit reduction bill passed last summer? In half the time?

Of course, no one wants to lose tax deductions. But 70% of the benefit from the tax expenditures mentioned above benefit only the richest households, the 15 percent making more than $100,000.  

A deduction for home mortgage interest is worth about twice as much to someone in the 28 percent tax bracket as to someone in the 15 percent tax bracket. Simply converting the deduction to a modest, maximum tax credit could lower the government's tax expenditure significantly, while focusing the benefit on lower income families.

In fact, economist Donald Marron points out that "If policymakers want to use the tax code to encourage certain types of behavior, credits can often achieve the same results as exclusions and deductions, but more efficiently and at lower cost."  

Furthermore, although these tax expenditures have commendable goals -- such as encouraging home ownership and capital investment -- they can also have perverse consequences.

For example, excluding the cost of employer provided health insurance from taxation favors people who work for large companies and may prompt people to consume more health services than they really need. The home mortgage deduction may prompt high-income people to buy more expensive houses -- or borrow more money -- than they would otherwise since the government is subsidizing their loan.

Attacking tax expenditures won't solve all our budget problems. But I'm convinced they will go a long way towards finding the beginnings of a solution. I'm joing good company on that score -- both the Bowles-Simpson deficit commission and the Dominici-Rivlin task force demonstrated that eliminating or reshaping tax expenditures can allow for significant cuts in tax rates, while significantly reducing budget deficits. 

That's a twofer we can't afford to ignore.

 

 

Comments

[Jack Hoey]

Unfortunately President Obama has ignored the recommendations of the Bowles-Simpson Commission including ending the proliferation of tax exclusions, deductions and credits. Meanwhile, the GOP candidates, when they aren't busy trying to curry the religious right,have championed a simpler, flatter tax code. A de-politicized tax code should be, by definition, a non-partisan issue.