Spending: Tax Expenditures

As I alluded to in the last post, governments in the US spend over a trillion dollars more than the “official” spending statistic of $6.1 trillion across all levels of government.  This “unofficial” spending is, as you might have guessed by now, done via tax expenditures.

Tax expenditures are loopholes in the tax code, created specifically as a way to subsidize taxpaying individuals or corporations for doing (or being) something in particular, whether that means donating to charity, owning a house with a mortgage, paying employees with healthcare benefits, etc.  These loopholes take a number of forms (exclusions, exemptions, deductions, credits, preferential tax rates, refunds, etc.) but they all amount to the same thing: spending via the tax code.

The Numbers

The precise quantity of this spending isn’t as firmly documented as one might like.  Estimates place tax expenditures somewhere well above $1 trillion; one estimate by the Tax Policy Center puts the federal tax expenditure budget at $1.34 trillion in 2013.  That’s more than a third of the official federal spending budget, and over a quarter of the actual one:

fedspend-plus-taxexpend

(This is the same data set as in the post on the numbers of spending, courtesy of http://www.usgovernmentspending.com/, but with the addition of the Tax Policy Center’s estimate of the 2013 tax expenditure total in dark red.)

State and local governments have also been using tax expenditures, most notably to attract industries or particular businesses but also for a variety of other purposes.  The problem with the state and local side is that, apparently, no studies or surveys have been done to actually measure the total amount that is being spent this way.  Individual states have done internal reviews of their tax expenditure budgets, which run the costs into multiple billions per state, but nobody has put the data together.  As a very rough estimate, I’d put the total for state and local tax expenditures at $500 billion.

Shadow accounting

The critical problem with tax expenditures as a way of spending government money isn’t their size, though – it’s the fact that they aren’t treated like spending at all.  To illustrate, I want to share a thought experiment with you, from Bruce Bartlett’s book The Benefit and the Burden:

Some years ago the economist David Bradford explained how conventional concepts of taxing and spending distort our understanding of how government affects the economy.  As he hypothesized, suppose the Defense Department decided to pay for a new bomber by giving the contractor a tradable, refundable tax credit instead of just writing a check.  The contractor would save an amount of taxes exactly equal to what it would otherwise charge DOD, and if its tax liability wasn’t large enough, it could simply sell the tax credit to another company.

In this example, government spending will be lower by the cost of the bomber, and taxes will also be lower by the amount of the tax credit.  Superficially it would appear that we have achieved a magical way of cutting the size of government costlessly.  But it is just sleight of hand.  Exactly the same resources – the labor, technology, energy, and materials necessary to build a bomber – have been taken out of the private economy and preempted for government use, just as they would if DOD paid for the bomber directly.

This is the big reason why politicians, especially those on the right who pride themselves on cutting government spending, love being able to use tax expenditures.  They get to fund a pet project or support an important donor or interest group, and the official measure of government spending never changes.  This is, as Bartlett says, a magical formula for politicians who have become very sensitive to the issue of excessive government spending.  In the words of Orrin Hatch (R-UT), the ranking Republican of the Senate Finance Committee:

The federal government cannot spend money that it never touched and never possessed.  Tax Expenditures let taxpayers keep more of their own money.  And only by the public consent is the government permitted to take some of it in taxation to pay for certain public goods.  When tax hike proponents say we are giving businesses and individuals all this money in tax expenditures, they are incorrectly assuming that the govenrment has that money to give in the first place, when in fact it does not.  To the contrary, the government never touches the money that a taxpayer keeps due to benefitting from a tax expenditure, whereas with spending, the government actually collects money from taxpayers and then spends it.

Another difference between tax expenditures and spending is that reducing or eliminating a tax expenditure without an offsetting tax cut to reach a revenue neutral level will cause the size of the federal government to grow, while reducing or eliminating spending causes the size of the federal government to shrink.

Both arguments that Hatch makes – that the government doesn’t touch the money involved in tax expenditures, and that “reducing spending” is fundamentally equivalent to “smaller government” – are, as Bartlett notes, utter nonsense, and feed into a climate of blatantly dishonest accounting and corruption in our government.

The government does touch the money that it gives back in tax expenditures.  Every dollar that people would normally pay in taxes, based on their income, belongs to the government; people have to do something, or prove something, in order to not have to pay a portion of that money.  This can be as simple as ticking a box saying you have two children in order to get a tax exemption, or as complicated as using shell companies in an offshore tax haven and shuffling intellectual property payments to reduce taxable profits to near-zero.  Whatever the case, the government is rewarding people for doing something.  It may not actually take possession of that money, true.  But it has a right to it, and waiving that right so long as someone does X, Y, or Z (whether that be giving the government a bomber, investing in a retirement plan, or owning a mortgage on an expensive house) is the same thing as collecting the money and immediately giving it back.  It’s still spending.

As for equating “lower spending” with “smaller government”… the tax code is ridiculously long, in large part thanks to piles of tax expenditures being added to it each year.  While they may well reduce the “official” spending budget, each one is another piece of red tape that individuals and corporations have to wade through and interpret; every one is something that can trip someone up unless they hire high-powered tax attorneys.

Whether the government is buying bombers with tax credits or cash, it’s still buying bombers.  If the government taxed employer-provided health insurance as income, but sent people who paid that tax a check every year for that extra amount, how would the government be any larger?  The same amount of money would be ending up in the same people’s pockets; the same incentives would be in place for people to prefer employer-funded healthcare over cash income; the only difference is that the government would actually be counting those checks as spending, instead of pretending it didn’t happen.

I’m hammering Senator Hatch’s comment because it’s such a beautifully concise summation of the argument in favor of tax expenditures, and indeed it represents the majority view of the budget-hawk segment of the GOP.  That said, I don’t want to give the impression that this is solely a Republican point of view, nor that all Republicans are in favor of it.  Plenty of Republicans are quite aware that this is a dishonest way to do the government’s books, just as there are many Democratic politicians who take advantage of this kind of sleight of hand – just look at all the ones who vote like clockwork for alternative energy tax credits and the like.

The problem is not that Republicans fight hard to avoid anything that might be construed in a campaign as a tax hike, nor that Democrats are just as willing to profit from such tax expenditures.  The problem is that this is a fundamentally dishonest and extremely misleading way to look at the way our government is spending money, and that every time a new curlicue is added to the tax code it increases the bureaucratic burden that every person and company in America is being forced to bear.

Those that have, get

Let’s leave aside the question of honesty for now, and delve into how all this money is distributed.  Check out the chart, below, which lists the top 20 biggest single tax expenditures in 2012.

tax-expenditures-deductions

[20 biggest tax expenditures by the federal government in 2012, $ billions; chart/data from Credit Suisse, link here: http://www.businessinsider.com/the-top-20-tax-expenditures-2012-11 ]

As you look at which ones make up the lions share of that $1.3 trillion, you’ll notice that the vast majority of them are for individuals, not corporations.  All told, around 90% of the money the US spends on tax expenditures goes to individuals, with only 10% going to corporations.  Of that 90%, fully half goes to the top 20% of households (see chart below).  While the lowest 20% get more of their income proportionally from tax expenditures (via the Earned Income Tax Credit, among others), the wealthy get by far the most in terms of total dollars.

This is a development that makes sense, when you think about it; if you earn more money, and thus pay more in taxes, not only can you gain more by taking advantage of a tax loophole, but you also have more ability to take advantage of said loophole, by hiring tax lawyers and accountants.  Further, because those at the top of the economic ladder gain so much from tax expenditures and have so much money available, they have a very strong incentive to lobby politicians for more tax expenditures.  Even if the new loopholes are presented as being for the middle-class, the wealthy end up gaining far more in terms of actual reward.

43768-land-TaxExpenditures

  http://www.cbo.gov/publication/43768

However, just because it’s understandable that the wealthy would receive more in tax breaks than the middle class or poor doesn’t make it right, and neither is it good policy, for many reasons.

Dishonest, Regressive, Prone to Corruption… and Unnecessary

Tax expenditures are, at heart, a subversion of the proper functioning of a tax system.  They drain money from the government’s coffers.  They increase the incentive for corruption while at the same time making that corruption harder to detect.  They act as a regressive subsidy for the wealthy.  They distort the economy through often-perverse incentives.  And – here’s the kicker – they are, from a practical administrative and governmental point of view, completely unnecessary.

Politically, they may be a fantastic way of packaging government spending – for a politician, it’s far easier to sell something as a “tax cut” than a “subsidy.”  But the effects that they have on society, politics, and the economy are, in many ways, worse than the government sending a check.

Further, the need for the things that tax expenditures subsidize – which, again, go predominantly to those who have no need for subsidies – is rather low, compared to most of the other programs that policy-makers have to juggle if they’re to balance the budget.  Compare the return-on-investment of $1 billion in education, or infrastructure maintenance, or proper funding of the courts, all of which have large positive ROIs, to that of $1 billion in subsidies for rich people to buy more expensive houses, which actually has a net negative ROI.

Each individual tax break may have had a good reason for its implementation (though quite a few are blatantly corrupt).  But the sheer number and total size of these subsidies has created a situation in which, collectively, they are a large net drag on the economy and the government.

When people in politics are discussing tax reform the goal is often a “Grand Bargain” that would include eliminating most (or all) tax expenditures in return for a general lowering of the tax rates.  This kind of grand bargain has proved impossible for political reasons, thus far, and in our current political climate is likely to continue to be a pipe-dream.  While conservative economists like this approach because it reduces distortions in the marketplace and improves economic growth, conservative politicians have refused to sign off on it because reducing tax expenditures has been declared anathema by a large part of the conservative base.  Liberal politicians are somewhat more willing to consider it, but they face their own set of vested interests (like the alternative energy industry) who would fight hard to maintain their own personal handouts.

This is a prime example of the Interlock effect, and it is not going to be an easy thing to fix.  Until something happens to break this political deadlock, it’s unlikely that we’ll see any significant progress on the deficit, the debt, infrastructure problems, improving the economy, or the many other issues related to government finance.

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