There’s a new buzzword in Washington: tax expenditures. Well, actually, the concept isn’t really new, but the buzz around it has certainly increased now that the Obama administration has shifted to a more conciliatory approach to budget negotiations after the threat of the sequester failed to coax Republicans into compromise.
That’s because tax expenditures are one thing on which both Democrats and Republicans seem to agree. The term essentially means tax deductions, but the Washington lingo does a nice job of highlighting why they’re so attractive to both liberal and conservative lawmakers. Though they’re technically part of the tax code, deductions are a revenue loss for the government and can be portrayed as “spending in disguise.” Eliminating them can thus be conveniently sold as either a tax increase or spending cut, depending the tastes of one’s constituency.
Even better, economists and budget experts too would like to see tax expenditures go. From an economic point of view, tax exemptions on things like the interest rate on mortgage payments create market distortions (Canadians, who can’t detract mortgage interest from their taxes, for example, have historically carried less real estate debt than Americans). They also complicate the tax code, which is a waste of time and administrative resources. Besides, unlike entitlement programs, which undergo regular scrutiny because they must be renewed every year, tax deductions, once introduced, aren’t subjected to much oversight—no one is weeding out badly designed or anachronistic provisions. From a budgetary perspective, tax expenditures are like holes in the straw from which government draws its revenue. According to the Treasury Department, such deductions will amount to $1.3 trillion just this year.
Eliminating tax expenditures, in other words, is the bipartisan move that fiscal policy dorks can love. If this sounds like a dream, it’s because…it might be. The trouble is that reforming the tax code is both more politically complex and fiscally less effective than it might appear.
Let’s start with the politics. The problem with eliminating deductions is that for every wasteful provision there’s often a well-funded constituency ready to fight tooth and nail to protect it. The Washington Post described hordes of lobbyists descending onto Capitol Hill when the U.S. last tried to overhaul its tax code and eliminate billions of dollars worth of tax expenditures under President Ronald Reagan. In general, talk of tax reform often invites efforts to insert even more customized exceptions with the risk that the overall outcome is more rather than fewer loopholes. As the Post recalls describing the same hordes crowding around Congress today, Reagan’s 1986 Tax Relief Act was appropriately dubbed the Lobbying Relief Act.
From a budgetary point of view, as former Treasury Secretary Tim Geithner once put it, “There is a lot of magical thinking about how much money you can raise from tax expenditures.” No tax reform would ever eliminate all tax exemptions, nor it should. It’s easy to agree that taxpayers who aren’t bankrupt shouldn’t be able to deduct forgiven home mortgage debt. It is a lot less obvious, though, that tax exemptions on charitable donations or R&D investment should go too. No matter how sensible a bill Washington manages to produce, the revenue boost is sure to be significantly less than $1.3 trillion.
Another reason to fret is that tax deductions nowadays tend to benefit the rich disproportionately. According to Senator Patty Murray, who chairs the Budget Committee in the Democratic-controlled Senate, tax deductions increased the after-tax income of the top one per cent of earners by $250,000 on average in 2012, while for middle income families the average benefit was $3,500. (In part this is because the wealthy are much more likely to file itemized returns.) Though targeting the rich makes tax reform all the more palatable to Democrats, it also means actual revenue gains will likely be lower than expected. The one per cent — here in Canada too — is notoriously apt at finding creative ways to limit the taxman’s reach. Increase taxes on Average Joe and he’ll probably pay up, try to turn up the heat on the rich and their accountants will reorganize their finances to dodge the new taxes wherever the law allows it.
All this isn’t to say that America shouldn’t clean up its tax act. Indeed, it is refreshing to see Washington embrace a sensible idea on fiscal policy. It’s the leap between the theory and the practice that warrants measured expectations.
Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.