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It’s That Damned “Holey” Tax System

February 3rd, 2011 . by economistmom

mouse-in-swiss-cheese

Fed Chairman Ben Bernanke gave a very good speech today at the National Press Club.  In it he emphasized why having a plan to get back to economically sustainable deficits is not only important for longer-term economic growth, but to our near-term economic health as well.  He also suggested that “acting now to develop a credible program to reduce future deficits” is not so daunting a task now that the President’s fiscal commission and related groups have put forward proposals that “provide useful starting points.”

Chairman Bernanke then hints about what he likes about the commission proposals, in his concluding paragraph (emphasis added):

Of course, economic growth is affected not only by the levels of taxes and spending, but also by their composition and structure. I hope that, in addressing our long-term fiscal challenges, the Congress and the Administration will seek reforms to the government’s tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of our economy–for example, by reducing disincentives to work and to save, by encouraging investment in the skills of our workforce as well as in new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure. Our nation cannot reasonably expect to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.

With tax policy, the only way to raise revenue (and reduce the deficit) while reducing disincentives to work and to save is to broaden the tax base rather than raising marginal tax rates.  Luckily we have tremendous room to broaden the tax base, because the existing federal income tax base is really “holey”–as in chock full of holes.

Such tax base “holes”–as in special exemptions, deductions, and credits that narrow the definition of taxable income–comprise the bulk of what are labeled “tax expenditures.”  In total, federal tax expenditures add up to around $1 trillion per year, or about as much as all of discretionary spending (both defense and nondefense) combined.

It so happens that the Tax Policy Center’s Donald Marron testified before the Senate Budget Committee yesterday and very clearly presented the case for getting rid of some of these tax expenditures, in the title of his testimony calling “cutting tax preferences” the “key to tax reform and deficit reduction.”  His main points:

My message is simple: the income tax is riddled with tax preferences. These preferences narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates higher than they would otherwise be, and are often unfair. By reducing, eliminating, or redesigning many of these preferences, policymakers can

  • Make the tax system simpler, fairer, and more conducive to America’s future prosperity;
  • Raise revenues to finance both across-the-board tax rate cuts and deficit reduction; and
  • Improve the efficiency and fairness of any remaining preferences.

Donald later explains some analysis with Eric Toder that I have previously mentioned here, stressing the point that when tax preferences take the form of reducing the definition of taxable income (what I think of as “poking holes” in the tax base), then they both reduce revenues and expand (not reduce) the size of government.  Donald’s bad news for tea partiers is that to be truly committed to smaller government may require a willingness to give up one’s (very own) tax preferences and end up paying more, not less, in taxes (my emphasis added):

In some preliminary research, my Tax Policy Center colleague Eric Toder and I (2011) have tried to estimate how large the government is when we recognize that many (but not all) tax preferences are effectively spending programs. For fiscal 2007, we estimate that spending-like tax preferences amounted to 4.1 percent of GDP. Adding that to official outlays yields a broader definition of spending, 23.7 percent of GDP in 2007, about a fifth larger than the official 19.6 percent. Similarly, our broader definition of revenues—official revenues plus revenues foregone through spending-like tax preferences—is 22.6 percent of GDP rather than the official 18.5 percent.

These figures illustrate that conventional budget measures understate the extent to which federal fiscal policy affects economic activity. They also suggest that some policy proposals that increase revenues, as conventionally measured, may nonetheless reduce the size of government. If policymakers reduce the tax preference for employer-provided health insurance, for example, that would increase federal revenue but reduce the government’s role in private insurance markets.

Advocates of smaller government are often skeptical of proposals that would increase federal revenues. When it comes to paring back spending-like tax preferences, however, an increase in revenues may actually mean that government’s role is narrowing.

The trouble is that once people start realizing that reducing govenment “spending” may include things like reducing the subsidy to employer-provided health insurance received via their (very own) tax exclusion, instead of clamoring for government to get smaller they might start screaming that “the government needs to get its hands off of”…”my tax preferences.”

The “holey” tax system enlarges the deficit and enlarges the government, but most of us don’t want to give up our (very own) precious holes.  See, tax cuts can be just like spending dressed up in a different costume.

(**NOTE: here’s the link to Donald’s own blog post on his testimony, and here’s a link to the Senate Budget Committee page where you can read/watch testimony by the other witnesses, Gene Steuerle, Rosanne Altshuler, and Larry Lindsey.)

14 Responses to “It’s That Damned “Holey” Tax System”

  1. comment number 1 by: SteveinCH

    Diane,

    No offense but you are confusing size and influence. Repealing the health care exemption would reduce government’s influence but not its size. I support the idea but it does nothing to the size of government other than increasing the size of government assuming that the incremental dollars raised are spent.

  2. comment number 2 by: AMTbuff

    >Donald later explains some analysis with Eric Toder that I have previously mentioned here, stressing the point that when tax preferences take the form of reducing the definition of taxable income (what I think of as “poking holes” in the tax base), then they both reduce revenues and expand (not reduce) the size of government.

    Do you believe that expanding the definition of taxable income is always a good idea, no matter what concerns of horizontal or vertical equity are present, and no matter how poorly the new taxable income relates to disposable income or to current consumption?

    If you really want to broaden the base, why not just impute $50,000 of additional taxable income to every person for the benefits of living in the USA? Then we could REALLY increase revenue, provided that we could collect from the deadbeat poor. In my opinion this absurd idea would be more fair than removing the more justifiable of tax breaks (e.g., casualty losses) that are typically counted as “tax expenditures”. Would my screwy straw man proposal reduce the size of government under any common sense notion of the word “size”? No. Taking more revenue from taxpayers can be structured to limit the economic damage, but it is undeniably a tax increase.

    Base broadening, even in the 1986 reform, consists in part of taxing income that the taxpayer never received and/or is unable to spend. I regard that as unfair. However if base broadening is always a good idea and if no limits apply, then my straw man has to be a top choice. If it’s not, I want to hear what the limits are and how we decide on them.

    >the Tax Policy Center’s Donald Marron testified before the Senate Budget Committee yesterday and very clearly presented the case for getting rid of some of these tax expenditures

    The critical word here is SOME. Marron always makes it VERY clear that he is talking about a minority of tax breaks, the ones that qualify as essentially equivalent to spending. The employer-provided health care exclusion is one of these. The mortgage deduction is not, nor is the deferral for retirement savings accounts. You are selectively quoting Marron to make it appear that he supports the notion that tax expenditures are ordinarily equivalent to spending. His presentations state exactly the opposite.

  3. comment number 3 by: Gipper

    As I recall, it was Presidential candidate Barack Obama who erected the firewall around tax breaks for employer-provided health care. He chastised John McCain’s plan to end the exemption.

    So it’s not the Tea Party that Economistmom should be worrying about. It’s the President’s stupid, fiscally irresponsible campaign promises not to raise taxes on the middle class. He’s the big obstruction to progress, and it’s telling that Economistmom jibes the Tea Party instead of the President.

    And where did the Tea Party ever express an opinion about employer-provided healthcare tax breaks? Talk about straw man arguments.

  4. comment number 4 by: Vivian Darkbloom

    Bernanke was quoted as saying:

    “I hope that, in addressing our long-term fiscal challenges, the Congress and the Administration will seek reforms to the government’s tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of our economy–for example, by reducing disincentives to work and to save, by encouraging investment in the skills of our workforce as well as in new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure.”

    Bernanke has been previously criticised for commenting on tax policy, which is beyond is brief as Fed Chairman, and these remarks clearly show he’s out of his depth.

    Most of that quote was set in bold type by Economist Mom, but it’s not clear to this reader if she is noting that bolded text with approval or disapproval (it was a *very* good speech, after all). If you put in in context, one could go either way, but on balance it appears to me that Economist Mom is quoting with approval.

    Exactly how is the government going to “encourag(e) investment in the skills of our workforce as well as in new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure.”

    Well, probably by increasing investment tax credits, R&D credits, accelerated depreciation deductions, hiring credits, education credits or enhanced deductions, perhaps some credit or increased depreciation deduction for needed infrastructure such as low income housing. The list goes on. Aren’t these “tax expendtures” Diane? How does this” broaden the tax base”?

    The point here is a simple one and I think it’s basically the point made by Marron. Once government goes down the road of “encouraging” one sort of investment over another we’re quickly in the same position we’re now (or worse) in with respect to our “holey tax code”. If you believe in the capitalist system, which I generally do, then you should have confidence that private industry will allocate capital and investment in the most efficient manner without this sort of “encouragement” offered through the tax code. I’m disappointed that Bernanke can’t seem to see through this and that Economist Mom seems ambivalent, at best.

  5. comment number 5 by: Brooks

    Steve,

    Re: Repealing the health care exemption…does nothing to the size of government other than increasing the size of government assuming that the incremental dollars raised are spent.

    Let’s say we started with a scenario in which all employer-provided compensation were taxable, including the part that came in the form of health insurance, but however much compensation an employee got in the form of health insurance, the Treasury would send the employee a check for that amount multiplied by the tax rate(s) they pay on that amount of income at the margin.

    So if Joe gets $10,000 of insurance and for all of that he’s in the 28% bracket, he gets a check from the Treasury for $2,800. Joe ends up with $2,800 more and the Treasury ends up with $2,800 less (and thus a higher deficit and more debt as a burden on everyone else), just as would be the case if that compensation were just tax-exempt in the first place.

    Now Diane, or Donald or I come along and advocate getting rid of that spending policy of the Treasury sending those subsidy checks to Joe and others who get employer-provided health insurance. We say “Stop sending those subsidy checks”. Ending that subsidy would mean Joe ends up with less money and the Treasury has that much more and the deficit is that much lower (and from there either the deficit stays lower or some of the incremental money in the Treasury is spent on something else and/or saved by other taxpayers via lower tax rates, all the same possibilities as if we were ending the equivalent tax exemption).

    Would you say that ending that subsidy policy (sending those checks) would reduce the size of government?

    Or would you say that halting that spending “does nothing to the size of government other than increasing the size of government assuming that the incremental dollars [in the Treasury] are spent [in some other way]” ?

    Isn’t government bigger if it subsidizes purchases of particular products — interfering with buyer and supplier decisions (vs. decisions markets would produce), particularly when it funds those subsidies by taking on more debt on behalf of everyone else?

    I realize you probably won’t answer, but feel free, and I at least offer this for others.

  6. comment number 6 by: SteveinCH

    No Brooks, it’s not bigger, it’s exactly the same size. It’s more intrusive but not bigger.

    Your argument, as it always does, relies on the existence of a counterfactual.

    Instead, let’s say that the government raised 20 percent of GDP and insurance was tax deductible. The government then cancels the tax deduction and lowers rates to raise the same 20 percent of GDP. Is government bigger or smaller as a consequence? The answer is neither and hence the point I have made to you all along. You have to have a baseline to make the argument.

    In your original example, you proposed one and I proposed a different one. Your perspective on whether government is bigger or smaller depends entirely on the counterfactual baseline.

    You and I don’t agree on this but spending and not taxing are not the same thing to me. I’m not going to debate it again beyond that point.

    Peace.

  7. comment number 7 by: AMTbuff

    The truth is typically in between those two baselines. A tax break influences economic decisions, harming the economy to some extent. Does it harm the economy as much as spending the money directly and incurring large administrative costs? Typically not, so Brooks’ baseline is not accurate. Is the economic damage zero? Typically not, so Steve’s baseline doesn’t fully apply either.

    I would add that beyond dollars and sense is the question of fairness. Some tax breaks improve fairness even though they meet some people’s definition of tax expenditure.

  8. comment number 8 by: SteveinCH

    AMT,

    I never said my baseline did apply. My point was simply the choice of baseline drives the answer. Since there is no way to determine the “right” baseline, tax expenditure is a valid concept with no valid way to be quantified.

  9. comment number 9 by: Brooks

    Steve,

    First, Re:
    Your argument, as it always does, relies on the existence of a counterfactual.

    That’s a pretty silly thing to say. Yes, I’ve tried many times to lead you out of your conceptual confusion by presenting hypothetical scenarios and related points and questions. Hardly a novel concept when trying to point out and correct a conceptual error.

    Now then, re:
    No Brooks, it’s not bigger, it’s exactly the same size. It’s more intrusive but not bigger.

    Just so I’m clear, are you actually saying that if government STOPPED sending those subsidy checks, government would be (1) MORE intrusive and (2) exactly the same size? If that’s what you’re saying, please try to explain your thinking, because I don’t see the sense in that.

    Or do you mean to say that the policy of offering and sending those subsidy checks makes government more intrusive (which is what I’d certainly say)? And if that interference in the economy and that additional spending wouldn’t mean larger government, how do you define government size?

    Please be clear about your answer and the “logic” behind it instead of just throwing out some inexplicable answer and trying to shift elsewhere. Please go ahead and give a real answer instead of a faux “answer” with pivot to some question you’d rather address.

    I’ll address your question, but again, please answer mine in a real way.

    Re: your scenario, if the government cancels a subsidy for purchasing Product X, that elimination of a subsidy makes government “smaller” whether that subsidy was provided through explicit spending or through the tax code, assuming (for simplicity) that the dollar amount of subsidy for each person would be the same either way, and there would be no timing differences. Regardless of which form the subsidy takes, eliminating it means Bob (a purchaser of Product X) ends up with $Z less than he’d have if the subsidy had remained, and the Treasury ends up with $Z more (leaving aside dynamic effects, again just for simplicity).

    By “smaller” I mean less intrusive in economic decisions, lower deficit and debt, and thus lower burden on all other taxpayers over time.

    In your scenario, the subsidy happens to take the form of tax deductibility. Eliminating it reduces the size of government, just as would eliminating the same subsidy in spending form (and the latter is what I tried unsuccessfully to get you to address clearly).

    If government also lowers tax rates, that reduces the extent to which taxation reduces incentives to work and invest and distorts economic decisions with resulting costs (“loss”) to society. Ultimately, just lowering tax rates doesn’t necessarily reduce the size of government since whatever we spend has to be paid for eventually, so lowering tax rates today doesn’t reduce the size of government over time. But as a package of lower tax rates and elimination of a subsidy, sure, that reduces the size of government. Wouldn’t you say?

    But maybe (not likely, but maybe) you could at some point see your error if you’d just give an actual answer to my actual question, with some (sensible) explanation of your “logic”. Any chance you’ll make a good-faith effort to do that?

    Re: the administrative costs that AMT mentions, that is beside the main point here, which is that it’s absurd to think of a subsidy for buying Product X as making government smaller (or even the same size) if that subsidy is provided via the tax code while at the same time thinking of the same subsidy (in every substantive sense) provided via explicit spending as making government bigger.

    And as AMT eventually acknowledged a while back, one need not get into any discussion of baselines in order to understand that point. If it’s the same dollar amount that each person (who spends a given amount on Product X) ends up with as a result of the subsidy (and the Treasury ends up with that much less), then there’s no substantive difference (let alone ideological difference or difference in economics) simply by virtue of that subsidy being provided via the tax code vs. via explicit spending.

    (As a tedious (for me), but probably necessary note, yes, baselines are indeed relevant to a discussion of what should be called a “tax expenditure” or at least to which tax provisions should be likened to spending. But I’m not fixated on the semantics of this as some commenters here are.)

    But as I’ve said Steve, you can’t break through some mental block you have that makes you say the equivalent of “If I hand a cashier $10 for Product X, and the cashier hands me $2, I’m spending a lot more and the store is spending a lot more than if I just give the cashier $8”. I know you’re most likely either unshakably stuck OR you’re beyond wanting to admit error, but I’m giving another shot at getting you to engage in good faith and see your error.

  10. comment number 10 by: AMTbuff

    I should have made it clear that withdrawing a tax break is typically done with the intention of curtailing the subsidy in favor of some other sort of spending or tax break. That other use of the money will have a different cost to the economy. If the tax break is replaced by a rate reduction, the economy benefits. If it is replaced by typical sorts of spending, the economy is damaged.

    Withdrawing a tax break for a given activity and replacing it with direct spending on that very same activity is never proposed, let alone done. It’s a thought experiment only.

  11. comment number 11 by: Brooks

    AMT,

    Perhaps you’re still stuck on the idea you got in your head that I was advocating shifting subsidies from tax code form to explicit spending form, which I’ve never even hinted at advocating.

    In any case, the immediate effect of eliminating a subsidy is the same regardless of whether the subsidy was provided via the tax code or via explicit spending: the purchaser of Product X ends up with less money and the Treasury ends up with more money, and the the deficit is lower. The options from that point are the same regardless of what form that subsidy took.

    You are saying essentially that subsidies through the tax code are typically done so the incremental funds that end up in the Treasury can be expended or so that some other tax break can be provided.

    Leaving aside the validity of that premise, it’s important to realize that what you are saying would be the same if the dynamic is/were that explicit spending subsidies were typically eliminated so the Treasury could have more funds to spend on something else or for some tax break. That wouldn’t necessarily increase the “size” of government or “damage the economy” more, just shift from subsidizing one thing to subsidizing (or spending in another way) another thing.

    Either way, we’re eliminating a subsidy, purchasers of the previously subsidized product end up with less, the Treasury ends up with more, and the deficit ends up lower (and by “ends up” I just mean as an immediate effect) and there is less distortion of economic decisions.

  12. comment number 12 by: AMTbuff

    >You are saying essentially that subsidies through the tax code are typically done so the incremental funds that end up in the Treasury can be expended or so that some other tax break can be provided.

    No, that’s why they would be withdrawn. I believe that they are created for other reasons: lower administrative costs (means testing is built-in) than a spending program, improved accuracy of measuring disposable income (tax equity), or historical accident.

  13. comment number 13 by: Brooks

    AMT,

    Re: No, that’s why they would be withdrawn.

    Yes, that’s what I meant to write. Just a sloppy error on my part. I knew what you meant: withdrawing them yields the incremental funds in the Treasury to which I referred.

    So you can just assume that correction to my comment and reply to it if you wish.

  14. comment number 14 by: AMTbuff

    >That wouldn’t necessarily increase the “size” of government or “damage the economy” more, just shift from subsidizing one thing to subsidizing (or spending in another way) another thing.

    Right. It depends on whether the economy is made better or worse by the combination of withdrawing the tax break and reducing tax rates, adding new tax breaks, adding new spending, or reducing borrowing.

    It’s conceivable but IMHO unlikely that any change in the last 3 categories could improve the economy. It’s also conceivable but IMHO unlikely that any tax rate reduction from current levels could sustainably increase revenues.