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The ‘Tastes Great, Less Filling’ Approach to Cutting the Deficit

June 29th, 2011 . by economistmom

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Here’s the column I wrote in last week’s Tax Notes (subscription-only access here) in my “Taxes for a Civilized Society” spot.  I reprint it here courtesy of Tax Analysts.  (By the way, next week I am taking a break from my every-two-weeks Tax Notes publication schedule, so my next column will appear in the July 18th issue and will be a “primer” on tax cuts and the economy.  I am working on a catchier title though…)

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The ‘Tastes Great, Less Filling’ Approach to Cutting the Deficit

Tax Notes, June 20, 2011

In my work I’ve often remarked that fiscal responsibility seems like a great idea — until you get right down to it. While policymakers are quick to promote themselves as fiscally responsible in the abstract, they loathe having to talk about the specific policies and hard choices that would actually reduce the deficit. Discussion of the particular solutions, like painful tax increases and spending cuts, calls attention to the mutual-sacrifice costs more than the common-good benefits. And tax increases are seen as directly contrary to the Republican antitax, free-market orthodoxy, just as spending cuts go against the Democratic ideal of a proactive and progressive government.

That is, unless the tax increases are really spending cuts, and unless the spending cuts aren’t the usual kind of spending cuts.

I refer to the tax increases and spending cuts that would result from reducing tax expenditures — the subsidies that are run through the tax code via exemptions, deductions, credits, and preferential tax rates. Reducing tax expenditures is a strategy that I believe is an essential component of any bipartisan solution to the deficit problem.

Make a Venn diagram of all the specific proposals that the various deficit reduction commissions, study groups, and task forces came up with, regardless of their political leanings, and what does the intersection of the proposals look like? It’s big, fundamental, and worth lots of money. That intersection is the proposal to raise more revenue by broadening the tax base.1 Of all the ways to significantly reduce the budget deficit, base-broadening tax reform has the qualities most likely to appeal to Democrats and Republicans alike.

Reducing tax expenditures is like the fiscal policy version of the old Miller Lite beer commercial: It tastes great and it’s less filling. Here’s why:

Spending-side blame shouldn’t rule out tax-side solutions. Although the largest projected changes to the federal budget come from rapidly increasing spending on federal entitlement programs, once we consider the reasons for that increase it’s unreasonable to think the solution is to just stop it. Given the demographic pressures of an aging population (which we cannot change) and rising per capita healthcare costs (which we don’t yet fully understand how to change), a spending-side-only strategy would mean drastic cuts in real, per capita benefits, which I don’t believe either political party really wants. Given the level of real entitlement benefits that our society wants to maintain, the problem is as much that revenues can’t keep up as it is that spending is growing too fast. That means our historical experience with the level of revenues as a share of our economy (averaging 18 to 19 percent of GDP) is not a guide for what we will need in the future, especially considering that those past levels of revenues haven’t even proved adequate to cover spending and have recently sunk to historic lows of just 15 percent of GDP.

Raising revenue by reducing tax expenditures would shrink, not expand, government. The Republican pledge on taxes has always been touted as a small-government stance. But some of the most fiscally conservative members of the Republican Party — such as Sen. Tom Coburn of Oklahoma, formerly a member of the bipartisan “Gang of Six” — now recognize that there’s no simple correlation between the level of revenues and the size and reach of government, given the prevalence of tax expenditures. Tax expenditures amount to approximately $1 trillion annually — as much as all discretionary spending combined. While it’s not realistic to imagine eliminating all tax expenditures — or raising that $1 trillion even if we could because of behavioral responses and the likelihood we’d see some eliminated tax expenditures appear on the direct spending side of the budget — the potential to cut significant levels of subsidies on the tax side of the budget is still huge. President Obama’s fiscal commission made that point when it proposed a “modified zero” approach to deficit-reducing tax reform, illustrating the trade-off between a broader tax base (the broadest of which would zero out all tax expenditures) and the marginal tax rates needed to achieve a specified level of deficit reduction.2

Reducing Tax Expenditures Both:
“Tastes Great” (Democrats like) and “Less Filling” (Republicans like) because it…
Reduces deficit on tax side and Cuts government subsidies/”tax entitlements”
Raises revenue and Reduces size of government
Enhances progressivity and Increases economic efficiency
Avoids cuts in high bang-per-buck, short-term stimulus spending and Reduces longer-term deficit to encourage higher savings and economic growth

And tax expenditures don’t just imply larger government because of the higher tax rates required to finance the rest of government; they expand government’s influence on the economy. Tax expenditures subsidize some economic activities over others. In recasting those tax subsidies in terms of what they would look like if they were run through the spending side of the budget, Donald Marron and Eric Toder of the Tax Policy Center (TPC) estimate that the implied level of government spending rises from roughly 18 percent of GDP to 24 percent.3 Republicans who continue to claim that any type of revenue increase would expand government are obviously missing this point.

Reducing tax expenditures is a progressive solution that defies the equity-efficiency trade-off. Raising taxes progressively (a Democratic priority) does not have to mean raising marginal tax rates on the rich and increasing the distortionary effects of taxes on economic decisions (a Republican concern). A TPC analysis has shown that raising the needed additional revenues to achieve fiscal sustainability from only the top 2 to 3 percent of the population, without any base broadening, would mean that increases in the top federal income tax rates would have to be prohibitively large — getting to Laffer curve levels in excess of 75 percent.4

Because tax expenditures poke holes in a progressively structured income tax system (with graduated marginal tax rates), filling in at least a portion of those holes would raise revenue (and cut subsidies) progressively, while smoothing out, instead of exacerbating, the dips and bumps in the tax policy playing field. By reducing tax expenditures, we can achieve a progressive change in tax policy that would avoid the trade-off with economic incentives and growth. Moreover, the progressive rate structure that causes tax expenditures to disproportionately benefit the rich also explains why these tax-side subsidies will grow dramatically in real costs over time as real incomes grow. Just as real bracket creep pushes more and more income into higher marginal tax brackets over time, it will push more and more economic activity into more-tax-preferred status. The single largest tax expenditure in the federal budget, the exclusion of employer-provided healthcare, will grow especially dramatically in cost over time — and the benefits will get more skewed toward higher-income households — as its value rises with the rise in per-capita healthcare costs as well as the growth in real incomes.

Reducing tax expenditures is an inherently progressive policy strategy and can be made as progressive as we want it to be through the use of caps and phaseouts, such as in Obama’s proposal to limit the value of itemized deductions to a maximum 28 percent rate. That makes it clear that reductions in tax expenditures are more easily tailored to the progressivity goal if they are modified via the personal income tax, a direct tax on households based on their directly observable levels of income. The healthcare reform bill’s approach to paring back the tax expenditure subsidizing employer-provided healthcare — by imposing an excise tax on high-end insurance plans to be paid by the insurance companies (but whose ultimate burden will be felt by households that purchase expensive insurance plans regardless of their income level) — is a prime example of how political concerns can turn good intentions into suboptimal policy.

Reducing tax expenditures would address both near- and longer-term economic concerns. There are two sides to achieving fiscal sustainability: the ways we spend, and the means to pay for it. Just mechanically reducing the deficit by cutting spending or raising taxes in any old way is not enough. The policies that reduce the deficit must be thoughtfully crafted to promote a strong economy, both in the short term as we continue to need demand-side stimulus to speed the recovery from an unusually severe recession, and over the longer term, when we should focus on increasing our productive capacity, or the “supply side” of our economy.

It’s difficult to find a deficit reduction strategy better suited to addressing both types of economic concerns than reducing tax expenditures. Because tax expenditures disproportionately benefit higher-income households, who are much less constrained and save large fractions of their income, paring back those benefits would be far less damaging to the short-term demand for goods and services than cutting other forms of government spending, which disproportionately benefit lower-income households. And because of the efficiency gains and reduced distortions that come from a broader tax base, reducing tax expenditures is a far better way to raise revenue and reduce the budget deficit (increasing public saving) while minimizing any adverse effects on private sector economic activity (which could come from the alternative of raising marginal tax rates). A base-broadening, tax-rate-leveling, revenue-raising tax reform is a sure thing in terms of boosting national saving and longer-term economic growth through increases in both public and private saving.

Cutting tax expenditures is the ‘tastes great and less filling’ approach to solving our fiscal problems. Even though achieving deficit reduction is naturally unpleasant business, there’s something for both sides of the aisle to like about doing it by cutting tax expenditures. Bottoms up!

FOOTNOTES

1 Even economic plans by Paul Ryan and Tim Pawlenty contain proposals to reduce tax expenditures; it’s just that their tax plans also reduce marginal tax rates. Those components of their plans ought to be evaluated on their own merits. But more on the issue of the costs versus benefits of marginal tax rate reductions will come in future columns.

2 For the plan, see Doc 2010-25486 or 2010 TNT 231-35 2010 TNT 231-35: White House News. I might disagree with the commission’s chosen tax rate ceiling and the extent to which it allows base broadening to go toward deficit reduction, but its report nonetheless demonstrates the trade-offs in making that policy choice.

3 For the study, see Doc 2011-12908 .

4 For the study, see Doc 2010-1009 or 2010 TNT 11-96 2010 TNT 11-96: Washington Roundup.

END OF FOOTNOTES

6 Responses to “The ‘Tastes Great, Less Filling’ Approach to Cutting the Deficit”

  1. comment number 1 by: Patrick R. Sullivan

    ‘Because tax expenditures disproportionately benefit higher-income households, who are much less constrained and save large fractions of their income, paring back those benefits would be far less damaging to the short-term demand for goods and services than cutting other forms of government spending, which disproportionately benefit lower-income households. ‘

    Which is theory. Any empirical evidence to support the theory?

  2. comment number 2 by: SteveinCH

    It rather depends on what your base is. Here’s some data from TPC on the incidence of increased tax payments from the ending of certain tax expenditures

    http://www.taxpolicycenter.org/UploadedPDF/411922_expenditures.pdf

    Dealing with the big ones. The combination of the MI deduction and the property tax deduction, would come 70.9% from the top quintile which currently pays 86.3% of income taxes and 69.3% of all (including imputed) Federal taxes. At best it’s neutral is my conclusion, it might be regressive if your baseline in income taxes (which arguably it should be).

    It looks even worse if you look at the top of the income pyramid. The increased collections from eliminating those two deductions would come only 9.6% from the top 1% of income earners who currently pay 39.1% of Federal income taxes and 28.3% of total (including imputed) Federal taxes.

    For the health care deduction, it looks even worse (from an increasing progressivity point of view). Only 41.9% of the increase comes from the top quintile and 2.4% from the top 1%.

    Retirement savings looks more like housing…about 79% from the top quintile and 16% from the top 1%.

    As to the contention that this is less damaging than cutting other forms of government spending, that is, of course, an overgeneralization. Cutting farm supports or means testing entitlements would be far more progressive than cutting tax expenditures.

    This of course explains the approach that Dems are taking, rather than cutting tax expenditures directly they want to allow them only to apply to certain income levels to ensure the benefit is progressive.

  3. comment number 3 by: Gipper

    SteveinCH

    Bingo! Means-testing entitlements. Why do we even have Medicare? We should just expand Medicaid to include seniors, and abolish Medicare. It’s ridiculous to enroll every adult into Medicare and Social Security. These should be means-tested poverty programs, not a huge net ensnaring every taxpayer into it’s web.

    We know exactly how to bend the cost curve in health care. If people changed their exercise and nutrition habits to more closely resemble Europeans, then we’d have far less morbidity costs (diabetes, stroke, heart disease, osteoporosis, etc.) that drive our costs through the roof. Democrats won’t touch this with a 10 ft. pole because it threatens their meme that it’s profit hungry insurance companies that cause our problems, only be solved by a single-payer system.

    Seriously, Economistmom, I keep laughing when I read about your passion for cutting tax expenditures. Until you show 40% of the same passion for cutting REAL expenditures, then you will be ignored by the folks whom you need to convince to cut a deal with.

    Obama’s moralizing diatribes aren’t going to move the needle when unemployment rates hover around 9%.

  4. comment number 4 by: Vivian Darkbloom

    As Ronald Reagan would say, “there you go again”. Reducing tax expenditures is indeed the way to go, but in giving precedence to your primary goal of “increasing progressivity” over simply reducing or eliminating tax expenditures, you’ve completely nullified the whole purpose of doing so.

    Let’s take the idea that we can make the tax code “as progressive as we want” by re-introducing Pease-like limits on deductions for higher income taxpayers. As I indicated in my comment to your prior post, Don Marron wrote a pretty good piece on the nature of tax expenditures, but I think you’ve failed to understand exactly what they are. The standard deduction and the personal exemption are not considered “tax expenditures” because they are available to everyone. By the same logic, the more a particular deduction is available to a wide range of taxpayers, the less it looks like spending and the more it looks like tax reduction. The reason we have so much confusion over tax expenditures is that, depending on the specific type of deduction, exemption or credit, and who can claim them, they can have simultaneous aspects of both spending and taxing. What you are proposing is not to eliminate or even reduce the number of tax expenditures; you are proposing to reduce only the number of taxpayers who can avail themselves of them. By proposing to re-distribute the benefits of those deductions to a more select group, you are in fact increasing the spending aspect of those deductions rather than reducing it. On the other hand, one could legitimately argue that because the effect of reducing the tax deduction is disproportionately on higher-income taxpayers, it is more in the nature of tax rate increase. For a very good example of this, see Greg Mankiw’s recent blog entry as amended with reference to the Wall Street Journal opinion piece on Pease limitations. Mankiw, whom I think knows what a tax expenditure is, calls this a “tax rate increase”. http://gregmankiw.blogspot.com/

    If you were really sincere about eliminating tax expenditures, then you would eliminate the ability of anyone to avail themselves of them. That’s what I would propose.

    Your analogy to Miller Lite’s slogan “Tastes Great, Less Filling” is flawed (like the advertising campaign) because it is based on a logical sleight of hand. The idea that you are trying to promote, like Miller Lite, is that this is a “win, win” situation. That would be true if the slogan claimed the beer “Tastes Greater” because it is less filling; in fact the slogan (“Tastes Great”) does not suggest that taste is enhanced at all. If they had made the claim, as you do in your little table of comparisons, that it “Tastes Greater and is Less Filling”, I suspect they would be open to sanction by the FTC or the FCC.

    I would like to hear more from you as to how, exactly, your idea of eliminating tax expenditures only for a select group of taxpayers both “increases progressivity” and “increases economic efficiency”. Take, for example, the mortgage interest deduction. If the idea is to merely cap the benefit for higher-income taxpayers, then there indeed is an increase in progressivity, but I completely fail to see how this “increases economic efficiency”. If anything, it detracts from it.

    There are a few ways to measure the “size of government”, but “size of government” is not a particularly accurate phrase. When people object to the “size of government”, what I really think they mean is “the extent of the influence the government has over our economy and our lives” and “size” is a rough but inaccurate proxy for that more precise concern. In this sense, government could literally reduce “spending”, but by eliminating that spending on some for the sake of increasing it for others, the “size” of government in its true sense is not reduced but increased. Thus, the “size” of government is actually directly proportionate to the amount of “progressivity” that is brought into the taxing and spending policies.

    Finally, I would like to hear more about how “avoiding cuts in high bang-per-buck short-term stimulus spending” reduces the long-term deficit. This is a nice Keynesian theory, but I have yet to see it demonstrated in practice. And, it seems to directly contradict your earlier statement that we need to focus not merely on the amount of spending but on the type of spending. I seem now to be mistaken because I actually thought you were talking about reducing “short-term stimulus spending” with sensible long-term infrastructure spending. Silly me.

  5. comment number 5 by: SteveinCH

    Good post Vivian.

    The only quibble from me is where you say, “On the other hand, one could legitimately argue that because the effect of reducing the tax deduction is disproportionately on higher-income taxpayers, it is more in the nature of tax rate increase.”

    I think it depends on what you mean by disproportionately. It is certainly disproportionate to their numbers or their share of national income but it is not disproportionate to their current share of taxes. As a consequence, the elimination (not restriction) of most major tax expenditures would decrease progressivity (as those on the left customarily define it).

  6. comment number 6 by: Vivian Darkbloom

    Steve,

    That phrase and specifically the word “disproportionately” was meant to refer to the idea that we should re-introduce Pease-like restrictions on deductions rather than eliminate tax expenditures outright. That is why I referred to the Mankiw post and the WSJ editorial both of which talk about Pease-like restrictions and not eliminating tax expenditures per se. Pease-like restrictions and other similar ideas to restrict deductions only at the top end would indeed be disproportionate to their share of current taxes.

    As I have written, I would be in favor of eliminating a lot of currently allowable deductions, such as that for mortgage interest. Doing so would to some extent be “progressive”. But, as noted here several posts previously, not nearly as “progressive” as some might think For example, because the mortgage interest deduction is primarily a benefit for middle income earners (even without Pease limits) it is not linearly progressive.

    I’m all for a fully transparent progressive rate structure. Eliminating tax expenditures across the board would allow us to focus more clearly on that central issue. In addition it would simplify the Code, eliminate much hidden spending (much of it in the form of political favors) and better align economic incentives.

    What bothers me about the current discussion is that it is meant to hide the real agenda(s). On the progressive side, I find little evidence that there is any serious intent to eliminate tax expenditures as such. When they say eliminate tax expenditures, what they really mean is eliminate deductions for high income earners only. Little wonder then, that in face of this, conservatives respond that it is a tax increase. Nomenclature aside, the real issue here among the politicians is the re-distributional effects of these changes. This was (again) made readily apparent by listening to the press conference yesterday in which Obama constinues to insist merely on taxing those “millionaires and billionaires.”

    Ideally, I think we would eliminate almost all tax expenditures for all taxpayers across the board. One could then take a look at the distributional effect of doing so, and go back to amend the tax rate schedule to try to achieve some rough status quo ante neutrality. That would be much closer to a “win, win” scenario than most of the phony Trojan Horse propositions that are being floated about.