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New CRS Report Says Base Broadening Is Hard to Do

March 26th, 2012 . by economistmom

crs-20-largest-tax-expenditures-march2012

[***REVISED 2 pm, to make correction noting that the CRS study does not assume the top 20 tax expenditures are completely "untouchable" but just that they would not likely be substantially reduced.]

The Congressional Research Service has released a new report by Jane Gravelle and Thomas Hungerford called “The Challenge of Individual Income Tax Reform: An Economic Analysis of Tax Base Broadening.”  In a nutshell, the report could be called “Base Broadening Is Hard to Do.”  The Washington Post’s Lori Montgomery summarized it nicely on Friday, including getting this Republican staffer’s reaction to it:

Republican tax aides dismissed the report as unhelpful.

“Reports suggesting tax reform isn’t easy are greatly appreciated. We look forward to future reports on water being wet,” said Sage Eastman, a senior aide to House Ways and Means Committee Chairman Dave Camp (R-Mich.), whose panel drafted the principles for tax reform laid out in the Ryan budget.

The CRS report emphasizes that although the 200+ tax expenditures under the federal income tax are worth over $1 trillion per year, the largest 20 of them represent 90 percent of that revenue loss.  When you look closely at that “top 20″ list, copied above from the table in the CRS report, it is easy to get discouraged about the prospects for substantial tax base broadening.  As I explained last November in Tax Notes (subscription-only access here), the largest tax expenditures look a lot more like “entitlements” than “loopholes”:

Consider the biggest of the big tax expenditures: the exclusion for employer-provided healthcare and itemized deductions. Economically, there is little rationale for subsidizing those particular activities, especially for handing out the largest subsidies to people with the highest incomes. But politically they are untouchable. They clearly benefit real people, not just individuals or corporations of questionable reputation, and they are far from “loopholes” that are easy to cut.

Those individual income tax expenditures sound a lot like entitlement spending, defined by Merriam-Webster’s Dictionary of Law as “a government program that provides benefits to members of a group that has a statutory entitlement.” Those groups are employees with health insurance, households with mortgages, people who donate to charities, and so on.

And that’s why the CRS authors conclude that “It appears unlikely that a significant fraction of this potential revenue could be realized.” Instead of the more than $1 trillion that could be gained if all tax expenditures were eliminated–which would support substantial marginal tax rate reductions including getting the top rate down from 39.6% to 23%–they believe “it may prove difficult to gain more than $100 billion to $150 billion in additional tax revenues through base broadening.”

I think I’m slightly more optimistic than CRS, because their conclusion assumes we can’t do much to change–at least in any substantial sense–those top 20 tax expenditures.  I think we could actually do better.  For example, in his latest budget the President himself has proposed to scale back a lot of these largest tax expenditures by limiting the benefit of those tax expenditures to the richest households to the levels of benefits that would be obtained at lower marginal tax rate brackets.  It’s an ambitious amount of base broadening, although only for a narrow group of taxpayers (the familiar households with incomes above $250,000).  (The limit of the broadening to that small group results in a revenue gain of $584 billion over ten years–which is like broadening the tax base by about 1/20th the total value of tax expenditures.)  But my point is there are ways to substantially reduce the cost of the most expensive tax expenditures to both make the proposals more palatable and to raise enough revenue to support a decent amount of rate reduction or at least “rate preservation.”  It still isn’t easy to do, but that’s still mostly a political obstacle rather than an economic or administrative one.

17 Responses to “New CRS Report Says Base Broadening Is Hard to Do”

  1. comment number 1 by: AMTbuff

    From the report: “30% of the revenue loss of tax expenditures is from provisions directed at encouraging savings”

    That’s because the methodology is faulty, looking only at fiscal year 2014. If you tax 401k’s and such today, you can’t collect tax on the same income when it’s withdrawn. That foregone revenue is beyond 2014, so it vanishes from this accounting. How clever.

    This same trick has been used for other items in the “Saving” category. The report appears to endorse a “spend as you go” approach to this one-time accounting change windfall. In other words, spend as if this revenue will continue even though as a matter of mathematics it cannot. I can’t argue the fact that Congress has been doing this for decades, but the CRS should not pander to this irresponsibility.

    The “Saving” category of the report, representing 30% of the total hypothetical dollars, looks dishonest to me.

  2. comment number 2 by: Vivian Darkbloom

    Here’s another example of creative accounting: per the CBO’s score of the FY 2013 budget, the 10-year revenue from limiting the benefit of certain deductions to 28 percent is not $584 billion; it is $523 billion:

    “Limiting Deductions and Exclusions. The President proposes to limit the extent to which higher-income taxpayers can reduce their tax liability through certain deductions and exclusions to 28 percent of those deductions and exclusions. The limit would apply to itemized deductions as well as to deductions or exclusions for tax- exempt interest, employer-sponsored health insurance, and employees’ retirement contributions, among other things. That change would boost revenues by $523 billion over the 2013–2022 period, according to JCT.”

    http://www.cbo.gov/sites/default/files/cbofiles/attachments/03-16-APB1.pdf

    (The JCT estimate was actually $520 billion; however, the CBO appears to have ignored the negative $3 billion of the first year).

    I guess the limitation on the employer-provided health insurance exclusion is on top of the proposed “Cadillac tax”?

    AMT wrote: “If you tax 401k’s and such today, you can’t collect tax on the same income when it’s withdrawn.”

    That may have been a correct observation regarding the CRS’ estimate, but, in fact, I think the above administration proposal shows you can do exactly that. If, as proposed, the benefit of an employee’s contribution is capped at 28 percent, there is partial double tax if the benefit is later taxed at a higher percentage (likely). There is nothing in the administration proposal to prevent this, to my knowledge. This provision actually *punishes* savings.

    It seems to be open season on “the rich”, particularly their savings. And, these provisions are not exactly “simplification”.

  3. comment number 3 by: Jim Glass

    Tax expenditures exist at the state level too — though there are a whole lot more in some states than others.

    http://www.taxfoundation.org/blog/show/28077.html

  4. comment number 4 by: Vivian Darkbloom

    “Tax expenditures exist at the state level too…”.

    That should not be surprising given the fact that most states “piggy back” on the federal tax code and then generally enact (limited) deviations from that foundation. There are certainly deviations from state to state as to the extent of “tax expenditures”; however, I’m highly sceptical that the Tax Foundation numbers are very accurate.

    Take Delaware, which is listed at the bottom with only 4.5 percent tax expenditure/revenue ratio. A quick look at the Delaware forms indicates, however, that they start with Federal AGI. They also allow federal itemized deductions (adding back state income but not real estate taxes). Thus, the biggest “tax expenditures” are allowed: health insurance exlcusions, 401(k), IRA, mortgage interest, etc. Those numbers can’t be right.

    State governments should love a federal effort to reduce “tax expenditures”. Because states largely piggy back on the federal tax base, states would get an automatic revenue boost if the base is expanded rather than federal rates increased. State politicians could sit back and watch additional state revenues roll in while the federal representatives take the heat.

  5. comment number 5 by: Anandakos

    Ms. DarkBloom,

    What are you babbling about this great injustice potentially to be perpetrated on the your scrimp-and-savings and those of your idle-rich friends? All withdrawals from a 401K or deductible IRA are taxable as ordinary income when they’re withdrawn. Everyone’s.

    If a young person — maybe with a couple of kids keeping his or her AGI low — contributes to a 401K at the 15% marginal rate and is an astute investor, that person may very well pay tax on the withdrawals at the 28% level or even higher. That of course includes the contributions.

    We don’t hear you whining about that “injustice”, do we?

    ALL tax-sheltered investments are a tax-shifting gamble, not just the one’s you and your entitled friends make.

    I especially enjoyed your hack at the Tax Foundation, which despite all it’s “non-partisan” drivel is funded lock, stock, and barrel by the very people to whose hinies your lips are sewn.

    You need to choose your targets more astutely; the white-envelopes from the “lunch ladies” may cease.

  6. comment number 6 by: Vivian Darkbloom

    “All withdrawals from a 401K or deductible IRA are taxable as ordinary income when they’re withdrawn. Everyone’s……..That of course includes the contributions.”

    Well, it is precisely my point that it has been proposed that this principle be changed.

    Let’s take two individuals—say you (A) and my “rich friend” (RF) (I’m not sure how someone who is idle can obtain the earnings to contribute to an IRA or a 401(k) plan, so I will refer to this person as RF rather than IRF, if that’s ok with you) You contribute $100 to your 401(k) and RF does the same. RF, being subject to the limitation on exclusions and deductions pays, say, $12 in current tax (assuming a marginal rate of 40 percent when the contribution is made and a limitation of 28 percent on the exclusion) on his contribution.

    Let’s further assume that you and RF are equally “astute investors” such that each $100 has grown to $200 and the latter is withdrawn subject to the marginal tax rate of, say, 40 percent,—A also having been relieved of the burden of his children). So, each pay $80 when the funds are withdrawn.

    Here, contrary to the principle you’ve cited, RF has paid tax on *his* contribution when the contribution was originally made and will pay tax again when that contribution is withdrawn. But, you, A, have never paid tax on your contribution, so tax is paid only once. A has paid a higher total tax($92), $12 of which was paid much earlier, even though the accretion to wealth and the ability to pay with respect to the withdrawal is the same.

    So, I would be interested in your take as to why RF has not experienced double taxation (or partial double taxation) on his contribution and withdrawal.

    I can imagine that given this proposed regime, many taxpayers approaching retirement age will come to the very sensible conclusion that saving via one of these retirement vehicles is a very bad economic proposition.

    I, of course, never did use the term “justice”. Nevertheless, since you raised the term, I would also be interested to hear how, in your view, the above scenario is “just”.

    Finally, apropos “justice” and appropriate targets, there are, unfortunately, too many to adequately discuss here. Nevertheless, in the interest of righting one little injustice, I find it only fair that you refer me (and other readers) to the place at the Tax Foundation where I have “hacked”. I doubt that I’ve ever submitted any comments to that site. In fact, I don’t think they even accept them.

  7. comment number 7 by: Vivian Darkbloom

    Sorry for little misstatement in the above comment–RF has paid $92 on his contribution and withdrawal—not A.

  8. comment number 8 by: AMTbuff

    VD, you say “RF has paid tax on *his* contribution when the contribution was originally made”. Some people would argue that the 401k contribution was not taxed, but rather that the benefit of the contribution was curtailed.

    Therefore to make your point unarguable, you need to say that “RF’s tax liability in the year of his $100 contribution was not reduced all the way down to where it would have been if had earned $100 less and not contributed anything to the 401k. This is mathematically equivalent to having been partially taxed on the 401k contribution.”

  9. comment number 9 by: Vivian Darkbloom

    AMTbuff,

    I like the idea of unarguability; however, some would argue that if RF had never earned that $100 and made that $100 contribution to the 401(k) plan); his tax liability would have been $12 less. If Anandokos had never earned $100 and made that $100 contribution to his 401(k) plan, his tax would not have increased (or decreased) by any amount.

    But, aside from the phrasing, I think we argree on the basic concept. I’m hoping that A will come back and argue the unarguable and prove us both wrong.

  10. comment number 10 by: Jim Glass

    All withdrawals from a 401K or deductible IRA are taxable as ordinary income when they’re withdrawn. Everyone’s.

    Well, not with the Roth versions. Contributions are not deductible but withdrawals are completely tax-free (including all earnings in the account) at retirement age.

    It might be worth noting that the Roth was created by Congress as a revenue enhancer — it was a way to get people to make IRA and 401(k) contributions without claiming a deduction for them, thus increasing tax collections.

    Of course, as with everything Congress does, it was a *short term* revenue enhancer with big costs kicking in over the long run (slashed tax collections later). Budget scoring counted the short run, not the long run, as always.

    The rationale-for-the-record of its creators on that point was that Roth v Regular were economically equivalent because “tax before growth, then take the growth tax free” and “let tax-free funds grow, then tax them” are mathematically equivalent.

    But that is only true if the individual’s tax rate never changes (as of course the creators well knew). For young people starting out at the zero tax bracket rate Roths are *wonderful* — every teenager with a summer job should have a Roth. Let the parents or grandparents provide the money to make the contribution. Fifty years or more of compound growth totally tax free! No matter what a child’s tax bracket may become! *Really* a child’s retirement can be amply provided for by age 20, run the numbers and see. It’s fantastic. OTOH, in top-earning, top tax bracket years, when one expects to be in a lower bracket after retirement, the “regular” options are a superior deal.

    Both the Roth and regular options also offer a plethora of estate planning possibilities to reduce taxes on bequests and such. (The creators knew that too).

    Well, a planning complication is that these days there is the question of whether anybody will be in “a lower tax bracket after retirement” if they retire post-2025 or so, for reasons that we all know only too well.

    However, breaking the rules on retirement accounts that then-seniors have relied upon for 30 years will be one of the absolute **last** things Congress will want to do circa 2025 to raise revenue. This a reason why many people who ponder such things believe Roths are becoming more attractive all the time for everybody.

    Congress can jack up the tax rate on regular IRAs and 401(k)s at any time just by jacking up the regular tax rate. Easy. But to jack up the tax rate on Roths they have to tax what was never deducted and break an explicit promise that savers have relied upon for decades (that investment returns on savings wouldn’t be taxed). Not so easy. So it is becoming a popular notion among financial planners who consider tax politics: “Roths over regular”.

    Thusly do short-term revenue enhancers operate in the long run.

  11. comment number 11 by: Vivian Darkbloom

    Good point on the Roth.

    If the limitation on the deductibility/exclusion of contributions to regular IRA’s is actually enacted, workers subject to the limit will likely merely revert to the Roth, particularly later in working life. With an up-front charge of 12 percent and no adjustment to basis on the regular IRA contribution, the Roth would be hard to beat.

    It is likely that budget estimates of the effect of these limiations have not (adequately) taken into account these tax planning responses. If one combines the limit on deductibility with the proposed increase in marginal rates, the case for the Roth is very compelling. The revenues to be raised from these proposals will be substantially reduced by planning.

    Another example of a short-term revenue enhancer would be the proposal to increase the tax rates on dividends and capital gains. If the administration proposal appears to have any chance of passage, I would expect a lot of gain acceleration and loss postponement late in the year. This will boost short term revenues; but long term revenues will be much lower than predicted.

  12. comment number 12 by: AMTbuff

    Jim, there are two ways to scalp Roth account holders: add a VAT or similar consumption tax, and impose a “success tax” on retirement account balances exceeding some “rich” threshold like $5M. The latter option is particularly attractive to Democrats with the news that Romney gamed the tax system to build a $100M Roth IRA.

    Of course, as with everything Congress does, it was a *short term* revenue enhancer with big costs kicking in over the long run (slashed tax collections later). Budget scoring counted the short run, not the long run, as always.
    That was exactly my point on how the Tax Expenditure list scores eliminating 401k deductions. The revenue increase up front will be mostly offset by a revenue reduction later, since retirees’ withdrawals will no longer be taxable.

    From their proposals and decisions, I get the impression that our leaders are expecting that a fiscal crisis will force a reset of all tax and spending rules. In that case any consequences beyond 2025 are meaningless. I agree with that, but I do not agree that the correct tactic is to grab whatever advantage you can before the crash.

  13. comment number 13 by: Jim Glass

    Arnold Kling:

    Because the budget is so far from being sustainable, budget rhetoric needs to be re-interpreted.

    When their side refuses to cut spending because it would be “cruel,” they are ensuring that future spending cuts will be even crueler.

    When our side refuses to raise taxes, we are ensuring that future tax increases will be higher.

    Until the baseline is a sustainable budget, the rhetoric will be the opposite of reality.

  14. comment number 14 by: Vivian Darkbloom

    Kling is right about the consequences, but I thought an equally significant insight, and one which he perhaps did not even intend to convey, comes from his use of the terms “our side” and “their side”. I guess we are now so used to this that it is accepted as a given that this debate is not multi-faceted.

  15. comment number 15 by: AMTbuff

    VD, the debate centers on whether or not a large majority of the public should depend on government for support at some time during their lives. Equivalently, the question is whether or not the middle class benefits when the government redistributes huge amounts from the middle class to the middle class and whether or not such a concept is sustainable.

    One side says yes, but they face a painful fiscal reckoning as baby boomers retire and as the moral hazard of third-party payment forces health care spending inexorably upward. This side is in denial and has not yet conceived a workable long-term solution.

    The other side says no, that government’s promises are untrustworthy and Ponzi-like when they extend beyond the needy minority who face disability or some other unusual misfortune. This side says that spending on the non-needy and on illegal immigrants is what’s breaking the bank. It has outlined part of a long-term workable solution with the Ryan plan, but that plan maintains the fantasy that the middle class benefits when the government redistributes huge amounts from the middle class to the middle class.

    I don’t see a multi-faceted debate here. Either the middle class depends on themselves and their families or they continue to attempt to finance their ordinary and expected living expenses via government redistribution of their own tax dollars. As the initial positive cash flow stage of that Ponzi game ends, the public is unlikely to approve continuing this wasteful approach. Reliance on self and family is so much more efficient that it will prevail in the end.

  16. comment number 16 by: Vivian Darkbloom

    “VD, the debate centers on whether or not a large majority of the public should depend on government for support at some time during their lives. Equivalently, the question is whether or not the middle class benefits when the government redistributes huge amounts from the middle class to the middle class and whether or not such a concept is sustainable.”

    AMT,

    While I tend to agree with how you’ve framed (part of) the issue, do you actually think that this is how our politicians are presenting it to the public or how the public is viewing it? If you think you are typical, you are very out of touch. And, who is “our side” and “their side”, anyway?

    I think the observation Kling has very concisely and wisely made is that we are now at the point where this is less than a zero sum game (a negative sum game, if you will) for *each* “side”. Each side is going to have to compromise and if they don’t each side is going to get less than if they did, in real rather than comparative terms. My guess is that each “side” is hoping the fall election will give them more leverage than they’ve now got. My bet is that the election will solve nothing. And, in the meantime, the debt just gets bigger.

    As to “sides”, the debate has been oversimplified by the “raise taxes (on the rich) side” and the “cut spending” side. Roughly, this is the red side and the blue side. This is in part because the respective “sides” are not rational policy positions, but merely negotiating starting points.

    There are not many moderates out there who are going to suggest to the voting public a more balanced and detailed (multi-facted, if you will) proposal. And, if let’s be real: neither “side” is going to get its way completely.

    Bowles and Simpson were interviewed on Charlie Rose the other day. They are the rare exception, but then again they are not (any longer) politicians.

  17. comment number 17 by: Jim Glass

    Vivian,

    I think you put that very well.