This column originally appeared in Tax Notes, a subscription-only publication, http://www.taxanalysts.com/ .
By Diane Lim Rogers
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)|
|"Less Filling" (Republicans like) because it...|
Reduces deficit on tax side
|Cuts government subsidies/"tax entitlements"|
|and||Reduces size of government|
|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!
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 . 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.