The Back-Door Entitlement

Volume II, Number 10 September 13, 1996

The days when a proposal to expand the welfare state could get a serious hearing are long gone, right? Think again. Although both major party candidates agree that growing and untargeted benefits to the middle class must be controlled, Clinton and Dole are peddling a raft of tax favors, from the child tax credit to the tuition tax credit, that amount to the same thing.

Economists call this type of back-door spending a "tax expenditure." The concept is simple: When government gives you a break on your taxes because you engage in a special activity or belong to a special group, this tax break is the fiscal and economic equivalent of a government benefit check in the mail. From the home mortgage interest deduction to the tax exclusions for employer-paid health care and Social Security and Medicare benefits, the federal tax code contains dozens of such provisions, each of which adds to the deficit just as a direct benefit program would.

Tax expenditures should be recognized as a major problem. They are large and growing. The great majority are regressive. They misallocate economic resources. And, most important, they typically serve no legitimate social purpose that couldn't be better served at far lower cost through other means.

Intriguingly, both the left and the right have found ideological reasons not to care about most tax expenditures -- which is why Clinton and Dole can propose new ones with impunity. It's time to wake up. Our system of tax expenditures is even less defensible than our system of direct benefits. Rather than compete to expand it, policy leaders should be seeking to cap and control it.

An Indefensible System

Let's start with the question of size: roughly $470 billion in FY 1996, according to Joint Committee on Taxation data. (This total is the simple sum of all tax losses classified as tax expenditures by the Joint Committee and ignores interactive effects.) True, other figures are possible, since what you classify as a tax expenditure may vary depending on how you define the "normal" tax structure. While the general principle underlying the federal tax code is that everyone should be taxed according to a uniform rate schedule imposed on everyone's ability to pay, economists differ about whether income that is saved, donated to charity, or taxed away by state and local government ought to be included in the tax base --and hence about whether deductions for these items are genuine tax expenditures. Still, even if we look only at consumption-oriented tax breaks for individuals that would be classified as tax expenditures in any framework, the total is huge: at least $224 billion this fiscal year.

Tax expenditures are not only large, they are growing. Since 1950, the value of the exclusion for employer-paid health care per U.S. household has shot up thirtyfold, from roughly $30 to about $900 in today's dollars. Since 1975, the Social Security exclusion and the home mortgage interest deduction per household have both more than doubled in real terms. Obviously, any tax expenditure associated with retirement or health care will continue to grow explosively as America ages.

But big and growing isn't all. Most tax expenditures are regressive in the strictest sense of the word. Even when poorer households qualify for these benefits, the fact that tax rates rise with income means that the size of the tax break they get is smaller, relative to their income, than the break the affluent get. Take the home mortgage interest deduction. Last year, the average value of the deduction for taxpayers with incomes over $200,000 was $9,763. In contrast, the deduction was worth an average of only $502 for taxpayers in the $20,000 to $30,000 income bracket who qualified for the benefit -- and many, including renters and those who opted for the standard deduction, did not qualify.

When we add up all of the housing, health-care, and other consumption-oriented tax expenditures for which we have income data, a clear picture emerges. Nearly three-quarters went to the half of all households with incomes over $30,000 in 1991 and nearly half went to the one-quarter with incomes over $50,000 -- a distribution far more skewed toward middle- and upper-income Americans than that of direct benefit outlays.

Then there is the issue of misallocated resources. It is a basic law of economics that you get more of what you subsidize and less of what you tax. Given how we distribute tax entitlements, is it any wonder that Americans are the world's most profligate consumers of medical services? Or that they overconsume jacuzzis, five-car garages, and vacation homes at the expense of productive investments in factories and workers?

Yet perhaps the crowning indictment of tax expenditures is that so many serve no coherent social purpose. Why is it that we spend billions of dollars annually subsidizing health plans for corporate professionals -- while doing nothing for the roughly 35 million Americans who have no insurance at all and are twice as likely to be poor as other Americans? And why is it that a number of other nations -- most notably Canada -- have achieved rates of homeownership comparable to ours without our lavish home mortgage subsidy? The truth is that many tax expenditures do not represent purposeful policy choices at all, but are historical accidents -- the result of ad hoc rulings by Congress and the IRS, enacted without much debate and far from the scrutiny that normally accompanies direct benefit spending.

Why Ideologues Don't Care

Unmoved by this critique, many conservatives repudiate the very concept of tax expenditures. It implies, they argue, that government owns all of your income until it does you the favor of letting you keep part of it. This is not the case. The concept (let us repeat) simply assumes that each person owes the government according to a uniform rate schedule imposed on every person's ability to pay. Whatever violates such equal treatment is deemed the equivalent of a benefit outlay -- the same, that is, as a government check in the mail.

From the dogmatic insistence that there is no such thing as a tax expenditure, any number of absurdities follow: for instance, that a public policy exempting all circus clowns from income taxes would not be a public benefit to circus clowns -- who would simply be keeping more of "their money." Who cares if this means taking more of someone else's? Or if it means heaping more debt on everyone's kids? The ultimate thrust of this line of reasoning is to deny that a society can consent to any equitable principle of public sacrifice. Accordingly, all taxation is inherently unjust, and though cheating on your taxes may be illegal, it cannot be morally wrong.

For their part, liberals accept the concept but apply it selectively. To judge by the usual rhetoric, you'd think tax expenditures were mostly give-aways to industrial robber barons. In reality, all corporate tax breaks totaled just $65 billion in 1996, about the price tag for the home mortgage interest deduction. Most of the so-called "business" loopholes are actually individual tax breaks for pensions, IRAs, and capital gains -- provisions that may not be genuine tax expenditures at all and which most Americans, including most liberals, agree are essential savings incentives. As for the huge consumption-oriented tax expenditures going to middle- and upper-income households, most liberals are silent.

This hypocrisy rankles conservatives -- as does the typical assumption that getting rid of tax expenditures is a "painless" way to raise more revenue. Conservatives rightly respond that closing tax loopholes while lowering tax rates might indeed be a relatively painless way to promote economic efficiency -- but that raising revenue is never painless. After all, a tax is a tax, and raising taxes will place an extra burden on U.S. households just as surely as cutting Medicare will. The issue is whether bearing this extra burden is in our public interest.

Let's Quit Playing with Words

It's time to move beyond semantic quibbles and agree on a simple ground rule: However we resolve our ideological disputes, we must hold our children harmless. It will make no practical difference to future generations whether they must defray the cost of today's debt-financed direct benefit outlays or today's debt-financed tax expenditures. Indeed, if we look at the EITC, where a refundable tax credit (a direct benefit outlay) and a nonrefundable tax credit (a tax expenditure) are flip sides of the same policy provision, one wonders if there is any meaningful distinction at all.

Clearly, our biggest fiscal challenge is to control the cost of direct benefits. But while we pursue that goal -- and while we ponder the holy grail of "tax simplification" -- we should also begin to scale back tax expenditures, starting with those that are largest, that are the most distributionally perverse, and that constitute the biggest roadblocks to economic efficiency. Unfortunately, the proposals being offered up this election season would move us in precisely the wrong direction.

Selected Tax Expenditures in FY 1996

(Billions of Dollars)

Consumption-Oriented Individual*.$224
Exclusion of Employer-Paid Health Care**$92
Home Mortgage Interest Deduction$59
Exclusion of Social Security Benefits$23
Exclusion of Medicare Benefits$13
Earned Income Tax Credit (EITC)$4
Total Corporate*$65

*Totals ignore interactive effects. **Includes FICA tax losses.

Source: Joint Committee on Taxation and Congressional Budget Office


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