Tax Deductions or Tax Expenditures?

(Photo: David Reber)

Chances are, you’re going to spend tonight finalizing your taxes, making sure that you ferret every last deduction. And probably pretty pleased to be getting these deductions; but when you dig in a bit deeper, you may not be so sure — at least that’s what Betsey Stevenson and I argue in our latest column.

In fact, tax breaks are no different from either government handouts, or federal mandates, whether evaluated in terms of your finances, the government’s finances, or incentives:

Instead of looking at all the breaks for mortgage interest, health care, retirement savings and so on as deductions, picture the government writing you a check for each item. This equivalence between tax deductions and government spending leads economists to call them “tax expenditures.” Reformers have hit on an even more pointed description: spending through the tax code.

The tax system is also equivalent to a collection of individual mandates, like the one in the Obama health-care law, with penalties for Americans who fail to buy insurance. For many people, that’s how our system works. You and your neighbor might have the same income, but if, unlike your neighbor, you fail to have a mortgage or buy as much health insurance, then you have to pay higher taxes. 

It’s hard to see how you could be against government spending or against mandates, yet for more tax breaks.  Yet that’s exactly the position of Grover Norquist, the czar of the anti-tax pledge. Behavioral economists would call this a framing effect.      

For instance, you might think the mortgage interest deduction is a good idea.  What if we changed the framing though, and made it an explicit government handout:

Would you support giving millionaires with mansions 25 times more than the typical family? That’s effectively what we do: Middle-class families get an average benefit from the mortgage interest deduction of $139, while families in the top 1 percent get $3,752.

The non-partisan Tax Policy Center has done some great work shining a statistical spotlight on these tax expenditures:

Taken together, individual income tax expenditures are the equivalent of sending $686 each year to those in the bottom fifth of the income distribution, $3,175 to those in the middle fifth, and $30,714 to those in the upper fifth. The average member of the top 1 percent gets nearly a quarter of a million dollars a year.

So how does such an unfair system continue?  It’s politics.

Unlike typical government spending, tax expenditures aren’t reauthorized each year by Congress, so they have immense staying power. Because they aren’t as visible as outright spending, they aren’t subject to the scrutiny of campaigns to pare back waste or assess effectiveness.

This seems crazy.  So Betsey and I have a simple policy proposal:

Let’s replace all tax expenditures with explicit subsidies — that is, with actual federal payments — so we can really see the costs and debate all spending programs on an equal footing. Doing so would help us answer crucial questions, such as whether we get more bang for our buck by subsidizing homeownership or by spending more on schools.

Here’s Betsey making exactly this point last Sunday, on MSNBC’s Up! With Chris Hayes

What do you think?  Is there any reason that this should be controversial? 

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COMMENTS: 52

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  1. ThatGuy says:

    Wow, way to brazenly misrepresent what Grover Norquist has asked for.

    He wants to eliminate tax breaks too, but only in return for lower rates that keep the whole thing revenue neutral.

    And if you want to talk “framing,” let’s talk about framing letting people keep their money as the government giving them the same amount. That’s like saying I didn’t mug you today, so I gave you $300.

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  2. Norm says:

    Framing or not, the reason for treating all mortgages on first homes the same is that in many ways it is fairer to treat everyone the same instead of trying to figure out who to help ( and indirectly who to hurt). For example where I live, San Francisco peninsula, has no middle class 3 bedroom homes under $600,000 (and not that low if you want a safe neighborhood.) There are plenty of places in the country where you can buy a reasonable place for $300-400,000(or less I suppose). So if you are going to severely limit tax credits or reimbursement for mortgage you are saying you want to penalize many middle class Californians (who generally earn more to be able to afford the crazy house prices.) Our politicians will rightly object and then everything becomes very complicated.
    This issue is part of the reason there is so much fighting about conforming and jumbo loans.
    It is also a reason to not try to modify behavior by special breaks of any kind.

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  3. BillD says:

    It all depends on your baseline – are you starting from current (marginal) or zero (absolute)?

    See Tabarok: http://marginalrevolution.com/marginalrevolution/2012/04/relative-to-baseline-forecasts-aca-and-otherwise.html

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  4. Walter says:

    I suggest that all tax deductions be eliminated and tax rates be lowered for all tax rate categories. Secondly, I suggest that people mail in their taxes quarterly. Tax payers would have quite a different reaction to government spending if they wrote checks rather than payroll deductions.

    Secondly, the federal agencies should be required to publish the average annual salary of federal employees including benefits such as health care and retirement.

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    • Joe J says:

      Good suggestions, too many times, groups making it ‘easier’ to pay something use it to hide the true payment. Although we just past Tax day. most at a gut level think the amount the pay in taxes is the final balance, (whoo hoo I got $20 back) instead of the amount they actually paid over the year.

      I would also add two other numbers. Their share of this years deficit, and the total debt. We will never get control of our spending if no whare on the bill is the actual amount owed, all we list is the equivalent of the credit cards minimum payment due.

      So instead of it just being You owe $7000
      your share of the extra spending for this year is an additional $20,000
      Your share of the debt: $150,000.

      Without us being serious about how much in debt we are we will never coe close to a true tax rate.

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  5. INTJ says:

    “It’s hard to see how you could be against government spending or against mandates, yet for more tax breaks.”

    Hardly. There is a huge distinction between keeping more of the income that I earned myself, with my own blood, sweat, and tears, and a government handout that gives me money someone else earned.

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    • Michael says:

      It seems like there’s a huge distinction, which is why politicians get away with it, but economically it’s identical. Plus, it creates the same distortions as other subsidies. For example, I recently bought a condo even though I would prefer to have an apartment – both to avoid the risk of real estate prices moving and to increase my ability to move for work if necessary. However, the value of the mortgage interest tax deduction was to great for me to ignore, so I bought a place even though – absent that deduction – it’s certainly a suboptimal decision for me.

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  6. Michael says:

    Prof. Wolfers
    The reason your proposal would be controversial is ultimately the reason why the tax code is so complex – because the ability to grant special interests favors enriches politicians. Explicit subsidies are unpopular, but tax cuts are viewed as different in the popular mind. Thus, tax expenditures – both corporate and individual – make for good business for the political class.

    As an aside, I’d propose going even further with redoing the tax code. Not only should tax expenditures be replaced with explicit taxes, but as many indirect taxes as possible should be levied directly. End the employer portion of the payroll tax and levy it directly on the tax payer. In addition to that, end the artificial distinction between payroll taxes and federal income taxes. Both Republicans and Democrats would howl since, that would simultaneously erase the myth that the poor don’t pay taxes while demonstrating to the average person how high his tax burden truly is.

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  7. forgetaboutit says:

    This is a really lousy idea, based on muddled thinking and massive confusion.

    Take the deduction for state income tax. Is this “no different from either government handouts, or federal mandates, whether evaluated in terms of your finances, the government’s finances, or incentives”? Really? It seems a very unnatural way of looking at the deduction. The obvious and intuitive way of looking at it is that these taxes are deducted at source and so should not be counted as “income”.

    The “tax expenditure” argument is at heart a bait-and-switch way of justifying higher taxes. You’re taxed at15%? Well then, it’s “as if” the government taxed you at 50% and cut a check to you for 35%. Since it comes to the same thing, it must BE the same thing. And now that we’ve established that, the government is having second thoughts on sending you that 35%: you’re not grateful enough and they have other ways in mind for spending that money!

    Forget about it!

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    • Michael says:

      You’re example about a 15% tax being identical to a 50% tax combined with a 35% subsidy is actually totally correct from an economic perspective. Wolfers point is that, in your example, it’s easier for people to understand what the government is doing economically if the government is straightforward about it. Thus, it’s easier to understand the economic implication of a 15% tax rather than a 50% tax coupled with a 35% subsidy.

      Wolfer’s main point, I think, is that tax expenditures create the same distortions as subsidies and other forms of government spending. However, because they’re structured as tax breaks, most non-economists get confused about their true impact.

      To take an absurd example, you’ve probably heard of the earned income credit. It’s what the government calls a ‘refundable tax credit’. What that inscrutable phrase means in reality is that if you qualify for the credit the government will allow you to take it even if the credit exceeds your total tax burden. Thus there are actually a significant number of people in this country who have negative income tax rates. You’ve got to admit that’s pretty clearly a subsidy.

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      • forgetaboutit says:

        Any transaction is equivalent to some other transaction with assorted changes that all cancel each other out. Your employer pays you a salary? Well then, it’s as if (or is “identical from an economic perspective”) to your employer paying me, and me forwarding the money on to you. Saying this is so doesn’t mean that the alternative way of looking at it is “clearer” or more real or preferable in any way.

        Taxes are applied on a measure of net income, not on gross income. You may disagree with that, but the rates that apply were set after all the main deductions were established and so are tied to the definition of net income. If I buy stock for $1000 and sell it for $1100, I receive $1100 but deduct the $1000 basis and am taxed on $100. Is this deduction a “tax expenditure” by the government? It can be seen that way if you really squint, but the natural (“straightforward”) way of looking at it is that the deduction is a necessary part of measuring your true income. You didn’t really earn $1100 of what any reasonable person would call income, you earned $100.

        Similarly for many of the so-called “tax expenditures”. State and local income taxes are a key example. Your employer deducts state taxes from your paycheck. Rather than seeing this as some bizarre hypothetical spending program in which the federal government is in effect “spending” money by declining to tax you on it, why not take the straightforward approach? It’s as if the employer pays you a smaller salary and sends a separate payment directly to the government (which is much closer to what actually happens) so this separate payment should not be seen as part of your true income. It never “came in”.

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    • Michael says:

      Capital gains are a different beast entirely from other forms of income – though, truthfully, that distinction can sometimes become murky.

      I understand to the philosophical objection people have to viewing tax expenditures as government spending because – as you say – the current rates were decided on in context of the deductions. The point is that people easily grasp that subsidies distort economic behavior, but they don’t realize that tax deductions and credits do the same thing. State income taxes are an excellent example. By allowing the state income taxes to be deducted, the federal government subsidies state governments and creates an incentive for states to spend and tax more rather than less.

      Take another extreme example. The income tax rate is 100% on all income, but the government allows deductions for food, clothing, housing, other consumables and investments. The catch is that you have to buy government approved food (no mean), government approved clothing (functional only), buy other consumables from government approved stores (like the Friendship store in China), and you have to invest in government bonds to qualify for the investment deduction (no stocks). It’s easy to see how you could get your tax burden down to 0% in this example, while the government would be exerting far more influence over your behavior through the tax code than it does currently.

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      • forgetaboutit says:

        One of the many problems with the “tax expenditure” concept is that its enthusiasts seem to find it impossible to analyze the effects of the tax system without resorting to it, whether it is appropriate or not in any given case.

        Let’s say my employer graciously permits me to take a reasonable number of extra days off without pay. (Which is in fact the case, and I genuinely welcome the flexibility.) From my point of view, the effect on taxes is simple: I have less income, therefore I pay less tax. What could be simpler? But the tax expenditure enthusiast has to resort to all sorts of contortions in which I somehow have derived a tax benefit that is in effect government spending, and all sorts of hand-wringing results in whether the government should permit this. (Is the government encouraging people to take more time off than they would otherwise?)

        You may think I’m exaggerating here, but if so, consider the idea floating round to cap the “benefit” of itemized deductions at 28%. Otherwise, the reasoning goes, a high-income taxpayer derives more “benefit” from a charitable contribution than a lower-income worker. It seems to me that the straightforward approach, whether it’s extra time off without pay, or a charitable contribution, or state income taxes for that matter, is to consider that I’m being taxed as if I received less money. That’s because ***I received less money***. It’s quite bizarre how much this straightforward conclusion is resisted.

        To see all this as “distorting economic behavior” is wrong-headed on so many levels I hardly know where to begin. The government adds up my net income and taxes me on it — that I get. The government could treat me as having received income I never got, or having money I don’t have, and the government’s failure to do so somehow distorts my economic behavior –that I don’t get. It seems muddled, confused, wrong-headed, unnecessarily complicated, and obsessed with contorting real life to fit a preconception.

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    • Michael says:

      It’s not that I exactly disagree with the points you’re making; it’s that I think the current tax code is badly structured. The government doesn’t really tax net income; it really taxes revenue and arbitrarily allows deductions for some expenses, but not others. For example, there’s no rational reason why the government should allow me to deduct my mortgage interest but not the cost of food, clothing, and heating. After all, I need food, clothing, and heating every bit as much as I need shelter. Because there are only a few deductions that most tax payers can take, the government encourages overconsumption of such tax favored resources – like housing – and that causes bad side effects. Certainly, the mortgage interest deduction contributed to the size of the housing bubble.

      While an individual income tax that essentially taxes revenue isn’t perfect, it’s probably better than alternatives. If we’re going to have such a tax, the least distortionary method is to tax revenue and allow no deductions. There’s certainly room to argue about how to best structure the tax code, but the earned income tax credit, the deductions for mortgage interest and student loans, and the deductions for state income taxes should certainly be dropped (and there should be a commensurate decrease in tax rates).

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  8. BILL says:

    This is just so misleading in so many directions, it is hard to even believe that these people believe what they say..

    Good lord.. If you rent vs own, you are under a mandate of some kind!!…

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