Tax Expenditures: What They Are, and Why They Need Reform

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President Obama's decision to support a deficit commission has helped pull debt-reduction to the front of Washington's hivemind. The background story is familiar and oft-repeated: Low tax receipts, rising debt interest payments and looming explosions in entitlement spending threaten America's fiscal health.

Fareed Zakaria, who's always been an admirably efficient thinker, breaks down his diagnosis for the debt into three solutions: institute a value-added tax; make "sensible adjustments" to entitlements like tying benefits to inflation rather than wages and raising the retirement age; and cut distorting "tax expenditures" -- for homeownership, health care and agriculture. Those first ideas are commonplace among debt doctors. Let's take a look at the third.

t_exp_budgetFirst, tax expenditures: what is that term, anyway? As Ezra explained nicely, if the government spends a thousand dollars on Defense, that's an expenditure. When it withholds a thousand dollars of potential revenue by not taxing your employer's health care plan or mortgage interest, that's a tax expenditure. It's basically the principle that if you don't pick up a dollar on the ground, it's the same as spending a dollar in a store.

Taxes can be used to discourage behavior, so government uses these tax breaks -- which total $900 billion ever year according to the Tax Policy Center -- to encourage certain activities. The number one tax break is on employer provided health insurance, because we want employers to provide health insurance. Another top-ten tax expenditure is the tax deductible status of charitable donations, because charitable giving is, we agree, a nice thing to do. You can find a full list of the largest tax expenditures here.

So what's the problem with encouraging nice things like getting health care, and saving for retirement, and giving money to charities? The problem, as Zakaria helps point out, is that their not-so-nice consequences. For example, the health care debate helped shine a light on the distorting effect of the employer insurance benefit, which encourages employers to shift more money away from wages toward insurance, which conceals from workers the true cost of their insurance, and promotes overuse of health services, contributing to rapidly increasing health costs.

There are other problems with tax expenditures. Broadly speaking, the government withholds more taxes -- which is like giving you more money -- if you earn more, and pay a higher tax rate. That makes many tax expenditures regressive. Spending programs in Washington carry a stigma, so politicians have elected to run de facto spending programs through the tax system (after all, they are tax expenditures). But this is utter self-deception: Electeds convince themselves that they're not spending money, but they're giving up revenue.

Tax expenditures are easy to advocate, and that's exactly why we need more congressional advocates for capping or partially eliminating them. The Senate plan to tax gold-plated employer insurance is a smart idea (that the policy is designed to expand to more and more employers over time is even better). The Wyden-Gregg tax reform plan goes even further by gutting dozens of tax deductions. But real change will be slow and frustrating. Already, pressure from unions and liberals forced the latest Obama health care plan to delay the insurance tax eight years and raise its threshold. That's what tax expenditure reform will look like. Politics makes an enemy of good policy.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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