Tax Expenditures Are a Form of Big Government, and We Should Cut Them

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S&P's downgrade underlines the need for U.S. lawmakers to come together to raise revenues. The solution should be blindingly simple: Reform the tax code by filling the holes in the cheese.

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If you want to know how not to handle a debt crisis, look at 18th-century France.

Every time Louis XIV, Louis XV, or Louis XVI fought a war, spending went way up, forcing the government to borrow. After the war, interest payments consumed most of the government budget, and the debt only continued to grow.

But the kings couldn't raise money effectively because the tax code had more holes than cheese.* There were loopholes for social groups and tax breaks for provinces, and the rich could literally buy government positions just to get tax benefits. France's finances were in such bad shape that in 1789 Louis XVI called the Estates General to meet for the first time in 150 years. After that meeting failed, public outrage at the special privileges helped launch the French Revolution.

That's right. The French Revolution was, to an extent, about tax loopholes.

THE HOLES IN OUR CHEESE

The Capitol isn't the Bastille, and we're not pre-Revolutionary France. But our tax system is similarly shot through with deductions, exemptions, and loopholes that exacerbate our deficit problem. One of the most absurd examples is a measure that allows corporations to buy themselves jets and write them off faster than airlines.

But tax loopholes are not just for corporations. The mortgage interest tax deduction will cost the Treasury $94 billion this year. The tax deduction for property taxes and the exclusion of profits on the sale of your house will cost another $39 billion. That's $133 billion the government is paying every year to encourage people to buy houses (and look where that got us). The single biggest tax break is the exclusion of employer-paid health insurance, which costs $117 billion.

You probably know all about tax expenditures--the respectable name for loopholes--so I'll be brief. Tax expenditures are modifications to the tax code that further some alleged societal interest or help some interest group. They function like government spending--more money ends up in certain people's pockets--while being accounted for as lower taxes. This means they perform the magic trick of increasing the government's influence over society while reducing tax revenues (further proving that total spending and total taxes are nearly meaningless when determining the size of government).

Tax expenditures are often less efficient than spending, and they tend to benefit the wealthy. The rich are in higher tax brackets, so they gain more from deductions. They have bigger houses and better health plans, so they have more house and health care to deduct. Meanwhile, millions of lower-class families often don't have enough deductions to itemize, so they get little benefit from deductions.

WHAT WE CAN ACTUALLY DO

With the debt ceiling crisis past, and S&P demanding further deficit reduction, the next step is for a joint committee of Congress to identify at least $1.5 trillion in deficit reduction over the next ten years. The simplest, most sensible way to do this would be to eliminate tax expenditures.

For starters, eliminating the mortgage interest tax deduction, the exclusion of profits on the sale of your house, and the exclusion for employer-paid health insurance would yield $240 billion next year: phase that in over ten years and you easily get far more than $1.2 trillion (in nominal terms). I picked these because they are big, they are simple, and they distort the economy in bad ways. The housing subsidies lead people to buy too much housing, and the health insurance subsidy leads companies to pay too much for health insurance.

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James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.
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