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.

Some of the other big expenditures can be plausibly defended on economic grounds, although I could live without them as well. Tax preferences for retirement plans ($123 billion this year), while tilted toward the rich, arguably encourage people to save more. The deduction for state and local taxes ($66 billion) is basically a transfer to state and local governments, and eliminating that transfer would just increase state and local government deficits. But there are plenty more to choose from, like the step-up in basis at death (if you die holding an asset, no one ever pays tax on the appreciation during your lifetime; $32 billion) and a host of industry-specific tax breaks.

The mortgage interest tax deduction and the exclusion for employer-paid health insurance help the middle class, you may say. First, not so much. To begin with, 46 percent of households pay zero income tax. (Half of them would pay some income tax if there were no tax expenditures, but in the vast majority of cases it's other tax breaks for the elderly, children, and the working poor that make the difference.) Even if you do pay taxes, the size of your tax break depends on the size of your house and the cost of your health plan--and only about sixty percent of people have employer-sponsored health insurance anyway. Second, the right way to create a more fair tax system is not to introduce distortions that help the middle class a little and the rich a lot. The right way is to have a more progressive income tax to begin with, which we could get simply by letting the Bush tax cuts expire.

MORE REVENUE, SMALLER GOVERNMENT

Closing tax loopholes should be a Republican objective not only because it would reduce the deficit, but also because it would actually make government smaller. That sounds impossible. How can raising government revenue make government smaller?

The only meaningful measure of the true size of government is the impact it has on private-sector decisions. Loopholes lead people to make choices they wouldn't have made otherwise, such as buying bigger houses and taking out more debt. That is government interference in the private sector. Closing tax loopholes eliminates that interference. And since it doesn't affect marginal tax rates, it doesn't change the incentive to work, either.

You'd think Republicans might support a compromise to eliminate tax expenditures and use some revenue to reduce the deficit and even reduce marginal tax rates. (This is exactly what the president's deficit commission proposed in 2010.) Instead, Republicans have locked themselves into the "principle" of no new net tax revenue using permanent Bush tax cuts as the baseline. This fetishization of an economically meaningless number means that they will reject any plan to eliminate tax expenditures unless every single dollar is used to reduce tax rates even further below the levels set in 2001.

This is just further proof that the conservative bloc that dominates the Republican Party doesn't actually care about deficits, only about protecting tax cuts and slashing spending. But that's never been a secret. As anti-tax czar Grover Norquist said, "Anyone who says we have a deficit problem is either a Democrat who wants to raise taxes or a Republican who's dimwitted and doesn't understand what he's talking about." And as a result, we are likely to keep the tax expenditures, and the distortions they create, while gutting spending programs that ordinary people really do need.

The dead French monarchs would be so proud.


  • Great Britain's postwar debts were just as big, but it was able to raise taxes--which were much higher than in France--and pay down debt in peacetime.

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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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