Preferential Rates on Capital Gains (62 billion dollars in FY 2013). The lowered rates on capital gains are the most regressive tax expenditure: in 2011, 96% of the benefits went to the highest quintile of earners. Tax filers with income of more than a million dollars per year or more gained on average nearly 120,000 dollars from these reduced rates (over 6% of income), and only 13% of all filers gained any benefit from the lowered capital gains rates.
In other words, the direct middle class benefits were essentially zero from lowered capital gains rates.
Employer-Sponsored Health Insurance Exclusion (180.6 billion dollars in FY 2013). Determining distributional effects of the largest tax expenditure is difficult because it is deeply interconnected with larger issues of health care provision. This is also why few policymakers have suggested significantly altering the policy unless it is done as part of a larger health care overhaul toward a single-payer system.
Middle-class families do benefit from the exclusion employer health insurance benefits since a majority of all workers receive health insurance through their employers. However, just as with other major tax expenditures, the distribution favors the wealthy. Middle-class families benefit less than the highest earners do, and as employer-sponsored health insurance coverage continues to decline, the middle class will see fewer benefits from this provision.
In a 2009 analysis, Jonathan Gruber estimated the cost and coverage effects of changes to the employer-sponsored insurance exclusion. Leaving the exclusion for payroll taxes aside, the top 20% of earners would bear 50% of the cost of repealing the exclusion for federal income taxes (which means that these earners receive approximately 50% of the benefit of the exclusion). The three middle quintiles combined receive the other half.
Exclusion for Retirement Savings Plans (165.4 billion dollars in FY 2013). Tax exclusions for retirement plans, including 401(k)s and other employer pensions, sound like they should help the middle class, but the distributional effects are similar to other major tax expenditures. Approximately 80% of the benefits from all tax-favored retirement plans will go to the top quintile of earners this year. As a percentage of their income, individuals in the three middle quintiles will benefit about 0.9% on average, while top quintile earners will benefit 3.2%.
With the continued decline in employers offering defined benefit pensions, defined contribution pension values damaged by the stock market, and questions about the long-term solvency of Social Security possibly leading to significant benefit cuts, the tax exclusion for retirement savings plans will not make up for a decrease in middle class retirement benefits.
Taken together, the Tax Policy Center estimates that 2/3 of the benefit from all exclusions (including health insurance, retirement savings, and a number of others) accrued to the highest quintile of earners in 2011.
Yet despite this imbalance, exclusions are far more important to the middle class as a percentage of income than itemized deductions and preferential rates on capital gains. If all exclusions added together were eliminated, the middle three quintiles would see their after-tax income decline by about 4.4% (compared to 0.6% for itemized deductions and less than 0.1% for capital gains).
The differences between total benefits from tax expenditures and benefits as a percentage of income means that eliminating these regressive expenditures without adding further supports will take a toll on middle class budgets. As income inequality and the cost of goods like health care increases, these tax expenditures become more important to the middle class, even if the distribution favors the highest earners.
Earned Income Tax Credit (55.7 billion dollars in FY2013, including money refunded). Any full discussion of tax expenditures also needs to differentiate between deductions/exclusions and credits. Tax deductions (and exclusions) reduce the amount of income that is subject to taxation, while tax credits rebate or offset the direct amount of tax being paid.
About 80 percent of tax expenditures are deductions or exclusions, rather than credits, which is why most of the biggest expenditures fall into this category. But the distributional effects of deductions and credits are very different. Credits - particularly refundable ones, meaning that if the tax burden is reduced to a negative amount the filer receives a positive rebate - are progressive. More than 90% of the benefits of all refundable credits, including the EITC, went to the bottom four quintiles of earners in 2011, and the elimination of all refundable credits would hurt the middle quintiles of earners about 3% of income on average.
This does not mean that credits are exempt from the debate: there is a strong argument to be made that providing benefits through the tax code is less effective and less efficient than crafting more direct social policy. In America, we help offset the cost of raising a child with the child tax credit; in Finland, however, families are given a direct child benefit payment each month. And the use of tax policy (particularly credits) to provide social policy reduces many Americans' federal income tax burdens to zero or less, which has become a point of contention in the public sphere.
Rather than defending current tax expenditures or focusing on reducing tax rates, the debate we should be having is how to create a "middle class welfare state" that actually works. We can continue to use the tax code but make it radically more progressive by replacing deductions with credits or creating mandatory universal tax-favored savings programs, or we can switch from the system run through the tax code to a simpler, more direct slate of policies, such as expanding social insurance programs like Social Security and Medicare and increasing public provision of services like education and childcare.
Both sides agree that the American middle class is "under stress" and facing stagnating incomes, higher costs, and more insecurity. If we are in an economic situation in which any action that would hurt the middle class is wrong, even if it is extremely regressive and inequitable, it should make us think that the overall welfare state for the middle class needs to be stronger. If without the half-dollop of mashed potatoes the middle class is going to starve, we should rethink how we are serving dinner.