Are Tax Expenditures Evil?

This winter, as the Bush tax cuts come up for renewal and the fiscal commission releases its report on the deficit, the national media spotlight will turn to the budget. One shadowy nook that's sure to enter the harsh limelight is our tax expenditure budget.

I know, the term tax expenditure looks weird and oxy-moronic, but it's fairly straightforward. When the government spends a dollar on the military, it's an expenditure. When the government awards a tax credit, or withholds a dollar of potential revenue by not taxing your health care plan, that's a tax expenditure. At the end of the day, you should think of it like regular government spending -- the same way that if leave a dollar on the floor, it's the same as spending a dollar in a store.

(For a longer explainer about tax expenditures -- what they are and why we should reform them -- go here).


Where do tax expenditures go? This graph from the Tax Policy Center breaks it down by category. The largest single expenditure is on employer-provided health care. The largest segment is commerce and housing.

So why does Reagan chief economist Martin Feldstein want to slash this budget -- now worth nearly $1 trillion -- by a third? I'll let him explain:

Tax expenditures have been cut before on a large scale. President Ronald Reagan's 1986 tax reform reduced tax expenditures to 6% of GDP (from 9%), the level at which they remain today. Cutting them another 2% of GDP would reduce the national debt in 2020 by some $4 trillion, bringing the projected debt down to 72% of GDP from 90%.

One simple approach would be to reduce [the deduction on federal tax returns for local property taxes] by 10% in the first year, 20% in the second, and so on until the deduction is cut to 50% of its current size. That same kind of gradual and partial phase-down could also be applied to some of the employer-provided benefits such as life insurance premiums and travel costs that are now excluded from taxable income.

It's good to see tax expenditures on the operating table, but smart surgery will, he ruefully continued the metaphor, require a scalpel. It's true that tax expenditures are a haven for the welfare state, because Republicans and Democrats are happier to run programs through the tax system than announce new spending. It's also true that some tax expenditures -- like the mortgage interest and employer health care deductions -- arguably encourage bad behavior. But that's not a reason to go at the tax expenditure budget with a hatchet.

The Earned Income Tax Credit, for example, offsets the regressivity of payroll taxes and encourages lower-income people to work. It's more efficient to run some welfare programs through the tax system. To eliminate them because tax expenditures seem inherently shadowy is truly cutting off the nose to spite the face. When the country gets talking about this trillion-dollar shadow budget in the winter, it will be important to study tax expenditures as we would any other expenditures, on its impact on incentives and production, rather than broadly paint the whole system as shady.