Calculating 'Tax Expenditures' Is Complicated

Let me start off by noting that I am madly in favor of simplifying the tax code.  I think personal income tax deductions should be zero, beyond a generous personal deduction, and that the employer health insurance tax break should be zeroed out, along with the tax break for (new) retirement savings.  This is not a post supporting the Republican notion that giving someone a tax break for doing something is somehow mystically, metaphysically different from giving them a cash subsidy to do the same thing; either way, that money has to be made up by taking it from someone else.

It's just a post about how hard it often is to calculate the cost of a program.

You're starting to hear noise about the cost of tax breaks for retirement plans like 401(k)s . . . aye, and it's possible that I've even made some of that noise myself.  But as a Washington Post article points out, calculating that cost is extremely sensitive to the time window you use.  That's because "tax exempt retirement savings" isn't actually tax exempt; with the exception of Roth IRAs, it's simply tax deferred--the government will tax every dollar you save, at ordinary income tax rates, when you withdraw it.

To be sure, deferring taxes is very valuable; the longer your money grows without paying a periodic bite in capital gains taxes to Uncle Sam, the more of it you'll have when you finally spend it.  This is especially true if you expect to have a lower tax rate later--if you can put tax-free dollars into your 401(k) when your income tax is high, and withdraw it when your income tax is considerably lower.

However, in the case of tax-deferred retirement savings, there's a wrinkle: IRAs, 401(k)s, and so forth are taxed at ordinary income tax rates, which are often much higher than capital gains rates.  This erodes some of the gains of the deferral.  Not entirely, of course.  But some.

Because the accounts are only deferred, not exempt, we'll end up getting a lot of the money back in taxes.  But not yet, because they're a relatively new innovation, and still growing.  That means that if you calculate the cost today, or for the next five years, 401(k)s look like a very expensive tax subsidy.  But if you calculate them over the lifetime of the accounts, the loss of tax revenue is much smaller.

This sort of wrinkle is important to keep in mind when you look at the cost of tax expenditures: those costs are often calculated directly, right now, rather than dynamically, over the life of the asset.  So the home mortgage interest deduction is very expensive--but it might be less expensive if you assume that without it, people might put less money into homes and more into, well, tax-deferred retirement accounts.  Childcare subsidies are pricey--but maybe not that pricey if they encourage more women to go into the workforce and earn taxable income.

I still think that simplifying the tax code is a very good idea.  But just keep in mind that if we eliminated them, we wouldn't necessarily garner as much for the treasury as simple calculations might lead us to expect.