The Tax Code Is a Complicated, Horrible Mess Because We Like It That Way

Hooray, you've finished your taxes! Let's complain about them.

There's no wrong way to whine about the U.S tax code, but some of the most popular fine whines are more intertwined than you might think. Consider a few common refrains:

(1) Poor families should pay more income taxes. (The GOP presidential candidates said this.)
(2) The tax code is too complicated. (Everybody says this.)
(3) Tax breaks privilege the rich. (Liberals say this.)
(4) Tax rates are too high. (Conservatives say this.)

These are separate complaints, but I think they're all part of the same story. And that story is tax spending in the federal income tax code.

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You can think of the U.S. tax code as mostly comprising two separate tax buckets. The first bucket is payroll taxes. They tend to account for about 40% of government income. It works like this. Everybody on a payroll -- hence the name -- gives up a bit of money to fund dedicated programs like Social Security and Medicare and unemployment benefits. We don't tinker much with payroll taxes because, after all, they're for dedicated programs. (We did, however, recently cut them to stimulate the economy.)

The other "bucket" is federal income taxes. These also account for about 40% of the government. But they don't really fund specific programs. They pay into a general fund that pays for everything from education to defense. But with this tax bucket, we tinker, tinker, tinker all the time to award and punish behavior. This tinkering is expensive. By choosing not to tax employer contributions to medical insurance, the government gave up $130 billion in 2008. By letting families deduct mortgage interest on their homes, we gave up another $90 billion. By paying families credits for their children, we gave up another $30 billion.

The important takeaway is that the federal government is running a multi-hundred-billion welfare and social policy program through this "second bucket" of our tax code. If you add together all the money we "give up" in the federal income tax bucket, you get a really big number. Bigger than Medicare or defense spending, even. Here's a picture:

This isn't pernicious, exactly. The vast majority of income tax carve-outs go to the rich, because the rich have most of the taxable income to begin with. The top quintile makes 50% the national income, pays 90% of federal income taxes, and receives more than 70% of all tax breaks from exclusions and itemized deductions. That doesn't sound so crazy.
 

But how do you maintain the progressivity of the tax code if 70% of your carve-outs just make the rich richer? There are two solutions. One is to have higher tax rates to offset larger carve-outs. We have those. The second is to make some tax credits "refundable," which means families can earn a tax credit that exceeds their tax bill -- they can profit from federal income taxes. We have those, too. In fact, about half of U.S. households get a tax "refund" every year in the income tax code. Here's a graph of the growth of refundable credits since 1975. Tweetable fact: Refundable tax credits have increased 1,800% in the last 37 years.

What happens when you run social programs through tax breaks in federal income tax code? Three things happen. First, you have to offset more breaks with higher rates, which makes some people angry. Second, the majority of the benefits accrue to the rich, which also makes people angry. Third, to maintain the progressivity of the tax code, you have to make some tax credits refundable, which wipes out the income tax burden of tens of millions of households, which makes yet more people angry!

The solution to this quandary -- after "ask everybody to stop being angry" -- is to stop shoveling our hard decisions about social policy and welfare into the tax code.*

The irony is that the tax code is complicated because we want it to be complicated. Home owners want to be rewarded for their home ownership. Parents want to get money for their kids. Everybody wants a subsidy for health care. Poor people appreciate the extra cash. Break by break, tax breaks are popular. Hugely popular. Come-and-take-this-from-my-cold-dead-hands popular. But in the aggregate, they make people furious about the tax code. They push up rates, distribute money to the rich, and make it look like people aren't paying their fair share. That's democracy for you.

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*The New America Foundation recently released a report that measured how much government invests in entrepreneurship, housing, retirement, savings, and other forms of human capital. What it found won't be surprising in the flow of this article. Tax spending, especially for retirement and housing, turned out to be regressive, so that rich got most of the money. Meanwhile, direct spending on programs like education turned out to be progressive. One implicit conclusion of the report was that human capital investment programs are more likely to progressive if they are spending by government, not "spending" by the tax code.