February 14, 2012
In recent debates over reducing the budget deficit, even politicians adamant about not raising taxes have been discussing the elimination of tax loopholes, or “tax expenditures.” We turned to Professor of Practice Stephen Shay, who recently joined the law school faculty after extensive experience developing and overseeing implementation of U.S. international tax policy. We asked the former deputy assistant secretary in the U.S. Treasury: What are tax expenditures, and should they be repealed as a means to lower tax rates, reduce the deficit or both?
The concept of tax expenditures is closely associated with the late Harvard Law School Professor Stanley Surrey, who, as assistant secretary of the Treasury, in 1967 gave a speech arguing that a tax provision that gives a subsidy or benefit to a taxpayer group or category of income should be considered the equivalent of direct spending by the government. Professor Surrey’s policy insight was that targeted tax relief was functionally equivalent to the government collecting the tax from the taxpayer receiving the relief and immediately giving it back to that taxpayer as a spending outlay.
In 1974, Congress adopted budget legislation requiring annual estimates of tax expenditure costs. Tax expenditures for this purpose are revenue losses attributable to provisions of the federal income tax laws that allow a special exclusion, exemption or deduction from gross income, or that provide a special credit, a preferential rate of tax or a deferral of tax. However, tax expenditures listed in the annual budget are not treated in the same manner as spending. There is no established process, such as an annual budget appropriation, for reviewing individual tax expenditures or for evaluating whether an individual tax expenditure achieves congressional objectives at a reasonable cost. Even tax expenditures scheduled to expire are routinely renewed, which reduces the visibility of their true costs.
The tax expenditure concept has been controversial. Some scholars argue that whether a tax provision should be treated as a tax expenditure, in relation to an income tax base or a reference tax baseline, is an unprincipled exercise. Consumption tax advocates object that existing tax expenditure analysis favors income over consumption as the basis for taxation with the result that provisions that exempt or reduce tax on income from savings and investment are classified as tax expenditures. Notwithstanding these and other criticisms, there is a broad consensus among policy analysts that tax expenditure budgets have provided useful information to legislators and tax policymakers.
For fiscal year 2012, estimates of annual revenue loss from tax expenditure provisions total in excess of $1 trillion, exceeding the discretionary spending portion of the federal budget (i.e., spending other than for entitlements, defense and interest on the debt). For this reason, tax expenditures have been a “quick fix” target to raise revenue in the name of deficit reduction or to reduce tax rates in the name of tax reform or both. It is not so easy.
Today, more than 90 percent of tax expenditures benefit individuals and less than 10 percent benefit corporations. Some of the largest tax expenditures and some of the Treasury’s five-year (FY2012-2016) estimates for these provisions include: the employee’s income exclusion for employer-provided health insurance ($1.1 trillion), the home mortgage interest deduction ($609 billion), and deductibility of state and local taxes (not on owner-occupied homes) ($292 billion). Other tax expenditures, such as the child credit and earned income tax credit, perform important social safety net functions.
Some tax expenditures are poorly designed subsidies that create inefficient incentives, and many inappropriately benefit higher-income taxpayers. The largest tax expenditures, however, are embedded in the fabric of important sectors of the economy, such as health care and residential housing, and most tax expenditures support social program activities: housing (especially low-income housing), education, social services, health, income security (including for retirement), veterans benefits, and aid to charities, states and localities. Moreover, the revenue loss estimates for tax expenditures are static and do not take account of behavioral responses that would substantially limit revenue that would actually be raised by repeal of certain tax expenditures such as capital gains preferences. Tax expenditure repeal is not a panacea for achieving deficit reduction or tax reform.
Reform, and in some cases repeal, of tax expenditures should be a part of tax reform and contribute to deficit reduction. Consistent with Professor Surrey’s original vision, there should be an analysis of the objectives of each provision and an evaluation made whether the provision’s benefits outweigh its revenue and administration costs in the current context of substantial deficits. If a provision is to be retained, there should be a further consideration whether it should be redesigned as either a tax or spending provision.
Real tax reform would go deeper than merely re-examining tax expenditures; it should also re-examine and rehabilitate the individual and corporate income tax bases to fairly and efficiently raise the revenue needed to support the size of government adopted through the democratic process. Tax expenditures deserve scrutiny, but the tax expenditure classification does not address whether a provision is good or bad policy, and it does not cover the full extent of inequities and inefficiencies in our current income tax system.
This article was previously published in the Winter 2012 edition of the Harvard Law Bulletin.