Tax Expenditures - What Oregon Did - Should CA Do the Same?

Basically, "tax expenditures" is the term for spending that is buried in the tax law. They are tax provisions, such as a deduction for charitable contributions or mortgage interest or a jobs credit, that are not necessarily elements that are required to define a particular tax base. However, some items that are called "tax expenditures" such as a personal exemption in the income tax, could also be viewed as key elements of an income tax based on ability to pay.

Tax expenditures are a form of spending because they reduce one's tax liability. Thus, they are similar to a spending item in the budget. For example, the government can encourage businesses to hire workers in disadvantaged categories either via an income tax credit or a direct grant (check) from the government. A big difference between the two formats is that a tax expenditure one in the tax law is not subject to annual budget review where as a program administered by a government agency (such as the Dept of Labor) is subject to annual budget review. [For more info, see a 2/08 op ed of mine from the SF Chronicle.]

The federal government and most states track tax expenditures - typically in an annual report. Despite the annual report, I don't think they get much attention by policymakers despite the fact that some tax expenditures become outdated.

Recently, Oregon enacted HB 2067 which adds a sunset date to many of its tax expenditures, such as business tax credits (signed 8/7/09). Generally, the ones not designated to sunset are those required by federal law or Oregon's constitution. The rationale expressed by the House Majority Office is that the number of tax expenditures - 380 was getting large. They also noted that the "cost" of the expenditures - over $30 billion per biennium, is greater than the spending for education, health care and public safety combined.

Technically, the sunset date just means that if the lawmakers want to continue a deduction or credit beyond its expiration date, they need to renew it. This illustrates a benefit of sunsets - it forces tax expenditures to be reviewed regularly so that lawmakers can see if they are working as intended and if they are even still needed. It also forces them to have to find the funds to pay for them - they are no longer automatic spending items.

What about California? CA has used sunsets on many provisions, but not all. How does California's tax expenditures compare to key categories of spending. Here is some data from the Department of Finance's Tax Expenditure Report for 08/09:

• Personal income tax - 42 expenditures that are each at least $5 million per year - totaling an estimated $34.4 billion for 09/10
• Corporate income tax - 15 expenditures that are each at least $5 million/year - totaling an estimated $3.9 billion for 09/10
• Sales tax - 20 expenditures that are each at least $5 million per year - totaling an estimated $9.3 billion for 09/10

So for these 3 key state tax categories, the tax expenditures total almost $48 billion annually. Of course, this is not really the same as an expenditure. For example, if a credit with an estimated "cost" of $5 million were repealed, it does not mean the state collects $5 million more (mainly due to behavior changes).

Also important in examining tax expenditures is the reality that identifying the elements of an "ideal" tax system is subjective. For example, one of the tax expenditures for the personal income tax is the head of household filing status. Some might believe that there should be a preferential filing status for singles with a dependent (relative to the single filing status) as part of a basic income tax system based on ability to pay. Also, the starting point is the legal definition of the tax rather than an ideal tax. For example, the CA sales tax by law only applies to tangible personal property. Thus, it does not apply to consumption of services. So, the list of tax expenditures does not include the revenue not collected due to an exemption for services.

How does $48 billion of tax expenditures compare to other California figures?

• In Feb. 2009, the budget gap was estimated to be $42 billion.
• K-12 education General Fund expenditures for 09-10 are estimated to be $35 billion.
• Higher education General Fund expenditures for 09-10 are estimated to be $10.5 billion.
• A 2004 UCLA study found that the cost of providing health insurance to the roughly 6 million uninsured Californians would cost about $7.4 billion per year.

There is a lot of money buried in "tax expenditures." A sunset date on more of them would cause lawmakers to have to determine periodically to see if they still make sense and whether we can still afford them. I've written about this before (here) - I note examples of ones that no longer make sense (and some probably never made sense). Some examples:

• Allowing a deduction for mortgage interest on a second home.
• Capping the deduction for mortgage interest on a principal residence at debt of $1 million when the median home price in CA is under $500,000.
• Allowing a deduction for interest on home equity debt - particularly when interest on other types of personal debt is not deductible (favors homeowners).
• Exempting Social Security benefits that are taxable at the federal level.
• Providing a senior exemption based on age rather than income.

One of the proposals that the CA Commission on the 21st Century Economy is looking at is reducing the deductions for the personal income tax to only include the standard deduction, mortgage interest, property taxes and charitable contributions. The rate would also be lowered. Hopefully, if this is part of their final recommendations, it will be modified to make the home mortgage interest deduction better reflect CA home prices and not allow this deduction so skewed to wealthy individuals.

But this is an example of the benefits of looking regularly at tax expenditures - many just don't make sense and for a state in need of finding revenue, there is money to be found in outdated and inappropriate tax expenditures. Perhaps another recommendation of the Commission should be that new tax expenditures have sunset dates. New expenditures should also require collection of data so that prior to the sunset date, lawmakers have appropriate data to determine if the expenditure is serving its purpose or instead needs to be modified or allowed to expire.

It is worth taking a look at what Oregon recently did in adding sunset dates to many of its existing tax expenditures. That will force lawmakers to have to evaluate them rather than let them continue unexamined in the law (while line items in the budget get annual review). This is also an opportunity for more people to understand the fiscal and strategy impacts of these items. By strategy impacts - I mean that if we looked more closely at tax expenditures and more people really understood them, better budget decisions could be make. For example, CA struggles with how to help those without health insurance. The data above indicates it will cost about $7 - $8 billion to insure them. Where can that money come from? While some should come from the uninsured, some could also come from the state. Today, one of the largest tax expenditures in the CA personal income tax is for the exclusion for employer-provided health insurance. That "costs" the state almost $4 billion annually. Yet that expenditure only benefits employees with employer-provided health insurance. Why not modify the exclusion to enable part of the $4 billion to be used more equitably to benefit all individuals rather than only those fortunate enough to have employer-provided health insurance? That's just one example of better and more strategic budgeting that might occur if tax expenditures were focused on as much as line items in the budget.

What do you think?