Distribution of individual tax expenditures

The Congressional Budget Office (CBO) recently released a report - The Distribution of Major Tax Expenditures in the Individual Income Tax System. The CBO examined ten of the largest "tax expenditures" (special deductions, exclusions, credits and rates) used by individuals. They are, as categorized by the CBO:

Exclusions from taxable income—

• Employer-sponsored health insurance,
• Net pension contributions and earnings,
• Capital gains on assets transferred at death, and
• A portion of Social Security and Railroad Retirement benefits;
   

Itemized deductions—

• Certain taxes paid to state and local governments,
• Mortgage interest payments, and
• Charitable contributions;
   

Preferential tax rates on capital gains and dividends; and

 

Tax credits—

• The earned income tax credit, and
• The child tax credit.

While there are about 250 tax expenditures in teh federal income tax, the ten listed above account for the bulk of the dollars. For 2013, the "cost" of the above tax expenditures is $926 billion out of about $1.1 trillion for all tax expenditures. CBO notes that these expenditures total about 5.7% of GDP. In contrast, CBO reports that Social Security spending is also about 5.7% of GDP, defense spending is about 4% of GDP, and individual income tax revenues are about 8.2% of GDP. So, these ten tax expenditures are a significant cost.

 

In addition to the significance of these ten tax expenditures in terms of cost, CBO points out that the benefit derived from these items (tax savings) is skewed to higher income individuals. Per CBO:

 

"For 2013, CBO estimates that 51 percent of the total benefits from the 10 major tax expenditures analyzed in this report will accrue to households that make up the one-fifth of people with the highest before-tax income, 13 percent will accrue to households in the middle quintile, and 8 percent will accrue to households in the bottom quintile."

 

This skewed distribution is due to the progressive rate structure. So, some may argue that this is all appropriate because if you are in a higher tax bracket, of course your deductions will be worth more to you, but you are still in the higher tax bracket.  But, to counter that argument, bear in mind that the government has selected certain expenditures for tax-favored treatment and several on the list above do not have any limits, such as the exclusion for employer-provided health insurance and the lower rate on capital gains. The greater the benefit you have, the greater your tax savings. The greater your tax savings, taxes on others go up to help cover that cost. 

 

Why not just eliminate or cut-back on most of the 250 tax expenditures and lower the tax rates?  That would enable the tax system to better meet principles of good tax policy. That is also noted in the following list by the CBO of problems caused by tax expenditures. 

 

The additional problems noted by CBO (besides their cost) pertain to most tax expenditures. The CBO lists five such problems:

 

1. "Tax expenditures may lead to an inefficient allocatio nof economic resources by encouraging more consumption of goods and services receiving preferential treatment."
2. "Tax expenditures increase teh size an dscope of federal involvement in teh economy."
3. "Tax expenditures reduce the amount of revenue that is collected for any given set of statutory tax rates—and thereby require higher rates to collect any chosen amount of revenue. All else being equal, those higher tax rates lessen people’s incentives to work and save and therefore decrease output and income."
4. Tax expenditures make the tax system more complex.
5. As indicated in this CBO report, "tax expenditures affect the distribution of the tax burden in ways that may not always be recognized, both among people at different income levels and among people who have similar income but differ in other ways."

I encourage you to take a look at the report. It includes some charts (one is produced below) that help illustrate the cost and distorted distribution of the tax expenditures. This report should prove useful to the congressional tax committees because a big part of their tax reform effort will be to reduce corporate and individual tax rates in a revenue neutral manner. That means they will need to cut back and eliminate tax expenditures. Much of this CBO report provides good reasons for doing so beyond just lowering rates, but to add fairness to the tax system and reduce its impact on the economy and decision-making. The tax system should be used primarily for revenue generation.

 

What do you think?