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Monday, June 3, 2013

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?




    EllCee said...

    Please explain the reasoning behind this sentence:

    "The greater your tax savings, taxes on others go up to help cover that cost."

    Are you saying if the government can't get it from a rich person, they'll gouge someone else?

    Professor Nellen said...

    Thanks for the question. I don't know if "gouge" is the best term, but assuming the government needs to generate a certain amount of revenue to cover expenses, if one (or more) person's tax liability goes down, someone else's goes up.

    Anonymous said...

    Admittedly, I cringe every time Prof. Nellen suggests the elimination of expenditures. Don’t get me wrong. I want what’s best for the greater good, just not at my own expense. I’m one of those taxpayers that benefits greatly from itemized deductions, and preferential treatment on capital gains and dividends. As an owner of two Bay Area homes, knowing I can deduct mortgage interest and property taxes on the Schedule A softens the blow of paying monthly mortgage payments and astronomical property taxes. Nonetheless, as much as I hate to admit it, Prof. Nellen’s suggestion to eliminate expenditures would make good tax policy. If doing so improves the Simplicity, Certainty, and Neutrality of our tax code, we should be able to restore taxpayer faith in the system, increase compliance, and most importantly, decrease the Tax Gap.

    The tax gap statistics are staggering. In this report from the IRS, the tax gap was estimated to be around $385 billion a year. [;-Compliance-Rates-Remain-Statistically-Unchanged-From-Previous-Study] And, in June 2011, the US Senate Committee on Finance had a hearing called “Complexity and the Tax Gap: Making Tax Compliance Easier and Collecting What’s Due”. [] If you were neutral about the tax gap crisis before, listening to this hearing will encourage you to care. From the hearing, we learn that while some non-compliance is intentional, a lot of it is unintentional and is due to the complexity of our tax code. Also, because of complexity, many taxpayers entitled to certain benefits never receive those benefits because they’re unable to navigate the quagmire within the tax provisions. Furthermore, it’s admitted that the tax code is so complex, that not even those who drafted the provisions have enough clarity to confidently prepare their own tax returns.

    While it breaks my heart to part with my beloved tax deductions, it makes sense to eliminate most of them in an effort to simplify the tax code. As a result, the tax gap will decrease and, hopefully, the overall tax rate will be decreased for all taxpayers. One can only hope.

    Grant said...

    I think this paragraph from the report pretty much sums up how tax expenditures as a whole are not meeting their original intent and their inherient inequity. "The 10 major tax expenditures considered here are distributed unevenly across the income scale. In calendar year 2013, more than half of the combined benefits of those tax expenditures will accrue to households with income in the highest quintile (or one-fifth) of the population (with 17 percent going to households in the top 1 percent of the population), CBO estimates. In contrast, 13 percent of those tax expenditures will accrue to households in the middle quintile, and only 8 percent will accrue to households in the lowest quintile."

    I take advantage of many of the top 10 tax expenditures, including employer paid health insurance and the home mortgage interest deduction. I benefit from these two a great deal, but I would gladly see them done away with or turned into specific credits as they currently inflate the cost of housing and health care for all and effectively subsidize consumption of housing and medical services for those in higher tax brackets to a greater degree. It will be painful , but something needs to be done.

    Professor Nellen said...

    I don't advocate for elimination of all tax expenditures. Some likely are good for the economy - perhaps some version of the research tax credit, charitable contributions. But many can be eliminated or cut back so that rates can be lowered and the tax law made more equitable.

    Unknown said...

    I agree with the observations of the Joint Economic Committee ( that the idea of "tax expenditures" causes tension between taxpayers and their government. It should not be communicated to people who work hard to make a living that all their money earned is not in fact theirs, it belongs to the government and the government decides how much of it we should be able to keep. This encourages disrespect for the system.

    Taxpayers would have more respect for the system if they felt it was equitable and fair.

    Nina Olsen, the Taxpayer Advocate, in her 2012 Annual Report to Congress ( explains the benefit of a zero based budgeting approach to tax reform. She advocates for starting with zero exclusions, deductions, exemptions and credits. Each item should be analyzed to determine if the benefit of running a public policy through the tax system outweighs the cost of increased complexity of doing so. She admits this could cause hardship for some but asserts that this would be better for everyone in the long run. Not all such "expenditures" should be eliminated, but with an appropriate approach and framework the burden of such programs can be lessened.