Minnesota Examines Tax Expenditures

Tax expenditures are special rules in a tax system that are not part of a "normal" tax. For example, special deductions, exclusions and credits in our Federal Tax system generally are tax expenditures. This includes the exclusion for employer-provided health insurance (the largest tax expenditure at $296 billion costs per year per the Treasury Department), step-up in basis at date of death ($40 billion per year per Treasury), mortgage interest expense, tip and overtime deductions, and vehicle loan interest deduction.

The federal income tax has over 100 special rules. States typically have more, particularly in their sales tax system that usually has numerous exemptions.  And many items of personal consumption that states do not tax do not get measured or identified as tax expenditures because they are not part of the state's statutory definition of the tax base. For example, California's sales tax applies to tangible personal property. So the fact that California doesn't impose sales tax on digital goods as textbooks and iTunes, isn't measured - which also masts who is getting tax savings.

Well, in 2021, Minnesota created the Tax Expenditure Review Commission consisting of legislators and the commissioner of revenue. They meet to evaluate the effectiveness of their state tax system's 327 special tax rules (tax expenditures). Apparently this past year they looked at 15 of these and made recommendations on their effectiveness and determined if changes were warranted. That is better than not looking at all, but out of 327, more seems needed.

But I applaud the lawmakers in Minnesota for creating the commission because tax expenditures result in lower revenue, and higher tax rates than would otherwise be needed without the special tax rules. They are spending that is easily overlooked in the state budget because only direct spending (sending money directly to an individual or business) is noted, not the spending this is done by lawmakers lowering your tax liability.

What do you think?

Improving Tax Systems

Over the years, we see numerous federal and state tax law changes such as adding or modifying a credit, deduction or exclusion. We sometimes see rate cuts and increased deductions, such as most individuals experienced for 2018 through 2025 with the Tax Cuts and Jobs Act of 2017 changes that lowered the individual rates, almost doubled the standard deduction (which 70% of individuals used prior to 2018; today about 90% claim it), and the child tax credit was doubled from $1,000 to $2,000. But there were numerous other TCJA changes many of which only affect the top 10% of taxpayers or even the top fraction of the top 1% of individual taxpayers (such as an almost $14 million estate tax exemption per person for 2025).

What was the purpose of these changes? Mainly it was to improve the international competitiveness of the U.S. corporate tax system. So, why any individual tax changes?  Well, people tend to favor individual tax cuts rather than corporate tax cuts (see this Pew Research poll among others). At the state level, what is the purpose of yet one more sales tax exemption or a new exclusion from income tax?

What about review and reform of the entire tax system? Well, it is a big project, but not an impossible one. It requires a good look at how much revenue is needed (where does the government need to spend money and what are public goods and services that warrant use of tax revenues), what should the mix of taxes be, and should certain spending be done through the tax law like we have today via special deductions, exclusions, credits and rates, or done directly and more transparently?

In a January 2025 Tax Notes State article, I suggest the need to look at four areas that tend to be overlooked in discussions of tax law changes, but that would improve tax systems if considered:

1. Articulate and use the jurisdiction's economic, societal and environmental goals.

2. Identify what tax revenues should pay for and how (directly via payments and grants or by the government paying for them directly or by reductions in recipient's tax bills via special deductions, exclusions, credits and rates?

3. Find missing voices and data.  For example, while a sales tax exemption for infant diapers might sound like something to help low income taxpayers, if higher income people spend more on diapers, they get the bulk of this tax break or subsidy?  Why do we have a $1 million limit on the debt to produce deductible mortgage interest for itemizers (since 1987 although only $750K for 2018 through 2025) when the median home sales price in December 2024 in the U.S. today is only $427,000 (Census Bureau data)?  Most likely because the drafters of this tax rule have far more expensive homes with large mortgages.

4. Provide tax transparency and tax literacy.  Provide the detailed reasons for tax changes, as well as who is affected including breaking it down by income groups including breaking it down for the wide range of income levels comprising the top 1% of individuals. Find ways to help individuals understand their own taxes (such as covering it in high school civics classes) and understand how spending occurs through our tax system and how it compares to the direct spending you can see in looking at budgets of government agencies.

I encourage you to read the article - Overlooking Considerations That Could Improve Tax Systems.

What do you think?

Tax System Changes Can Help Reduce Poverty

Today I received information from the National Academies on their new report, Reducing Intergenerational Poverty, Sept 2023. It defines "intergenerational poverty," provides demographics of this poverty, describes education and health issues associated with continual poverty, and makes recommendations. 

The introduction reminds us of the relevance of this topic to us all (page 1):

"Capable and responsible adults are the foundation of any well-functioning and prosperous society. Yet low-income families struggle to offer their children the same advantages and necessities that better-off families can offer. As a result, throughout their childhoods children living in families with low incomes face an array of challenges that place them at much higher risk of experiencing poverty in adulthood as compared with other children."

"The costs of perpetuating this cycle of economic disadvantage fall not only on low-income individuals and families themselves, but also on society as a whole. Poverty reduces overall economic output and places increased burdens on the educational, criminal justice, and health care systems. Understanding the causes of intergenerational poverty and implementing programs and policies to reduce it would yield a high payoff for children and for the entire nation."

One of the recommendations is to increase and expand the Earned Income Tax Credit (EITC). Per the researchers: "The strongest direct evidence on the likely intergenerational effects for children is found for programs that increase both family income and parental employment during childhood and adolescence." [page 133]

IRS data reports that in 2020, 26 million filers claimed the EITC with the aggregate credit at $59.2 billion (Table A of Individual Income Tax Returns Complete Report 2020).

Where could the money come from to increase and expand the EITC? We can and should reduce various tax breaks that reduce the tax liability of high income individuals by far more than a taxpayer can currently claim as the EITC. The OMB reports that the "cost" of the exclusion for employer-provided health insurance is $224 billion per year. It is not uncommon for this exclusion to be about $10,000 (or even lots more) for one of the roughly 64% of employees who get this tax break (their employer pays all or a portion of their health insurance premiums). Assuming $10,000 of excluded income, this tax break is worth the following at each individual marginal tax rate as follows (the savings is similar to a tax credit of the amount listed below):

   10%     $1,000 tax savings
   12%     $1,200 tax savings
   22%     $2,200 tax savings
   24%     $2,400 tax savings
   32%     $3,200 tax savings
   35%     $3,500 tax savings
   37%     $3,700 tax savings

The average EITC for a taxpayer claiming it is, per the IRS, $2,043. Thinking of the above tax savings as similar to a tax credit, individuals with $10,000 of employer-provided health insurance who are at a 22% bracket or higher are getting a larger credit than the average EITC claimer.  And this is quite a tax savings because someone in these higher brackets can afford to pay their health insurance without the tax subsidy. Unlike the Premium Tax Credit, there is no income threshold or affordability limitations on claiming the exclusion for employer-provided health insurance (see blog post of 5/14/23).

Even if this one tax break for employer health insurance were cut in half to $112 billion per year, that would enable the EITC on average to be increased by about $4,000.  I note this example just to illustrate that there are tax breaks that can be reduced or eliminated, particularly where they provide a tax break much larger than a typical ETIC, but to people with far greater means for whom the tax break doesn't make a life-changing difference where it would improve the life of a low-income worker and improve economic conditions and living standards in the U.S. for everyone. There are over 100 other tax breaks that could be reduced, particularly where they provide significant subsidies and tax breaks to higher income individuals, whose well-being and that of our society is not improved much by them due to their income levels.

So, why don't we reduce some tax expenditures and use the funds in ways that will truly help people who need the assistance more and will benefit our society and economy as a whole?

What do you think?

Tax and Biden's Build Back Better - What's Included and What is Missing?

The tax provisions included in President Biden's Build Back Better plan are mostly similar to what he campaigned on, such as repealing tax preferences for fossil fuels and providing tax breaks for most families. 

I have posted a table listing the tax provisions in the Administration's FY2022 Greenbook. There is a lot there relevant to all individuals, wealthy people with lots of appreciated assets, alternative energy companies, oil companies,and more.

I think it is also interesting what is not there such as:

• Limiting the QBI Section 199A deduction for individuals with income above $400,000.  I guess this is because 199A automatically goes away after 2025 so why waste political capital trying to reduce it for less than 1% of individuals.
• Capping the benefit of itemized deductions at 28%.
• No change to the estate tax exemption or tax rate. Again, this is likely because we automatically revert to the lower exemption and higher rate after 2025 (one of a few built-in tax increases in the Tax Cuts and Jobs Act, the temporary 199A).
• Fixing Section 174 so we don't start using the TCJA provision after 2021 that R&D must be capitalized and amortized rather than expensed. Expensing has been in the law since 1954. While the BBB plan mentions helping R&D, there isn't anything specific to fix the TCJA change.
• Reducing the over 100 special rules that don't need to be in the law such as the mortgage interest deduction, various education provisions, the exclusions for employer-provided health insurance, and more. These provisions are called tax expenditures and result in reduced revenues of about $1.8 trillion per year. Now would be a good time to phase out the mortgage interest deduction because only about 11% of individuals itemize deductions today and not all of them have a mortgage. This subsidy for higher income individuals doesn't belong in the tax system. If there is desire to use the tax law to help individuals purchase a home, a first-time homebuyer credit would be better. (more on this another time)
• An increase to the gasoline excise tax that has been at 18.4 cents/gallon since 1993.  Of course, this would represent a tax increase on individuals with income below $400,000, but with the outdated figure and a desire to reduce greenhouse gas emissions, seems like an oversight (and a reason why the campaign promise of no tax increases for those with income under $400,000 should have had some caveats).  And no mention of initiating efforts to shift from the gasoline excise tax to a vehicles miles travelled tax so that all vehicles contribute to the Highway Trust Fund rather than only gas-powered vehicles.
• Numerous simplifications and improvements. I started listing some of these in a recent blog post and will continue to and hope readers will add in their ideas in the blog comments.

What do you think?

Missing from Tax Plans - A "Normal" Personal Income Tax

 We can gather some general ideas about tax changes in looking at various websites and documents of presidential candidates. This includes the Democratic Party platform for 2020, Republican Party platform for 2016 (it was not updated for 2020, so actually includes pre-TCJA tax ideas), and candidate websites. I recently reviewed these plans for an upcoming webinar. One observation I'll make about both plans (best I can tell since most details are missing):

Why not fix an outstanding problem with the individual income tax that has worsened with recent law changes and ways people generate additional income and cash flow today? This problem is that expenses of producing taxable income are not allowed unless the activity is a business (other than the business of being an employee). This started with the Tax Reform Act of 1986 and worsened with the TCJA.

The TRA86 added section 67 to treat some miscellaneous itemized deductions as only deductible to the extent they, in aggregate, exceed 2% of one's AGI. The TCJA disallows this deduction entirely for 2018 through 2025. Thus, no deduction for unreimbursed employee business expenses or expenses of producing income from an activity not engaged in for profit, or expenses of producing investment income. These expenses generally are all limited to the income produced, but not deductible today.

There is a growth in individuals engaged in activities that likely are not a business but that generate income and cash flow. For example, today, technology in the form of apps run by platform companies make it easy to rent out your car or extra space you have, perhaps even a closet (yes, see Neighbor.com for example). While in some cases, this might be a trade or business, it is more often someone trying to monetize extra space or assets they have and not run as a business. The income is taxable, but no expenses are allowed. The main expense incurred is the fee paid for using the platform and likely some insurance. I think this type of income and cash flow generation will continue to become more common.

In its annual tax expenditure report, the Joint Committee on Taxation explains what a tax expenditure is. It is a special tax rule that is not part of the normal tax. They are deductions, special rates and tax credits that are not part of the normal design of the particular tax. For example, a basic or normal personal income tax would not include a mortgage interest deduction or an American Opportunity Tax Credit, among numerous other special provisions. Per the JCT (page 3) though, the normal individual income tax would include "the following major components:

• one personal exemption for each taxpayer and one for each dependent,
• the standard deduction,
• the existing tax rate schedule, and
• deductions for investment and employee business expenses.

Most other tax benefits for individual taxpayers are classified as exceptions to the normal income tax law."

And the expenses of producing the non-business income should be limited to the income produced and deductible for AGI (not as itemized deductions).

And individuals would need reminders about what is a personal expenditure and not deductible versus is truly an unreimbursed employee business expenses or other expense incurred to produce taxable income.

And more changes would be needed to get closer to the "normal" income tax. Per the presidential plans, we are likely to see more items proposed that continue to move us from that normal tax although some might be variations on the personal exemption and standard deduction noted above.

What do you think?

Tax Reform "Revolution" in 1986 But More Needed Today

Yesterday, October 22, was the 30th anniversary of the Tax Reform Act of 1986 (see 10/18/16 post). My class enjoyed a "Happy anniversary TRA86" cake! 

TRA86 represented a lot of changes that mostly broadened the base and lowered rates. When President Reagan signed the bill, he had lengthy remarks including this statement:

"this tax bill is less a freedom—or a reform, I should say, than a revolution. Millions of working poor will be dropped from the tax rolls altogether, and families will get a long-overdue break with lower rates and an almost doubled personal exemption. We're going to make it economical to raise children again. Flatter rates will mean more reward for that extra effort, and vanishing loopholes and a minimum tax will mean that everybody and every corporation pay their fair share. And that's why I'm certain that the bill I'm signing today is not only an historic overhaul of our tax code and a sweeping victory for fairness, it's also the best antipoverty bill, the best profamily measure, and the best job-creation program ever to come out of the Congress of the United States."

A lot has changed since 1986. Tax rates increased and the base was narrowed by adding over 100 new deductions, exclusions, credits and special lower rates (such as dropping the top capital gain rate from 28% to 0%, 15% or 20%). The income gap has widened, businesses face a more competitive global environment, intangibles are more significant business assets, carbon footprints are more important, and the nature of the workforce and business transactions have changed. Tax reform today needs to recognize these trends.

Also, the growth of special tax rules (ones that are not crucial to the design of an income tax) has budgetary, economic and social effects. Spending in the tax law has grown to equal discretionary spending. But the spending in the tax law is mostly hidden. Recent talks of tax reform though have begun to focus on it. That is important because any effort to broaden our current income tax base to allow for rate reductions will need to get public buy in that that is spending.

For example, the House Republican tax reform blueprint released in June 2016 said this about the spending in the tax system:

"Many of these tax preferences, sometimes referred to as "tax expenditures," are special-interest giveaways that are masked as tax breaks instead of direct grants. For fiscal year 2016, such "spending" through the tax code amounts to more than $1.4 trillion or almost three-fourths of the amount of revenue raised by the entire federal income tax. When Washington picks winners and losers with the tax code, the American people ultimately pay higher tax rates and keep less of their hard-earned money." (p. 9).

But even that problem was noted back in 1984 in efforts that eventually led to TRA86. Senator Bradley and Congressman Gephardt had proposed the "Fair Tax" which was a simpler income tax with fewer special rules and lower rates. In Senator Bradley's book, The Fair Tax, he suggests (page 66) a "unified budget" that "clearly lays out what government spends not only through the authorization and appropriations process, but also through the tax code and off budget. Once all those numbers are laid out, the people could better determine what activities government should increase and reduce."

Under a unified budget, for example, the cost of the American Opportunity and Lifetime Learning Tax Credits (about $20 billion per year) would show up in the same budget as spending on Pell Grants (about $30 billion). A unified budget would help improve budget literacy (awareness) for everyone. It's interesting that it was discussed back in 1984.

So, renewed tax reform efforts today mostly aim to get back to TRA86 days with a broader tax base and lower rates. To get there though, there seem to be a lot more tax provisions that would need to be cut or reduced to get there. We'll see.

What do you think?

House Republican's Tax Reform Blueprint

On 6/24/16, the House Republican's released as part of their "A Better Way" vision/plan, the last of six parts. That part deals with tax reform.  The plan offers some significant changes including moving business taxation to a consumption tax model at low rates (20% for corporations and a maximum of 25% for flow-throughs).  I have a summary of the plan at "House Republicans Offer "A Better Way" for Taxes" in the AICPA Tax Insider (7/28/16).

I also learned after having this short article published that the House Republican's did some good marketing in calling their plan "a better way."  I received a few emails from readers telling me it was not a better way, as if that was my description of the plan rather than the House Republicans.  While it has some good points, whether it is "a better way" than what we have now or other plans is for discussion.  I think the plan can help us move to reform in how they talk about tax incentives - the numerous special deductions, exclusions, credits and preferential rates in the law. On page 9 of the plan, the House Republicans state:

"Many of these tax preferences, sometimes referred to as “tax expenditures,” are special-interest giveaways that are masked as tax breaks instead of direct grants. For fiscal year 2016, such “spending” through the tax code amounts to more than $1.4 trillion, or almost three-fourths of the amount of revenue raised by the entire Federal income tax. When Washington picks winners and losers with the tax code, the American people ultimately pay higher tax rates and keep less of their hard-earned money."

I think that angle to describing tax preferences is not only correct, but necessary if tax reform that involves base broadening to allow for lower rates is going to occur.  Lawmakers need to shift taxpayer thinking from these tax preferences being crucial to the system to seeing that they are what supports higher rates, inequities, lack of transparency, complexity and economic inefficiencies.

I assume that the staff of the House Ways and Means is working on legislative language for the plan. Perhaps we'll see a hearing on it after the November election.

What do you think?

Tax expenditures and oversight

The GAO released a report today - Tax Expenditures: Opportunities Exist to Use Budgeting and Agency Performance Processes to Increase Oversight (GAO-16-622). It looks at the estimated $1.23 trillion annual cost of special tax deductions, exclusions, credits and preferential rates AND how there is basically no oversight of these costs relative to discretionary budget items. Apparently, OMB and federal agencies were to review tax expenditures (there are over 150 of them) to see how they help agency goals. So far, only 11 of 169 expenditures were addressed representing less than one-third of the total cost.

I have not yet read all of the 55 page report, but the exercise sounds somewhat futile because many expenditures likely don't fit into any agency goals.  For example, what federal agency supports not only ownership of a vacation home, but also having a mortgage on it?  Does the Department of Education's goals include making sure couples with up to about $180,000 of income can get a $10,000 scholarship (American Opportunity Tax Credit) for a child?  Seems to be contrary to the underfunded Pell grant program designed to help those in need pay for tuition.

The GAO website includes a nice infographic reproduced here. Too bad it is not part of any effort to increase government finance literacy among the public. I think it would be easier to broaden the tax base if more people knew of the costs of some of these tax expenditures and the minority of taxpayers who benefit from many of the more costly ones.  Helpful information would include how, for example, the annual $80 billion for the mortgage interest deduction might be used more widely to help more taxpayers.   [Data shows that only 1/3 of individuals itemize and that the mortgage interest deduction primarily helps higher income individuals buy a more expensive home. Also home ownership rates in the US are similar to UK and Canada that don't have this deduction (see p 27 of this JCT report.]

What do you think?

http://www.gao.gov/products/GAO-16-622

The fate of expiring provisions for individuals

Senate Finance Committee hearing of 4/3/14 on extenders

Over 50 federal tax rules expired at the end of 2013 and a few more will expire in the next few years. This is not news - it is a recurring event.  Often the provisions are renewed a year or more later after expiration. That makes planning impossible and it removes the incentive effect that some of these provisions are intended to have.

I've got a short article in the 4/10/14 AICPA Tax Insider that lists all of the expired and expiring provisions relevant to individuals. An accompanying table shows:

• When the provision was originally enacted.
• How many times the rule has already been renewed.
• How it would be addressed by proposals from Senator Wyden (although prior to some amendment by the Senate Finance Committee last week), Congressman Camp's reform proposals (of February 2014) and President Obama's FY2015 revenue proposals.

The table also includes my commentary on the particular items.

I hope you'll take a look and post a comment here on what you think of letting them all expire, renewing some, or something else and why. Thank you.

Time to justify your favored tax breaks - if you can

On June 27, 2013, Senator Baucus, Chair of the Senate Finance Committee and Senator Hatch, Ranking Member of the committee issued a call to everyone asking them to submit justification for keeping any tax break they believe should be in the federal tax law. They refer to this as a "blank slate" approach. That is, assume that none of the 200+ special tax breaks ("tax expenditures") are in the tax law. If you believe any should be there, send them the reasons why. House Ways and Means Committee Chairman Camp called this idea "welcome news" (6/27/13 press release).

The senators refer to the Joint Committee on Taxation tax expenditure report to define what a tax expenditure is. The Joint Committee on Taxation does not count rules tied to the basic design of a type of tax as tax expenditures. For example, the JCT states in its February 2013 report:

"Under the Joint Committee staff methodology, the normal structure of the individual income tax includes the following major components: one personal exemption for each taxpayer and one for each dependent, the standard deduction, the existing tax rate schedule, and deductions for investment and employee business expenses." (page 3)

The JCT also notes that the carryover of net operating losses is a normal part of an income tax. (page 8)

I can't think of any deduction, exclusion, credit or special rate that is crucial to our tax system. The provision that likely saves me the most tax dollars is the exclusion for employer-provided health insurance.  But, I should be paying income and payroll taxes on that benefit - it is income and something that not all individual filers get benefit of.  This is also the largest tax expenditure - over $110 billion per year. Removal of this special tax rule ought to allow for a drop in the individual tax rates. Some will argue that people will drop their employer-provided health insurance if it becomes taxable. I doubt it because the tax you pay on it is likely to still be far less than if you get your own insurance and pay for 100% of its cost. And, this change might also lead to a drop in insurance costs when the policy holders actually know the cost of that coverage.

The research tax credit is an incentive to conduct research in the US which is a good idea. And it also helps cover some of the spillover benefit others get from a company's research. So there is some justification for this credit even in the blank slate approach to tax reform, but it needs to be weighed against a lower tax rate and a simpler system. A simpler credit is likely still a good idea, as is expensing R&D rather than capitalizing and amortizing it (and simpler, and it is just a timing difference).

Ok - I'd also argue for allowing small businesses, even those with inventory to use the cash method rather than accrual because it is easier for them. This is just a timing item, so really not a significant cost. Also, the term "tax expenditure" is not viewed by everyone the same way. The JCT treats use of the cash method of accounting by a business to be a tax expenditure, but the Treasury Department does not (see page 21 of the JCT February 2013 report).  For more on this topic, please see Rethinking the Income Tax Calculation - A Look At Tax Expenditures, AICPA Tax Insider, 2/10/11.

What special tax rules can you justify keeping - and what is the justification?

GAO video on tax expenditures

The GAO issued a few reports this year on tax expenditures. I just watched their 4 1/2 minute video released May 30, 2013 on one of the reports. It is very good.  The diagram above is included in the video to show that for an energy credit, the net effect to the government of either a tax credit or  direct spending is $500. Take a look - here.

GAO has a tax expenditures website - http://www.gao.gov/key_issues/tax_expenditures/issue_summary.

And there is a nice infograph with a QR code too!  Good for GAO!  I tried the QR code - it takes you to their 11/29/12 report - Tax Expenditures - Background and Evaluation Criteria and Questions - a very helpful 40- page background report. If you search for "tax expenditure" you can also find this 1979 "primer" report on tax expenditures - also a good read.

I encourage you to take a look.

2012 GAO Report

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?

 

 

 

 

 

 

 

 

 

 

 

  

 

 

 

 

Budget and tax system spending

In looking for budget cuts, lawmakers have to look at all of the deductions, exclusions and tax credits in the tax system. As Mr. Simpson and Mr. Bowles, co-chairs of President Obama's Deficit Commission that issued a report in 2010, say - these represent about $1.1 trillion of annual spending. That amount is about the same as the amount of discretionary spending in the federal budget - it's a lot of money. I'm talking about, for example, the roughly $95 billion cost for allowing less than 1/3 of mostly high income individuals to have a reduced tax bill because of their mortgage interest deduction on their main home or perhaps also a vacation home and perhaps even a home equity debt.  It includes over $110 billion for the approximately 60% of employees whose employer covers all or part of their health insurance cost which is not considered compensation to them.

Well, on March 5, the Senate Budget Committee held a hearing on this spending - Reducing the Deficit by Eliminating Wasteful Spending in the Tax Code. Chairwoman Patty Murray noted in her opening remarks:

"Over the next few weeks, both chambers of Congress will be debating fundamental choices about our country’s direction, and what kind of nation we will leave to our next generation. We will lay out proposals that reflect very different approaches to the many challenges we face. One central question we’ll be looking at is how can we bring down our debt and deficits, while putting the middle class and broad-based economic growth first? Today’s hearing will focus on how cutting wasteful spending from our tax code can help us meet this challenge."

Not all tax expenditures are wasteful spending, but most can likely be improved to better aim at their intended purpose. Some, such as a mortgage interest deduction on a vacation home, should be phased out.  Doing so can help the income tax system be more equitable and transparent.  If enough tax expenditures are eliminated or reduced, lower rates and deficit reduction are possible.

For a list of the tax expenditures and their cost, see the annual Joint Committee on Taxation report.

What do you think?

H.R. 1 - Tax Reform in the 113th Congress

House Majority Leader John Boehner has announced that H.R. 1 is being reserved for tax reform legislation (see 2/26/13 Ways & Means website).  Apparently this means it is a key agenda item for House Republicans.

A 2/28/13 article in the Wall Street Journal, "The GOP Takes Back Tax Reform," notes that House leaders want tax reform to be revenue neutral and to address both corporate and individual taxes.

I think this is all good news.  Tax reform is needed to reduce the complexity of the federal income tax that is bogged down with over 200 special rules many of which do not need to be there. A tax system with a broader base and lower rates is more likely to meet the principles of good tax policy such as equity, certainty, neutrality, transparency, minimum tax gap and simplicity.

It is also good for reform to cover all aspects of income taxes - those relevant to corporations and other taxpayers. For example, if only the corporate base were broadened and the rate lowered, most businesses would still face a complex system and a higher tax. There are advantages to the system of having the top income rate be the same for individuals and businesses. That is not entirely possible though due to the Section 1411 Medicare tax of 3.8% that applies to high-income individuals and differences in the tax structure and timing for net capital gains.

It won't be easy though. Revenue neutral tax reform, which is a good thing (rather than deficit enlarging tax reform), means cutting back and eliminating special tax rules ("tax expenditures"). These rules are mostly like spending, only buried in the tax law.  For example, instead of giving a family a child credit or a business an energy credit, a government agency could just write these taxpayer a check. The effect to the government fisc is the same.  However, this tax system spending goes unchecked and isn't subject to spending cuts. For example, the sequestration that will kick in on March 1 which means spending cuts, won't cut back the spending in the tax law. It should though because it is all some type of spending.

We'll see how the House Republicans expect to lower the corporate rate to their desired 25% rate and how they expect to lower the individual tax rate as well.

What would you suggest?

Groups Raise "Corporate Welfare" Argument in California

This month, the Reason Foundation and Howard Jarvis Taxpayers Foundation released a 59-page report - Tax Credits in California - Economic Growth Engine or Wasteful Corporate Welfare?  The report suggests that California would be better off eliminating several corporate income tax and sales tax preferences applicable to corporations and lowering the corporate tax rate. The report also notes one property tax preference for certain computer programs (no mention of the favorable reassessment rule that corporations benefit from in the Prop 13 shaped property tax system).

Per the report:

"If these tax breaks could be eliminated and replaced with across-the-board tax cuts, California’s economy would benefit significantly from more innovation, more economic growth and greater satisfaction of consumers’ desires. The only real losers would be the companies currently benefitting from the tax breaks. As it is, special carve-out incentives for some mean higher tax rates for everyone else."

The report also notes that per data from the Legislative Analyst's Office (also from the Department of Finance), tax expenditures total about $30 billion annually in the personal income tax, $5 billion in the corporate tax and $9 billion in the sales tax. The report focuses only on the $5 billion. The tax benefits or "breaks" focused on in the report include the research expense deduction, research tax credit, film credit, hiring credit, expensing of timber growing costs, sales tax breaks for farm equipment and periodicals.

The report does a good job of explaining some of the key arguments against special rules in the tax system, such as lack of transparency and accountability and economic inefficiency.

But, I think the report does some disservice for these reasons:

• Focusing on part of the $5 billion of corporate tax expenditures rather than the bigger amounts in the personal income tax ($30 billion per year) and the sales tax ($9 billion per year). And the sales tax total of tax expenditures does not include the billions not collected because California's sales tax system exempts consumption in the form of personal services and digital goods.
• Focusing on "credits" in the title of the report and for most of the "waste."  Why not refer specifically to tax breaks or tax expenditures. Not all special tax breaks are tax credits.  In the personal income tax, the largest tax expenditures are deductions (such as the home mortgage deduction which is the largest of all tax expenditures) and exclusions (such as for employer-provided health care).
• Not addressing potential benefits to the state of the research deduction and tax credit. California has a generous research tax credit and can serve as an economic development tool to attract high paying jobs. While the report notes some research questioning the value of this credit (which is already incentivized at the federal level), it overlooks other problems in California that may lead businesses to not want to locate in the state. For example, in California, companies pay sales tax on manufacturing equipment - something not owed in most states. The report calls for having more businesses pay sales tax by removing some current exemptions.
• Why not more on property tax reform? (Yes, I know one of the co-authors is a strong supporter of keeping Prop 13 unchanged.) There are arguably some inefficiencies in the property tax as applied to businesses in that the same size and type of businesses may have drastically different property tax bills, which can cause competitive advantages and some businesses paying more so others can pay less.

But, I encourage reading of the report.  It is timely in that at the federal level, many elected officials are calling for base broadening - for both individuals and businesses. The report raises the profile of the cost of tax expenditures and raises some good points, albeit, in my opinion, with a few problems noted above.

What do you think?

Cutting back the state tax deduction

As lawmakers look at how to pay for keeping any of the lower tax rates that were temporarily set in place back in 2001 and 2003, they are looking at "base broadening." If you bear in mind that:

       Tax = tax base  x   tax rate

you can see that if you want to be revenue neutral (keep "tax" the same in aggregate for all taxpayers) and lower "tax rate" then mathematically, you need to increase "tax base."  That is, reduce or eliminate some of the 250 special tax rules that reduce taxes (deductions, exclusions, and credits). (Yes, credits are not in the above formula, but they also reduce "tax.")

A 12/6/12 editorial in the New York Times - "Keep the State Tax Deduction" presents the key reason for allowing this deduction for an income tax. To the extent you have a state tax obligation, that is income  you don't have available for paying federal income tax so it should be removed from the base.

While that is a valid point, it is too narrow and we need to move past "one-size-fits-all" types of statements if we are to have effective and appropriate tax reform.

Some state taxes paid should not be lumped into the mandatory exaction / not available for paying income taxes on because not all state taxes are the minimum obligatory amount. One recent high profile example is Mitt Romney. His 2010 federal return indicated he paid about $226,000 in real property taxes.  While that was all a required payment, it represents real property taxes on more than one home and on high value homes. To the extent he deducts that amount (depending on his AMT situation of course), others pay more taxes. Why should others subsidize this wealthy person's state taxes he owes because of his wealth 9which enables him to own high value property with high property taxes)?

There should be a cap on the amount of real estate and personal property taxes. The real property taxes can be tied to regional home prices in different areas in the U.S. And,, this is a large tax expenditure. Per the Joint Committee on Taxation, it "costs" about $70 billion per year.

So far as a deduction for state income taxes paid, there are some policy reasons for perhaps limiting that deduction as well. There are personal decisions on where to live and if a state has high income taxes resulting in large tax deductions, they end up shifting some of the tax to taxpayers outside of the state via the federal tax deduction.

Additional considerations in examining whether the state tax deduction should be reformed:

• It is only available to individuals who itemized deductions (about 1/3 of individuals).
• State tax deductions are not allowed in computing AMT. So today, many individuals do not get a tax benefit for all or part of their state tax deductions.

 All of this is not a new topic. It has been analyzed several times in the past in tax reform activities and some proposals to cut back the deduction have been offered. I even wrote about it back in 2008 when it was a subject of discussion - Goodbye State Tax Deduction, AICPA Tax Insider, 5/8/08.  That article notes pros and cons of the deduction and some of the reform proposals.

NYT questions value of mortgage interest deduction

The New York Times ran an article on 10/25/12 - "Who Really Benefits From Interest Deductions" by Lisa Prevost. It points out a few factors I have noted before in the blog (8/23/12 post and 7/3/11 post, for example). For example, since only 1/3 of filers itemized their deductions and not all itemizers have a home mortgage, less than 1/3 of homeowners benefit from the mortgage interest deduction. Also, the benefit tends to be significant, but primarily benefits those with income above $100,000. The author also refers to the mortgage interest deduction as a subsidy.

I know many object to that characterization (subsidy). They believe they are entitled to the deduction as a way to measure income. But, why?  Why that deduction and not the cost of college tuition or insurance or driving a nice car or taking care of pets?  When someone gets a deduction to lower their taxes, someone else (everyone) must pay higher taxes to allow for that lower tax bill.

Also, why have a deduction for mortgage interest when it does such a poor job of meeting its goals of encouraging home ownership?  The benefit goes primarily to higher income individuals and research shows it tends to just help them afford a more expensive home?  Also, home ownership rates in the US are similar to those of countries where there are no special tax rules?

Also, how does a deduction on mortgage interest on a vacation home help home ownership (it should be on your primary home, not your vacation home)? How does allowing interest deduction on an up to $100,000 home equity loan encourage home ownership?  It primarily encourages extra debt and is inequitable because a person without a home or without home equity who borrows, such as to buy a car, will have non-deductible personal interest expense.

The mortgage interest deduction is a $95 billion annual tax expenditure benefiting less than 1/3 of taxpayers. I think the economy would benefit by using part of that money to reduce the debt and the rest to help people purchase a home who might not otherwise be able to (people how today might not be itemizers).  The mortgage interest deduction also leads to overinvestment in housing. How might the economy benefit if some of that money went to other investments?

I realize that homeowners are not the only beneficiaries. Indirectly, the construction, real estate sales and mortgage financing industries also benefit. But that should not be reason to provide significant subsidies to high income homeowners.

Any change should be phased out with transitional relief provided to those with acquisition debt obtained in reliance on the current $1 million debt limit.

What do you think?   

  

Will Obama and Romney list the tax subsidies they will cut for lowered rates?

The calls for lower tax rates come along with vague calls for cutting tax expenditures or base broadening. I say vague because we rarely hear which specific deductions, exclusions or credits will be cut or scaled back. I say rarely because there are a few example. President Obama's FY2013 budget calls for cutting back on some preferential rules for oil, gas and coal producers.

Politics is a likely reason for the vagueness.  I suspect that most voters think the cuts would be for corporations  because they think that is where the bulk of benefits go.  But that is incorrect. Per data from the Joint Committee on Taxation, the largest tax break for individuals is the exclusion for employer-provided health insurance which costs $659.4 billion for 2010-2014. In contract, the most costly corporate tax expenditure is about 1/10 that size (it is for deferral of active income of controlled foreign corporations and costs $70.6 over the same five year period).

Here is an excerpt of a chart from the JCT report (JCX-15-11, page 25):

Clearly, to truly generate revenue to reduce both the corporate and individual rates, individual tax expenditures will need to be reduced.  There are additional good reasons to reduce or eliminate many of them, such as equity/fairness, neutrality, economic efficiency and simplicity.

What politicians need to be asking is - why do 70% of individuals want to subsidize home ownership for 30% of individuals who deduct mortgage interest?  Why do we spend roughly $90 billion per year to help middle and upper income individuals buy a more expensive home than they would otherwise purchase? Why do we subsidize borrowing to help someone purchase a vacation home?

But, how willing are politicians to do this when the questions are most likely to be misunderstood because the public has not been exposed to the data on the cost of tax expenditures and how inefficient and inequitable they are.

Yet, some of that may be starting. H.R. 6169 that passed in the House on August 2 refers to much of  the above as spending and subsidies.

What do you think?

Examining corporate tax expenditures

Alex Engler, Executive Online Editor of Georgetown's Public Policy Review and a Master's of Public Policy student, recently shared with me his article in the Review - "We’re Doing It Wrong – Corporate Taxation in the United States" (6/13/12). He points out some of the weaknesses in the corporate income tax including its high statutory rate relative to other industrialized countries and the 50+ special rules ("tax expenditures") some of which appear misguided.

It is good to see more people looking in more depth at our tax rules.  There is certainly a connection between our corporate tax rates and the special deductions, exclusions and tax credits.  The special rules help support high rates. Republicans and President Obama are calling for cut back in these special rules - sometimes mislabeled as "loopholes." 

For business taxation, it can be more difficult to discern what the special rules really are. That is, what rules are needed to determine business taxable income (similar to the concept of book net income). For example, businesses should be allowed a deduction for depreciation. The question is, at what rate and life?  Alex points out that there are some oddities in our depreciation rules, such as special (shorter) lives for corporate aircraft and NASCAR track.  I have written about the many weaknesses in our depreciation system.  One obvious one is that the key rule on depreciation (Code Section 168) is 50 pages long!  It should not take that many pages to describe how to calculate tax depreciation.  And we also have Sections 280F and 179 that also have depreciation rules. Amortization rules (for intangible assets) are in different Code sections (167 and 197). Too many special rules. And, some lives are too long (computers at 5 years) and some are too short (the special ones for certain leasehold improvements and others).  (For more, see my paper with Chad Jaben - Modernizing and Rationalizing Depreciation (2010).)

Alex questions the Section 199 manufacturing deduction, noting that it is available to more than manufacturers.  There are other weaknesses as well such as it being a disguised rate reduction.  It would just be better to change the rate rather than give an extra deduction.

He also suggests that LIFO is a problem.  I don't agree with that.  While LIFO allows costing sales at current prices, thereby lowering taxable income, it must also be used for financial reporting purposes resulting in lower book income as well.  This is all just timing differences.

We need more of what Alex is doing - critique to find weaknesses in existing tax expenditures to help identify where improvements can be made.  And, one important, first question should also be asked - why is this provision here?   Is it crucial to determining taxable income (depreciation, for example) or not (such as the Section 199 manufacturing deduction).  If crucial, then analyze the provision to be sure it is appropriately designed and meets principles of good tax policy such as equity, simplicity, neutrality and transparency. If not crucial, phase it out.

What do you think?

Hearing on expiring tax provisions

On June 8, a House Ways and Means subcommittee held a hearing on Framework for Evaluating Certain Expiring Tax Provisions. I think that is a good approach to the topic of dealing with the roughly 60 provisions that expired at the end of 2011 (many of which expire on a regular basis), as well as the 40+ that expire at the end of 2012.  I think all of the provisions are ones that reduce government collections (tax cuts). (See this Joint Committee on Taxation report for a list of the expiring tax provisions.)

A framework to evaluate them, if consistently used, is a logical way to address the question of which should expire as their purpose is no longer needed, which should be extended and of those extended, should it be permanently or temporarily. Some of the expiring provisions, such as the Social Security tax cut for employees and self-employed individuals was for economic stimulus. Thus, it should not be renewed. Others, such as the research tax credit, are temporary because lawmakers don't find permanent ways to pay for that tax cut. There are good policy reasons for a permanent research tax credit. They include that it will be more effective as a permanent provision rather than a temporary one. It is also disingenuous to keep renewing it rather than all in one effort finding the revenue to allow for a permanent research credit. I say disingenuous because when it is renewed, temporary revenue is found to pay for it and this is done over and over again (I think 13 times so far since the credit's first expiration in 1985). 

At the June 8 hearing, the GAO suggested this evaluation framework:

GAO Testimony of June 8, 2012

I think that is a good set. I'd also add the need to evaluate whether the purpose of the provision is still pertinent (assuming it ever was). I'd also add that if it is determined that the provision should be extended, whether it should be temporary or permanent. 

Another problem with expiring provisions is that they get a good amount of attention relative to permanent provisions of the law. Many state governments place sunsets on tax cuts to ensure that they do get regular review.  I'd suggest that any new tax cuts have an expiration date and that a system be created to enable all of the over 200 tax cuts in the system get reviewed over the next 5 years. Both President Obama and Mitt Romney (as well as Congressman Camp) have called for reducing tax preferences (or they may call them loopholes or tax expenditures). So perhaps the review of all of them will occur in the next few years - that would be great for the tax system. 

I suggest this reminder:

Tax expenditures should only be used and continued if they are an appropriate use of government resources and the best way to deliver the intended benefit.

I am going to work on testimony to submit for the written record; I'll post it here as well.

What would you suggest for your framework on how to evaluate expiring tax provisions?