Compare the following two simplified scenarios.
A. An oil company pays $1 million a year in taxes. Congress gives it a yearly cash grant of $200,000 to explore for new wells.
B. An oil company pays $1 million a year in taxes. Congress gives it a yearly tax break of $200,000 for exploration expenses.
As you can see, A and B are equivalent. In both cases, the federal government was going to get $1 million a year, but instead will get $800,000. In both cases, the federal government is foregoing $200,000 in revenue in order to favor a particular business or industry.
The first is a simple case of government spending. The second is what’s called a “tax expenditure,” i.e., government spending that takes place through the tax code. And while they are obviously equivalent in budget terms, the political differences are enormously important.
This is, I’m afraid, an unavoidably boring topic (as the very phrase “tax expenditures” indicates), but it is hugely consequential for American government and markets. It’s important to understand the basics, so what follows below is just a brief, simplified introduction. If you want to dig in deeper, here are some things to check out:
- The single best introduction I’ve read is Suzanne Mettler’s piece in Washington Monthly. The Center for American Progress (CAP) has “Tax Expenditures 101.”
- For wonkier and more technical takes from economists, see the great work done by the Tax Policy Center and Congress’s Joint Tax Committee on Taxation, along with Mark Thoma and Bruce Bartlett.
- Pew has a searchable database of tax expenditures.
OK, let’s begin with a sense of scale. What kind of money are we talking about here? This is what economists Leonard Burman and Marvin Phaup conclude from their comprehensive analysis:
Income tax expenditures will amount to about $1.2 trillion in fiscal year 2011 based on US Treasury estimates. That is significantly larger than nondefense or defense discretionary spending. Tax expenditures would roughly equal total discretionary spending were it not for the extra outlays authorized in an effort to boost the economy out of recession. Overall, income tax expenditures are one-quarter of total spending, or about 8 percent of GDP. Put another way, excluding income tax expenditures causes spending to be understated by about one-third. [My emphasis.]
CAP estimates, “If all these [tax expenditure] programs were repealed, we could cut corporate and individual income tax rates by over 40 percent and still collect the same amount of revenue.”
As you can see, this ain’t chump change! So why does it matter if this spending is buried in the tax code? Why are tax expenditures so different from programs like Social Security or unemployment insurance, which are budgeted as actual spending?
Saving money vs. raising taxes
The first difference has to do with rhetoric. If the feds stop giving oil companies cash grants, it is seen by everyone as an example of government saving money. Thrift, woo! However, if the feds stop giving oil companies a tax break, conservatives call it “raising taxes,” and boooo, everyone hates raising taxes.
Again, the situations are entirely equivalent in term of both the federal budget and the economic incentive to oil companies (with a few nerdy caveats we won’t get into). Pretending that one is Tyranny and the other Liberty is pure sophistry. You know it, I know it, they know it. Here’s what Sen. Tom Coburn (R-Okla.) said:
Tax expenditures are not tax cuts. Tax expenditures are socialism and corporate welfare. Tax expenditures are [tax] increases on anyone who does not receive the benefit or can’t hire a lobbyist … to manipulate the code to their favor.
Exactly. However, post-truth politics, etc. etc., blah blah.
This isn’t just a semantic quibble. It shapes U.S. politics. And it’s playing out in the energy space right now: Obama’s deficit plan includes the rollback of a number of sweetheart tax expenditures for the oil and gas industries. Sure enough, the GOP is calling the removal of these subsidies “tax hikes” on energy. And with gas prices this high, how can we afford to raise taxes on hard-working American energy companies? Why, it’s a job killer!
Transparency vs. opacity
Because they are buried in the tax code, tax expenditures are invisible to most Americans. Mettler calls them “the submerged state.”
By that I mean that they are public policies designed in a manner that channels resources to citizens indirectly, through subsidies for private activities, rather than directly through payments or services from government. As a result, they are largely hidden from the public: Through them, government benefits people, providing them with opportunities and relieving their financial burdens, often without them even knowing it. Appearing to emanate from the private sector, such policies obscure the role of the government and exaggerate that of the market.
Exactly: if people don’t know the things government is doing for them, it’s a lot easier to hate government. That’s one reason conservatives love to mask spending like this — it enables them to use government to pay off various constituencies while still decrying government in the abstract.
Tax expenditures don’t have to go through the annual appropriations process, so these deals are done behind closed doors. Particularly when it comes to obscure, industry-specific tax expenditures, the only ones who know about them are the people who benefit from them. They pay keen attention and actively intervene with lawmakers. On the other hand, there are few citizen groups devoted to tracking tax expenditures and making sure they serve the public interest.
In short, we’ve got an entire parallel government that is driven almost entirely by interest-group rent-seeking, with no accountability. It’s a recipe for abuse.
Progressivity vs. regressivity
As you would expect with lots of money at stake and no one watching, tax expenditures are tilted to the affluent. Here’s CAP again:
These types of tax benefits provide larger subsidies to higher-income individuals because the value is the amount deducted or excluded times the marginal tax rate. Many deductions are itemized deductions, which provide no subsidy to the 65 percent of mostly low- and middle-income tax filers who do not itemize deductions on th
eir tax returns. And all deductions and exclusions provide no subsidy at all to people with no income tax liability — even though they may pay payroll taxes, federal excise taxes, and state and local taxes — despite the fact that they comprise about 43 percent of all tax units.
There are tax expenditures that help the poor, most notably Clinton’s EITC (earned income tax credit), but they are the exception. The biggest ones, like the home mortgage interest deduction, serve mainly to channel wealth upward (and encourage home ownership, which has its own perverse effects).
Harder to get rid of than bedbugs
What can be done about tax expenditures? The news here is not happy.
If I may quote myself:
Earlier this year I read a fascinating book by political scientist Eric Patashnik called Reforms at Risk: What Happens After Major Policy Changes Are Enacted. It’s about the aftermath of political reforms — which ones endure and which don’t, and why.
One of the chapters is on the Tax Reform Act of 1986, which radically simplified the tax code, eliminating dozens of loopholes and shelters. It was somewhat of a miracle that it happened at all; the rules of political gravity seemed to undergo a strange inversion. But what happened afterward? As Patashnik documents, political gravity reasserted itself, various powerful constituencies came back to the trough, and over time the tax code returned to its former complexity. The reform didn’t stick because it didn’t change anything structural — all the same incentives were in place afterward.
Sure enough, since 1986, tax expenditures have crept right back up. It’s tough to see how or why another round of tax reform — which everyone in D.C. says they want — would end any differently. The problem is deeper, structural, and absent structural reform, tax expenditures seem likely to remain a fact of American political life.