Chad Stone is chief economist at the Center on Budget and Policy Priorities.
When policymakers settle down to craft a responsible long-term deficit-reduction plan, they will likely look for budget savings from closing tax loopholes. But, that's easier said than done. Nevertheless, if they have reasonable expectations about what they can accomplish, loophole-closing can still make deficit reduction a little easier.
Among tax policy wonks, loopholes are known as "tax expenditures," which the Brookings Institution-Urban Institute Tax Policy Center describes as "revenue losses attributable to tax provisions that often result from the use of the tax system to promote social goals without incurring direct expenditures." That may not sound as bad as "loopholes," but as the Bowles-Simpson report (from the president's deficit reduction commission) stated:
These tax earmarks—amounting to $1.1 trillion a year of spending in the tax code—not only increase the deficit, but [also] cause tax rates to be too high.
And as my Center on Budget and Policy Priorities colleagues have argued:
Tax expenditures can reduce economic efficiency by favoring some forms of investment or economic activity over others. Often, they also provide the largest subsidies to certain activities—such as saving for retirement—to high-income families, even though such taxpayers are … the people most likely to undertake the activities even without a tax subsidy. That makes such tax incentives inefficient and wasteful.
So why don't we just scrap them? Because what looks like a "loophole" or "tax earmark" to some looks like a treasured tax deduction or credit to those claiming it and, as this Center on Budget and Policy Priorities analysis shows, cutting tax expenditures is hard. For example, the Congressional Research Service looked at the $1.1 trillion of tax expenditures that the Bowles-Simpson report alludes to and concluded:
[T]here are impediments to…eliminating or reducing tax expenditures, because they are viewed as serving an important purpose, are important for distributional reasons, are technically difficult to change, or are broadly used by the public and quite popular. Given the barriers to eliminating or reducing most tax expenditures, it may prove difficult to gain more than $100 billion to $150 billion in additional tax revenues.
The mortgage interest deduction, the tax exclusion of employer-sponsored health insurance, and tax advantages for 401(k) plans and other retirement accounts are popular tax expenditures that taxpayers use widely, accounting for over a third of the cost of all individual income tax expenditures, according to CRS. The top 20 tax expenditures account for almost 90 percent of that cost and also include: deductions for state income taxes, property taxes, and charitable contributions; the exclusion of Social Security and Medicare benefits from taxation; and lower tax rates for capital gains and dividends than for ordinary income.
Tax expenditures disproportionately benefit high-income households (see chart below), in part because exemptions and deductions—in contrast to tax credits—are worth more to those who pay higher tax rates and because preferential rates for capital gains and dividends overwhelming go to high income taxpayers. Excluding those preferential rates, however, the remaining tax expenditures are fairly evenly distributed across income groups (as a share of income.)
In addition to overcoming the political hurdles, tax expenditure reform also faces significant technical and administrative challenges, such as how to place a dollar value on various tax exclusions. In addition, and importantly, large-scale tax expenditure reform would likely require extensive transitional rules or relief (especially in areas like the mortgage interest deduction) that would substantially limit the savings for a number of years.
Don't misunderstand me. I'm not defending tax expenditures. They are often an inefficient and unfair way to accomplish their putative goals. Reducing and reforming tax expenditures should be a feature of any deficit-reduction plan. But policymakers shouldn't fool themselves into thinking that they are a trillion-dollar-a-year golden goose that's there for the easy plucking.
- Read Antony Davies and James R. Harrigan: Why Politicians Don't Want to Simplify the Tax Code
- Read James Rickards: Congress Must Simplify Tax Code
- Check out U.S. News Weekly: an insider's guide to politics and policy