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Cutting "Tax Expenditures," Raising Taxes

By Joseph Lawler on 11.23.10 @ 3:54PM

The Simpson-Bowles deficit commission recommendations (pdf) have raised a sort of philosophical question for free-marketers: do so-called "tax expenditures" count as government spending?

Tax expenditures are preferences, deductions, credits, and loopholes in the tax code that allow targeted groups, products, or activities to avoid taxation. For example, the tax revenues forgone because of the tax exemption for employer-provided health insurance, the mortgage interest deduction, and the state and local tax deductions are all examples of tax expenditures. The Simpson-Bowles plan would eliminate or reduce many of these deductions and use the revenues to lower marginal income tax rates -- with a little revenue left over to reduce the deficit.

There is a question whether the revenues raised from eliminating tax expenditures should count as tax increases or spending cuts. Josh Barro, at NRO, argued that tax expenditures are indeed spending, and thinks that the Simpson-Bowles cuts are a good idea. The folks at the Cato Institute, however, have a different idea: tax expenditures should not be cut unless "every penny" of the revenue raised goes toward lowering tax rates. Dan Mitchell writes:

The bad news is that [the Simpson-Bowles measures would] result in more revenue going to Washington. In other words, the tax increase resulting from fewer tax distortions is larger than the tax decrease resulting from lower tax rates. To put it bluntly, the plans would increase the overall tax burden.

And in the Wall Street Journal a few days ago, Stephen Moore and Richard Vedder made a similar point, namely that increased revenues always means more spending, as opposed to less debt. According to their research, "over the entire post World War II era through 2009 each dollar of new tax revenue was associated with $1.17 of new spending. Politicians spend the money as fast as it comes in--and a little bit more."

Mitchell goes a step further and says that, because extra revenues yield increased spending, getting revenues from eliminating tax expenditures would actually make balancing the budget harder than otherwise. He produces this graph, generated from CBO data, to reinforce his point that simply curtailing spending is enough to balance the budget, even including extending the Bush tax cuts:

While there is a real tactical logic to opposing any tax hikes/revenue increases, there is a limit to this line of reasoning. That limit becomes apparent when you extend the budget graph past 2020, and show the components of spending. Austin Frakt has done just that:

It should be clear from this graph that the real threat to the nation's fiscal solvency is not just the near-term primary budget that Mitchell's looking at, but the long-term rising cost of health care entitlements, and the service on the debt that will be needed to finance those entitlements

One major driver of health care cost inflation is the tax exemption for employer-provided health insurance. Frakt estimates that this wrinkle in the tax code leads Americans with employer-provided health insurance to spend 26 percent more than they would without the tax benefit. That overspending, in turn, puts inflationary pressure on health care products and services, raising the costs for everyone

So the problem with the tax expenditure on employer-provided health insurance is not just forgone revenue. The exemption also exacerbates the biggest fiscal problem we face, namely health care cost inflation.

The other big-ticket tax expenditure items have similarly harmful secondary effects. For example, it could easily be argued that the mortgage tax deduction played a role in the housing market boom and bust.

Those unintended effects should be taken into consideration when talking about tax expenditures, whether eliminating them would be cutting spending or raising taxes.

View all comments (7) | Leave a comment

Chris| 11.23.10 @ 5:47PM

Simple solution to the entitlement problem in the future. SS and Medicare can only spend what they take in. At that point it ceases being a ponzi scheme. Then end the limit on income for paying into SS and Medicare.

I've noticed the major trend lately is to say it's time to end the medical and home mortgage deductions. Go ahead and watch a large chunk of the middle class get wiped out. A lot of them are hanging on by a thread and this would be the straw that broke their back.

It can't be argued that the mortgage deduction played more than a tangential role in the bubble. All the deduction did was allow a few more marginal income people into the market. It didn't cause banks to lend to people who were not credit worthy.

c. j. acworth| 11.23.10 @ 7:47PM

I disagree that the mortgage deduction did nothing but let a few marginal borrowers into the market. It also encouraged people to take on more debt by buying larger, fancier houses than they otherwise would've, and encouraged large-scale speculation by builders and developers. There never was a need for the mortgage interest deduction in the first place. Canada (among other countries) doesn't have it and yet their rate of home ownership is the same as ours. All that said, I do agree to simply drop the deduction now would screw a lot of folks to the wall because they borrowed in the expectation that it would be there. Doesn't seem fair to change the rules in the middle of the game. Some adjustment would have to be made, perhaps reducing the deduction gradually over time.

Chris| 11.23.10 @ 11:32PM

True, it did cause some people to buy bigger houses, but that doesn't necessarily mean it lead to the housing bubble. And, the mortgage deduction came about when the deduction for most other types of interest deductions where eliminated in '86.

Yes, it would have to be eliminated on a very gradual basis. Otherwise, housing prices will take another hit.

Larry| 11.24.10 @ 4:26AM

The truth is: the term "tax expenditure" is a complete fraud, because implicit in the term is the assumpti0n that revenue foregone is actually revenue in the first instance. It's our money, say the bureaucrats, and we're giving it away to the taxpayers by this system of exemptions and deductions. Which is a complete lie - the money belongs to us, and always has. It is time we began saying the emperor has no clothes in this respect. The burden of persuasion belongs to the government as to how much tax is owed from our money, based on the system of tax law THEY created. The practice of withholding has created the distorted thinking that enables the government to make this bogus claim for years, because they assume that you owe everything they withheld and you the taxpayer have to make the government give it whatever portion of it is exempt or deductible back to you. Which has been the tyranny of the income tax system since the middle of World War II.

Jennifer| 11.24.10 @ 5:15PM

Wow, Larry...that analysis is dead on. LIKE!! :)

Don Kosloff| 11.25.10 @ 10:05AM

You are exactly correct. A few days ago, I realized that the "tax expenditure" fraud is an attempt to legitimatize acceptance of a return to rule by the "Divine Right of Kings". Under that concept, God had given all property to the king, along with all of fruits of the labor of his subjects. In the "tax expenditure" usurpation, the king is replaced by an overweaning federal or state government. Thus, the "tax expenditure" fraud is a complete and intentional rejection of our heritage, Constitutions and thousands of years of human struggle for liberty. It is impossible to overstate the evil of the concept.

Dixie Pixie| 11.24.10 @ 9:35AM

The simple philosophical question is do you own the products of your own life.

Liberal now Progressives believe the government owns what you produce, so anything you are allowed to keep is a grant from the government. Viewed this way, tax expenditures, deductions, credits and loopholes are losses from the governmental revenue stream.

In short, in the eyes of Liberalism, you are a slave who very existence is owed to the government and to the liberals who run the government. In this way, anything you have is depriving Liberalism its wealth. Naturally in times of economic hardship they want that wealth back. Never mind Liberalism caused the hardships in the first place, they want their money plain and simple.

Long gone is the concept of a government exists at the consent of the people. Under the current philosophy of Liberalism the people exist because the government / liberalism allows the people to exist. That is the current philosophic thread that runs through the TSA scandal, the reelection of the Democratic Party leadership and the Simpson-Bowles Commission.

Until Liberal philosophy is changed the Liberals will try to steal everything that you own and justified by the belief that they own you already.