A Tax Expenditure, By Any Other Name, Would Be More Transparent
As we reflect on the failure of the supercommittee to reach a deficit reduction plan, it seems the most contentious points were entitlements and taxes. While Sunlight doesn’t have a position on the best way to balance taxation and spending, it is worth pointing out that these two sides of the budgetary coin have very different transparency implications.
Theoretically, I can look up exactly what we’ve spent on entitlements like medicare in USASpending.gov or the Department of Health and Human Services spending database, TAGGS. The demand for transparency around government spending was clearly recognized by both parties in 2006, when bipartisan legislation was enacted to create USASpending.gov, which has data on grants, contracts and loans. However, tax expenditures (aka tax breaks, deductions, credits) are subject to much less oversight, both in their transparency reporting requirements and in their visibility and accessibility to the public. This is why they’ve often been called “the hidden budget” or “the hidden welfare state”. Right now, the government only estimates tax expenditures, instead of explicitly calculating their value.
If you’re wondering why tax breaks should be considered spending, I present you with this passage from a recent Burman/Phaup article:
The late economist David Bradford (2003) famously illustrated this point by proposing, with tongue firmly in cheek, a Weapons Supply Tax Credit, which would allow arms manufacturers to sell their ordinance to the Pentagon in exchange for tax credits rather than cash. Instantly, the Defence Department’s budget would decline by the amount of transformed spending. By some measure it would look like a tax cut. Tax revenues would fall by a similar amount (or more, if weapons suppliers demanded a premium on account of the complexities and uncertainties associated with the tax credit mechanism). But government would be doing exactly the same thing. Only the accounting would change.
Most people can intuit what a government grant or contract might be like, but taxes are steeped in an accounting terminology that befuddles most people. Exclusions, deductions, credits … how do these differ from each other and how much do we spend on them? I took a stab at classifying tax expenditures into different categories using the tax expenditure data on Subsidyscope. Here are the biggies (from 2011):
Tax Expenditures By Type (FY 2011)
Exclusions – ($392B – $399B)
An exclusion is when the government makes a policy decision that certain kinds of income just shouldn’t be taxed. Period. And tax payers get to take that income right off the top of what they report as their adjusted gross income, just like they never got it. Examples of this include combat pay to members of the armed forces, medicare payments, and social security payments. Often, this can put you into a lower tax bracket, thus reducing the tax rate you pay, as well as the amount of income you have to pay it on.
To put this $390B number in perspective, consider that in FY 2011 we spent $335 billion on all government contracting. Would it be acceptable in this day and age to say we don’t need transparency and accountability around contract spending?
Deductions – ($263B – $257B)
Deductions are similar to exclusions in that you can use them to reduce what part of your income you’re allowed to be taxed on. However, instead of being defined by the type of income received, they’re often defined as what major expenses you’ve had to pay this year. For instance, you can subtract whatever you paid in interest on your mortgage from your taxable income, as well as whatever you paid in state and local taxes.
Credits – ($109B – $132B)
Credits are a dollar for dollar reduction in your actual tax bill. So after you go through the entire exercise of calculating what your tax owed is, based on your income, you get to subtract the value of the credit from that amount. Examples of this include the child tax credit, or the credit a business gets for investing in clean coal.
All Others – ($300B – $309B)
Other tax expenditures, like deferments, treatment of certain income as capital gains, or mixed types, account for $300B. Deferments allow you to shift your tax burden from year to year. For corporations, this can mean choosing to deduct an equipment investment several years from now when you may be operating with a higher profit margin. For individuals, it can be used for retirement accounts, where you defer paying tax on the money in that account until you retire, and are subject to a much lower tax rate. Sometimes other types of income will be taxed at the lower capital gains rate instead of the normal income tax rate, such as royalty income on coal.
There are a lot of arguments to be had about what our tax system should be like to begin with. Should we have consumption based taxes or income taxes? And what should rates be? Len Burman and Marvin Phaup have described our current system as a hybrid of a consumption and income based tax system, which makes determining the starting point (or baseline) even more difficult. Currently, tax expenditures are estimated to cost us over $1 trillion (for 2011). Even if we change our starting point for estimation to be either a pure consumption or pure income tax system, it’s estimated that $800 billion would still be considered tax expenditures under either system.
The bottom line: tax expenditures are a type of spending just like contracts or grants, both in practice and magnitude. We need more transparency about how much we actually spend on them, and transparency from law makers when they present plans that contain tax expenditures, instead of intentional obfuscation.
My classifications of tax expenditures into the different types can be found here and a summary spreadsheet here.