Tax expenditures, which are subsidies hidden in the tax code, took quite a thumping over the past year. The fiscal commission proposed scaling back many of the larger ones like the home mortgage interest deduction to close the budget deficit, arguing the move would result in a fairer and more efficient tax system.
But fairness and efficiency are two different things. The former addresses the issue of who benefits from a specific tax break. The latter concerns the distortions the tax break has on economic activity. And when it comes to expenditures, the only fair word to use for their distributional effects is unfair.
Hidden expenditures in the tax code undoubtedly have a tremendous influence on individual behavior and their removal would play havoc with huge swaths of the economy. Home values and the size of homes would be very different without the home mortgage deduction. Health care consumption would change dramatically if people had to pay for their health insurance in after-tax dollars. Would that CT scan for a headache really be necessary?
But much less attention is paid to which households receive the most benefit from tax expenditures. The latest report from the Joint Tax Committee of Congress, which was released earlier this week, provides a few clues by analyzing the distribution of itemized deductions for 2009.
The report revealed there will be an estimated $1.12 trillion in tax expenditures in 2010, up about $40 billion from 2009, with individuals and households being the primary beneficiaries this year as they are every year. Corporate “loopholes” will account for just $133 billion of the total in 2010, with the largest breaks coming from altered depreciation and debt repayment rules.
However, that doesn’t exclude the exclusion from taxable income of foreign earnings of U.S.-based multinational firms, which has been variously estimated to cost the Treasury about $60 to $100 billion a year. It is the major distortion in the corporate tax code since it encourages firms to move operations – or at least their taxable income – abroad.
Still, the big money lost to tax expenditures flows to individuals and households. Untaxed contributions to pension and retirement plans were estimated to cost $108 billion this year; the exclusion of employer-paid health insurance premiums will cost $106 billion; the home mortgage interest deduction loses $91 billion; and reduced rates on interest, dividends and capital gains will lower taxes by $78 billion. This so-called unearned income is taxed at about half the rate of wages and salaries.
The report couldn’t analyze who benefits from every tax expenditure. The health insurance exclusion, for example, is not itemized because it paid by employers. Still, for those it did analyze, it turned out that tax expenditures, like the tax breaks contained in the recently enacted Obama-Republican compromise package, were heavily skewed to higher income households.
Take the home mortgage interest deduction, for instance. Ten percent of the households who claimed that deduction and earned over $200,000 a year received 30 percent of those tax breaks. Households earning between $100,000 and $200,000 a year – about 30 percent all returns claiming the deduction – received about half the benefits. And the bottom 60 percent of households earning less than $100,000 a year? They received just 30 percent of the tax breaks.
A similar skew existed for deductions for state and local income, sales and property taxes. The charitable deduction, meanwhile, was heavily skewed to richer households. Among households that itemized charitable deductions, the 11 percent with incomes over $200,000 a year received 55 percent of the $35 billion in foregone tax revenue in 2009.
A 2008 paper by Syracuse University professor Leonard Burman and colleagues at the Tax Policy Center concluded tax expenditures were “regressive” from an overall fairness perspective. In other words, they flow to higher income households to a far greater extent than they do to lower income households.
But removing them was a two-edged sword. The paper, which was issued a few weeks before President Obama took the oath of office, warned that if additional revenue was raised by removing tax expenditures and it was used for across-the-board tax cuts, the distributional effects would still heavily benefit upper income households.
And that’s precisely what Congress and the president did before rushing home for the holidays – without removing any of the tax expenditures. All the more reason for the upper half of the income distribution in the U.S. to wish everyone, but especially the tax legislation writers in Washington, a very merry Christmas.
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