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Giving Credit Where Credit Is Due

• February 07, 2011 • 10:00 AM

A professor of tax law argues that tax reform to reduce federal spending, budget deficits and the size of government may start with axing deductions and subsidies while adding credits.

President Barack Obama deserves credit for speaking frankly in his recent State of the Union address about the critical need to cut “spending” in all parts of the federal budget, not just in the non-defense discretionary spending that makes up a relatively small part of the federal budget. Obama also deserves credit for suggesting that we eliminate tax “loopholes” — also known as “tax expenditures” (targeted tax subsidies that benefit a narrow group of taxpayers, reduce tax revenue and drive up tax rates for other taxpayers).

However, the president missed an opportunity to call for the reform of many of the loopholes in the individual income tax, to make the tax system more efficient and fair, and to contain the rapid growth of tax expenditures, currently estimated to total over $1 trillion a year.

Tax expenditures frequently are the economic equivalent of a federal spending program. Generally, in an income tax system, legitimate business expenses (e.g., the cost of renting an office) are deductible, but personal living expenses (e.g. the cost of renting an apartment) are not deductible. Our tax code provides generally that personal expenses are not deductible, but allows individual taxpayers to take certain types of itemized deductions (e.g., the home mortgage interest deduction) if the taxpayer’s total itemized deductions exceed the “standard deduction” ($11,600 for married couples and $5,800 for individuals in 2011).

The itemized deductions allowed by the tax code thus generally are the functional equivalent of a loophole-free income tax code plus a federal spending program. For example, the home mortgage interest deduction is a federal housing subsidy that disproportionately benefits upper-income homeowners. Our tax code also provides tax subsidies in the form of “exclusions,” meaning that the excluded item is not treated as income and is not taxed. An example is the income tax exclusion for employer-sponsored health insurance (ESI), which drives up the cost of healthcare and disproportionately benefits taxpayers whose employers provide “Cadillac” health insurance plans.

Converting various tax deductions and exclusions into tax credits makes sense for two reasons: 1) to deliver targeted tax subsidies to the taxpayers who most need them; and 2) to contain the rapid projected growth of tax subsidies. Both personal deductions and exclusions reduce “taxable income,” the base against which the income tax rates are applied. The dollar benefit of deductions and exclusions depends on the taxpayer’s tax rate; the higher the tax rate, the greater the dollar benefit from the deduction or exclusion.

Tax subsidies delivered in the form of deductions and exclusions thus generally provide an “upside-down” subsidy that disproportionately benefits upper-income Americans. Also, taxpayers who take the standard deduction (the vast majority of Americans) receive no tax benefit from their itemized deductions.

Compare the effect of tax subsidies that are delivered in the form of credits that reduce the taxpayer’s tax owed for the year. A refundable $1,000 tax credit saves a taxpayer $1,000 of tax, regardless of the taxpayer’s tax rate. If we converted personal tax deductions and exclusions into credits, tax subsidies would benefit those who most need them.

Converting personal tax deductions and exclusions into tax credits also would allow Congress to begin to control the rapid growth in the cost of these tax expenditures. Tax deductions and exclusions generally are on autopilot and grow without regard to their cost in foregone revenue. For example, the cost of the tax exclusion for ESI is projected to grow disproportionately in the future, as health care costs increase dramatically with the retirement of the baby boomer generation. We could replace the current unlimited exclusion for ESI with an ESI tax credit and structure this conversion such that the vast majority of Americans would pay the same amount of tax or less tax.

The conversion of the exclusion into a credit also would provide an incentive to slow the rate of growth of healthcare spending, which is the most alarming and intractable element in the long-term fiscal outlook for our country.

Tax expenditure reform also is necessary to reduce wasteful and inefficient federal spending. Although federal law requires “performance review” of tax expenditures, this requirement has been ignored for many years. It is time to consider which tax expenditures should be eliminated, consolidated or reformed. Some tax expenditures should be completely eliminated because they are not effective spending programs. Well-intentioned, lofty sounding tax subsidies may have unintended consequences that are inconsistent with the stated goals of the tax spending program.

For example, tax subsidies for education ultimately might result in tuition increases instead of making college more affordable and accessible for the students the subsidies were supposed to help. Enacting tax subsidies to promote higher education sounds like a no-brainer, but whether such tax subsidies are good policy depends on the actual consequences — both intended and unintended — of the subsidies. In addition, overlapping, duplicative tax expenditures could be consolidated and simplified.

If you want to limit federal spending, reduce the size of the federal government and reduce federal budget deficits, you should be in favor of tax expenditure reform to eliminate loopholes, make the tax system more fair and efficient, and contain the unbridled future growth of spending through the tax code. The president and the Congress should initiate tax expenditure reform by converting most tax deductions and exclusions into tax credits.

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Katherine Pratt
Katherine Pratt is a professor of tax law at Loyola Law School, Los Angeles.

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