Oh 'holey' tax system

The federal income tax base is full of holes, like special exemptions, deductions, and credits. Filling them in would broaden the tax base and help the deficit.

Fed Chairman Ben Bernanke gave a very good speech today at the National Press Club. In it he emphasized why having a plan to get back to economically sustainable deficits is not only important for longer-term economic growth, but to our near-term economic health as well. He also suggested that “acting now to develop a credible program to reduce future deficits” is not so daunting a task now that the President’s fiscal commission and related groups have put forward proposals that “provide useful starting points.”

Chairman Bernanke then hints about what he likes about the commission proposals, in his concluding paragraph (emphasis added):

Of course, economic growth is affected not only by the levels of taxes and spending, but also by their composition and structure. I hope that, in addressing our long-term fiscal challenges, the Congress and the Administration will seek reforms to the government’s tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of our economy–for example, by reducing disincentives to work and to save, by encouraging investment in the skills of our workforce as well as in new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure. Our nation cannot reasonably expect to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.

With tax policy, the only way to raise revenue (and reduce the deficit) while reducing disincentives to work and to save is to broaden the tax base rather than raising marginal tax rates. Luckily we have tremendous room to broaden the tax base, because the existing federal income tax base is really “holey”–as in chock full of holes.

Such tax base “holes”–as in special exemptions, deductions, and credits that narrow the definition of taxable income–comprise the bulk of what are labeled “tax expenditures.” In total, federal tax expenditures add up to around $1 trillion per year, or about as much as all of discretionary spending (both defense and nondefense) combined.

It so happens that the Tax Policy Center’s Donald Marron testified before the Senate Budget Committee yesterday and very clearly presented the case for getting rid of some of these tax expenditures, in the title of his testimony calling “cutting tax preferences” the “key to tax reform and deficit reduction.” His main points:

My message is simple: the income tax is riddled with tax preferences. These preferences narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates higher than they would otherwise be, and are often unfair. By reducing, eliminating, or redesigning many of these preferences, policymakers can

• Make the tax system simpler, fairer, and more conducive to America’s future prosperity;
• Raise revenues to finance both across-the-board tax rate cuts and deficit reduction; and
• Improve the efficiency and fairness of any remaining preferences.

Donald later explains some analysis with Eric Toder that I have previously mentioned here, stressing the point that when tax preferences take the form of reducing the definition of taxable income (what I think of as “poking holes” in the tax base), then they both reduce revenues and expand (not reduce) the size of government. Donald’s bad news for tea partiers is that to be truly committed to smaller government may require a willingness to give up one’s (very own) tax preferences and end up paying more, not less, in taxes (my emphasis added):

In some preliminary research, my Tax Policy Center colleague Eric Toder and I (2011) have tried to estimate how large the government is when we recognize that many (but not all) tax preferences are effectively spending programs. For fiscal 2007, we estimate that spending-like tax preferences amounted to 4.1 percent of GDP. Adding that to official outlays yields a broader definition of spending, 23.7 percent of GDP in 2007, about a fifth larger than the official 19.6 percent. Similarly, our broader definition of revenues—official revenues plus revenues foregone through spending-like tax preferences—is 22.6 percent of GDP rather than the official 18.5 percent.

These figures illustrate that conventional budget measures understate the extent to which federal fiscal policy affects economic activity. They also suggest that some policy proposals that increase revenues, as conventionally measured, may nonetheless reduce the size of government. If policymakers reduce the tax preference for employer-provided health insurance, for example, that would increase federal revenue but reduce the government’s role in private insurance markets.

Advocates of smaller government are often skeptical of proposals that would increase federal revenues. When it comes to paring back spending-like tax preferences, however, an increase in revenues may actually mean that government’s role is narrowing.

The trouble is that once people start realizing that reducing government “spending” may include things like reducing the subsidy to employer-provided health insurance received via their (very own) tax exclusion, instead of clamoring for government to get smaller they might start screaming that “the government needs to get its hands off of”…”my tax preferences.”

The “holey” tax system enlarges the deficit and enlarges the government, but most of us don’t want to give up our (very own) precious holes. See, tax cuts can be just like spending dressed up in a different costume.

(**NOTE: here’s the link to Donald’s own blog post on his testimony, and here’s a link to the Senate Budget Committee page where you can read/watch testimony by the other witnesses, Gene Steuerle, Rosanne Altshuler, and Larry Lindsey.)

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