Tax Expenditures

There's plenty to criticize in the Simpson-Bowles and Rivlin-Domenici deficit reduction proposals that have been offered in the last week. Our number-one problem right now is punishingly high unemployment, not the projected deficit in 2030. Also, our long-term fiscal problem is almost entirely a health-care story, and neither plan really addresses that.

But punishingly high unemployment is a really hard problem to solve, and health care is even tougher, so instead I'm going to talk – muse, really – about how much I like the fact that both fiscal proposals adopt the technique of "zeroing out" all the various tax deductions and credits that tend to accumulate in the tax code over time, thereby forcing would-be deficit cutters to justify their full cost if they want to add them back in.

The home mortgage-interest deduction is an obvious one. At the margin, it might turn a few renters into homeowners, but the vast bulk of the expenditure goes toward subsidizing larger, costlier homes than people would otherwise purchase. And, like all tax deductions, it is worth more to high-income families, who have bigger interest bills and higher tax rates, than it is to low-income families. Many if not most of those marginal home-buyers pay too little in interest to itemize anyway; they take the standard deduction and derive no benefit from this subsidy.

Then there are the various tax credits for children, for postsecondary education, for storm windows, for electric cars. If we want to subsidize children and education and storm windows and electric cars, we ought to appropriate the funds and send folks a check so they can pay for these items. That's harder to do politically, but it's more honest.

Businesses get special tax breaks on research and development expenditures, and from time to time they also manage to get Congress to pass accelerated depreciation rules, supposedly to encourage the purchase of capital equipment. Both subsidies may well be worthy goals; if so, let's just cut them a check for R&D and for capital equipment. I imagine this sort of thing would be distasteful to rugged-individualist business owners, but we all have to do our part.

In addition to distorting our economic decision-making and letting economic policy-makers off the hook, these tax breaks, deductions, credits, and so on all cost money. That's why analysts call them "tax expenditures." To offset the expenditure, we have to raise the statutory tax rate. It's like when a furniture store raises the retail price of a sofa before announcing a 50% off sale.

The 1986 tax reform, which abolished many tax breaks, including the preferential rate on capital gains, offers a partial guide, and I'm surprised I haven't heard more people citing it. The broader tax base made lower rates possible, though we may have overshot on the rate-cutting. George H.W. Bush and Bill Clinton both had to raise taxes in the early 1990s to deal with burgeoning deficits. Still, "broaden the base and lower the rates" is the right starting point for any reform.