The Case for Cutting Tax Expenditures

Screen Shot 2013-04-15 at 3.51.53 PMOur tax code right now is, simply put, a mess. At 73,954 pages, the 2013 tax code is a monstrosity of loopholes, central planning, and giveaways for the well connected. We have ‘tax expenditures’ (ie special deductions) for those who: are married, own private jets, and operate race tracks (Yes, NASCAR gets $20 million/yr in industry-specific tax exemptions).

This is not to say that tax expenditures are pure crony capitalism. After all, your loophole is my well-earned tax break. Many of the larger expenditures—like the mortgage interest rate deduction—were put in place with the best of intentions.

Nonetheless, we should radically simplify the tax code by eliminating tax expenditures. All of them.

Let me point out that this is not a new idea. The FAIR Tax repeals all 73,000 pages of the tax code in favor of a single 23% sales tax. Americans for Tax Reform proposes a single flat income tax. Next week, I’ll be laying out my own proposal for a revenue-neutral tax code with no loopholes.

It’s important to note that none of these proposals mean more federal revenue; they’re deliberately designed to be revenue-neutral. Tax expenditures come out to $1.3 trillion per year, and economists on both sides agree that taking that much money out of the economy would be suicide. Moreover, even prominent Keynesians recognize that raising taxes during a recession is a bad idea.

But for now, let’s just focus on the case for eliminating tax expenditures.

First, there’s the economic cost of compliance. With a tax code longer than a Stephen King novel, navigating it can take days even for professionals. You get a deduction if you have a child in college, but only if you make under a certain amount; and if you have capital gains income, but only if you do X and Y with it; and on and on.

The IRS says that compliance takes 6.1 billion man-hours annually. That’s 3 million people working full time for a year, just on taxes.

To look at this another way, we spent around $163 billion on the tax compliance industry. That was back in 2008. Admittedly, that’s a pretty rough estimate, because it includes a percentage of the economic cost of record-keeping, and some of the record-keeping you take advantage of for your taxes is something you’d have to do anyway for another source. Still, the cost is enormous. Even if $163 billion is a high estimate (estimates vary widely, and it could as easily be a low one), the federal government’s massive tax code created so many problems that a $100-billion-plus industry emerged to fix it.

Of course, not all expenditures are boondoggles. For instance, the largest expenditure is the exclusion for employer-sponsored health insurance. It saves businesses $177 billion annually and gives a lot of people access to health care. The charitable contribution tax deduction saves charitable citizens $43.9 billion annually and promotes giving.

However, for every ‘good’ loophole, there are a dozen that are either poorly thought out or the work of special interest lobbying.  And all combined, the system is tremendously expensive.

If we eliminate tax expenditures, some tax attorneys (at H&R Block, and also at the IRS) will be out of work. But they’re talented people with advanced degrees, and most of them will find work with different businesses. But in return, we’ll save the country $163 billion. Per year. That’s more money businesses can use to hire workers. More money you can use for car repairs or a family trip instead of paying a tax attorney. If you do your taxes at home, a simpler tax code will mean less time filling out Form 41-C and more time to play with your kids.

Those with more complicated taxes will benefit more from reform. But everyone who’s ever had to file taxes—including plenty of small businesses—will still win.

The second case for eliminating expenditures is crony capitalism.  There are plenty of ways Congressmen can dole out special favors to lobbyists, but tax expenditures are one of the big ones. If you own a private jet, for instance, you get a tax break. This comes out to $300 million per year. NASCAR owners get $40 million per year in special tax breaks. In the fiscal cliff deal, the railroad industry got $165 million in tax credits and Goldmann Sachs made their new headquarters tax-exempt.

More broadly, corporations receive $121 billion in tax expenditures per year. And, as a rule, the bigger you are the more you save, because you can hire lobbyists to write the rules and tax attorneys to navigate them. What we have is essentially subsidies for large corporations by a different name.  Admittedly, these tax breaks help keep people employed and promote lower prices. But they also raise barriers of entry and keep bad companies in business. Many smaller businesses have a hard enough time competing for customers without the state throwing its weight behind major corporations.

To be fair, some tax expenditures help small businesses. For instance, start-ups can deduct $5,000 of their first-year costs. But these benefits to smaller companies pale beside the handouts we give to larger corporations.

Tax expenditures that go to businesses rarely help the little guy. By aiding large corporations, we’re raising barriers of entry and stifling competition. It’s time we stopped.

You can make a similar case against many individual tax expenditures: regardless of their good intentions, they help those already at the top. The Home Mortgage Interest Deduction (MID), for instance, is intended to help middle-class folks buy a house. However, the reality of this deduction is a little different. Only 22% of Home Mortgage Interest Deduction (MID) benefits go to households making less than $100,000 per year. Households making $40,000 to $75,000 only receive $523 average from the deduction; families making $250,000 or more make 10 times that.

But the real tragedy for deductions like the MID is that they raise prices. The National Association of Realtors argues that reducing the MID would lower home prices by 15%. So what we have is a system that drives up costs, hurts every home buyer, and that then helps those at the top with large deductions. Because the system drives up costs, it ends up costing a lot of less wealthy home buyers more than it saves them.

The MID definitely helps some middle- or lower-class homeowners; let’s not paint this as black-and-white. If you’re lucky, MID deductions might help you more than MID-induced higher prices hurt you. But mostly, the MID benefits the housing industry and wealthy homeowners.

And this is, sadly, the case with most tax expenditures. Even the well-intentioned ones can hurt those they’re intended to help, through the law of unintended consequences.

This brings us to the third reason for reform: even well-meaning tax expenditures have unseen economic consequences. This is a large subject, and impossible to cover in one blog. In brief, however, when government pushes you to do X instead of Y, it distorts the free market. Government picks winners and losers by subsidizing some. Even for those like Jon Stewart who claim government does a great job of this, the issue is a moral one: freedom of choice. Consumers should be picking winners and losers, voting with our dollars for the companies that best serve us and the world at large. Governments, often victims of lobbying and backroom deals, should not be making our choices for us.

There are some tax expenditures that are well-intentioned and help those they’re intended to help. For instance, the tax deduction for charitable contributions saves people money and encourages giving. More importantly, there’s not really a charitable ‘market’ to distort; unlike the MID or many similar deductions, this one can’t drive up prices.  An argument could be made for keeping one or two deductions, but the problem with this is that it becomes a slippery slope. I want to put my deduction in, so I let you put yours in as well, and then we let Congressman James put his in so that he’ll vote for the overall package, etc.  It’s easier and simpler to cut all tax expenditures.

Tax expenditures are not all bad: they’re not all crony capitalism or loopholes. Your ‘loophole’, after all, is my well-earned tax break. They save real people real money. Sometimes they even help those they’re intended to. But tax expenditures as a whole promote central planning and often help special interests or those with money to pay. Even the ones that are well-intentioned, like the MID, often hurt those they’re intended to help.

So let’s reform the tax code. Not to raise new revenue; economists on both sides agree that you shouldn’t raise taxes in a recession. Let’s reform to create a leaner, simpler system. A system that promotes fairness instead of crony capitalism.

Next week, I’ll delve more into different ways of changing the tax code, including my own proposal. But for now: the tax code is a monstrosity. Let’s change it.

If you’d like to get involved with this issue or learn more, here’s how:

To learn more about crony capitalism (of which tax expenditures are a big component): Against Crony Capitalism

To learn about economists who support a more even tax: Friedrich Hayek Society 

To learn how crony capitalism differs from real capitalism: Crony Capitalism = Phone Capitalism 

To learn about the FAIR Tax (currently the most popular alternative to our system): FAIRTax 

All four of these are great sites. They offer the opportunity to learn more, but also to get involved politically and turn thought into action. While I cannot endorse everything they say or might say, I’m very glad to receive regular updates and information from all four.

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9 thoughts on “The Case for Cutting Tax Expenditures

  1. Thom A

    Your essay is a real eye-opener. We all want tax breaks that help us and resent those that help others. The notion of ditching ALL of them is tough to swallow coming from our selfish corners. But that is one way to make it more fair – eliminate all deductions. I am no economist but from what I’ve read a flat tax is regressive: it hurts the poor and middle class much more than the wealthy. Have you examined countries such as the UK that have a flat tax?
    In terms of your word craft, your writing is well thought through and has the needed punch in spots to grab the reader’s attention. I found the last two paragraphs a bit too repetitive, though, drawing almost verbatim on phrases you used earlier in your essay.
    I look forward to the next installment.

    Reply
    1. julianlibertarian Post author

      Thanks! A flat tax (ie everyone pays 15%) isn’t regressive, but it’s also not progressive like our current system. Consumption taxes like the FAIR Tax are regressive, but FAIR combats this with subsidies for those making under $X per year. I would like to stick with a Progressive income-based system, but without loopholes.

      Reply
  2. Jason Munkatchy

    Yes, a flat tax would be sweet provided we also implement VAT (value added tax). VAT’s are difficult to implement but worth the difficultly. Ideally they tax luxury items more than your everyday gas and groceries.

    I’m all about getting rid of the MID. I too believe it distorts the housing market. It would be a difficult transition for many homeowners but one that would help their children in the future. Which brings me to a bigger concept which you do not address. Free markets are great for allocating resources efficiently, but are terrible for avoiding collective hazards. This is where I see government having the most value in our society. How do you convince individuals to give up the MID when they won’t see the benefit in their lifetime? Answer that and you could really help Washington. Global warming is another huge problem which cannot be addressed until the cost of polluting is taken into consideration. This is why the GOVERNMENT must somehow encourage the world to put the price of carbon into everything we buy.

    We do need a smarter government and tax system. Good luck starting from scratch.

    Reply
    1. julianlibertarian Post author

      I see your point about the MID. Maybe we could grandfather in current home owners? Not a perfect solution, but it would ease the transition….

      I’m a little surprised that you advocate a flat tax (non-Progressive) + a VAT (downright regressive). I thought the whole idea was that the rich should pay a bigger chunk of their income, not the poor. That’s actually one of the reasons I advocate for a progressive income tax; I think (within reason) the wealthy should shoulder a larger share of the burden. What’s your thought process behind supporting a VAT?

      Reply
  3. Aurora

    Interesting argument. Personally, I’m not positive that this is the most pressing reform needed in Washington at the moment, but you raise some good issues. I’m curious to hear what you think about the tax-exempt status of certain nonprofit and religious institutions. For example, my understanding is that there are some religions (no names mentioned) that designate the head of every household as his family’s “religious leader,” and thus each house is a place of worship, and thus can file for tax-exempt status…? Or places like the Westboro Baptist Church (I have no hesitation naming names here!), which enjoy tax-exempt status as a religious entity (http://www.huffingtonpost.com/2012/12/17/westboro-baptist-church-hacked-anonymous-protest-newtown-shooting-victims-funerals_n_2315070.html), even though to all appearances, the only “religion” they seem to espouse is one of hate. At the same time, lots of religious and nonprofit organizations do great work, and the money they earn/raise does not go to stockholders, but back toward the communities and causes they serve. Thoughts?

    Reply
    1. julianlibertarian Post author

      Hmmm, tricky question. First, I’m all in favor of Westboro having tax-exempt status. They’re a religion; everything they believe comes from a (admittedly very strange) interpretation of the Bible and God’s word. They firmly believe they’re doing God’s will, which is pretty much the definition of a religion. I also believe that freedom of religion means freedom to be part of a religion the government may disagree with. The minute government gives some religions tax-exempt status and not others, they’re introducing a financial incentive. They’re basically saying, “You can be a part of a religion we disagree with, but only if you pay a tax”. To me, that violates the whole foundation of freedom of religion.

      As for the other unnamed religions (call it religion X): that’s clever of them. I do think there should be a line drawn for these sorts of loopholes, but it’s up to individual judges to decide. Without any more facts than that some head of households are designated “religious leaders”, I can’t really form an opinion as to the validity of X religion. It’d be up to local judges to hear both sides and determine if that’s a tax loophole or a legitimate function of X religion.

      As to other nonprofits: I think all religions, even Jedi Knight-ism (yeah, it exists) should be tax-exempt, for the reasons given above. That said, it’s tricky to make a case that nonprofit institutions (or donations to them) should not be tax-exempt. I think the tax-exemption for nonprofits are among the best tax expenditures in our tax code right now. I’m opposed to them mainly because I want a free market and a truly level playing field, where nonprofits compete for your dollars on the same footing as businesses (which, John Mackey would argue, probably do more for the common good than do nonprofits). If a nonprofit’s truly worthy, it should have to earn your dollars just like a business does; not get a special leg up from the government.

      Reply
  4. DanManEllen

    The biggest roadblock to reform is the fact of complication. Mike Gravel, who is something of a progressive hero and was one of Daniel Ellsberg’s big allies, tried very hard to reform the income tax code when he was in the Senate in the 1970s, and found it impossible. When he sought nomination for the Libertarian ticket for president in 2008, he advocated eliminating the national income tax and replacing it with a progressive national sales tax. He never made it clear how it could be made progressive, and I think it is a little odd to tax consumption (except maybe luxury taxes or taxes that offset public health risks, like taxes on alcohol and tobacco), but it was a provocative idea.
    It seems to me that the only way we are going to reform the tax code is if we get a bunch of very honest and principled tax lawyers, accountants, and IRS employees together, bring in a handful of people who are really good at writing legislation, prohibit lobbyists from corrupting the process, and have these people all sit down and draft legislation to recommend to Congress. Call me optimistic, but I think this is possible to do even now… well, except for keeping the lobbyists out.

    Reply
    1. julianlibertarian Post author

      Good point; fixing the tax code is pretty damn hard. And I do think it’d be impossible to keep lobbyists out, but that’s crucial to get any real reform done; otherwise, every lobbyist says they want just 1 small exemption or tax expenditure, and pretty soon you have a Christmas Tree bill.

      I’m confused as to how you can have a Progressive sales tax. Maybe tax big-ticket items at higher rates? Interesting idea.

      Reply

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