The Story Behind Tax Expenditures
They're the hottest topic in budget-balancing and deficit-cutting circles. They are also the least understood and the most controversial.
Tax expenditures. They've been mentioned prominently in President Obama's April 13 budget speech, and highlighted in two reports from prestigious tax commissions -- the Simpson-Bowles commission and the Domenici-Rivlin commission. Tax expenditures have officially entered the mainstream lexicon as a key chess piece in budget negotiations -- on the federal level and, to an extent, the state level as well.
Much of the federal debate centers on whether to eliminate all or some of these tax expenditures, such as the mortgage interest deduction or the earned income tax credit. States are also rethinking expenditures. They are trying to decide whether to designate sunset provisions or eliminate some of their tax incentives, credits and subsidies, such as offering breaks to businesses located in distressed neighborhoods.
To get a better grasp on the tax-expenditure bargaining chip, I talked to David Kautter, managing director of American University's Kogod Tax Center. Kautter also served as legislative counsel to U.S. Sen. John C. Danforth, who authored several tax bills. An edited transcript of our conversation follows.
What is a tax expenditure?
Basically, it is any reduction in income tax liability that results from a special provision or regulation that provides tax benefits to particular taxpayers. But, even a definition is controversial -- what constitutes special and what is regular or normal is not always clear.
There are various forms of tax expenditures: Some are incentives to encourage you to engage in certain behaviors (such as a research and development credit) and some are subsidies (such as the earned income tax credit). There also are hybrids of the two, and tax expenditures that compute the ability to pay.
If you eliminate a tax expenditure from the tax code, are you raising taxes or cutting spending?
The philosophical question politicians have to answer is this: Does the system of government work more efficiently if you provide incentives in the tax law to encourage certain behavior, or does it work better by collecting more revenue and then deciding where to spend it? Some politicians say, "Look, the last thing I want is bigger government. I'd rather provide a tax incentive where you don't need a lot of government employees. You just tell the public: 'You do this, here's the benefit.'" When I was on Capitol Hill, we would kid around and say, "If you wanted to build aircraft carriers without appropriations, you could provide a $2 billion tax credit and specify in the tax law what this ship needs to look like."
There's a secondary issue: accountability. Most tax expenditures, once they are enacted, tend to stay law. At the federal level, if you look at tax expenditures that existed 20 years ago, there were 128 of them; 20 years later, 100 of those, or 80 percent, are still in place. But, if you collected the money and decided how to spend it, you would have annual oversight on what is being spent on the incentivizing activity. That's where people think tax exemptions are inefficient. An incentive or credit may outlive its usefulness, but it rarely gets taken out of the law, whereas with spending, you're forced to review it as part of the spending budget.
What about designating sunset provisions with an exemption?
People that argue for permanency say, "Certainty is critical to encouraging the behavior the tax expenditure is encouraging. Sunsetting creates uncertainty, therefore diminishes effectiveness." Those in favor of sunsetting would say, "We should have a process for annually reviewing the spending that goes on through tax cuts."
If a tax exemption is added, changed or eliminated in the federal code, where does that leave states?
Many states [with income taxes] tie their state definition of taxable income to the federal definition. When the federal government enacts a tax exemption, it has implications for a state. All of a sudden, the state tax base is lowered. The state has to decide whether it is going to allow that change for state purposes. A state can decouple from the federal rules, or it can still conform to the federal rule -- at which point a state may have to raise rates to raise the same amount of revenue.
Some of the arguments about eliminating tax expenditures -- at both the state and federal level -- revolve around simplifying the tax code. What are the implications of a complex code?
The IRS code has become a labyrinth of intricate and overlapping rules. Even when you think you're complying, you're not. It's demoralizing; it discourages people from complying. It leads to taxpayer disillusionment, where they think they're being treated unfairly. So, simplifying the law has two aspects to it: Compliance becomes easier and goes up, and enforcement becomes easier because there are fewer places to hide income.
At the state level, the question is whether to conform or decouple from federal tax code expenditures. The more a state decouples, the more complicated it gets for its taxpayers. Instead of just picking up the federal number and multiplying [by the state rate] for the state return, the taxpayer now has to make adjustments.
What are some other advantages of eliminating tax expenditures?
It encourages market-based decision making. Some economists would call that greater economic efficiency. Also, it would increase revenue and accountability. Voters could see each year where the money went.
What about disadvantages?
You reduce your ability to encourage certain behaviors. An answer to that is, "Well, we can always decide to spend money on this." But a lot of people say that the last thing they want is to have more money flow into Washington -- or Annapolis or Sacramento.
What are the major tax expenditures on the state level?
The big one is the exclusion of interest on state debt. A Virginia taxpayer buys a municipal bond and doesn't pay federal income tax on the income from it; if it's a Virginia bond, that taxpayer doesn't pay state tax on it either.