The clamor over a rapidly approaching so-called fiscal cliff has both houses of Congress and the White House talking about much needed tax reform. Dave Camp, chair of the House Ways and Means Committee, recently has said they “will write, act on and pass comprehensive tax reform legislation in 2013,” and the U.S. Senate Committee on Finance has also made a case for tax reform. An August 1 deadline was included in a plan presented on Capitol Hill by Treasury Secretary Timothy F. Geithner. The last time the U.S. tax code was thoroughly overhauled was over a quarter-century ago, in 1986.
Much of the talk over the tax code obsesses over who pays what: who should pay more, and who should pay less. But for those keening about the high burden of taxation, both among the rich and among the middle class, the New York Times recently presented a reality check: today, most Americans, at every income level, face a lower tax burden than they did in 1980 (the results of their analysis are displayed in this very useful interactive graphic). What is also important to remember, but perhaps not as frequently discussed, is how our tax law works—in particular, how the tax burden has changed over the past few decades, how the code has only become more complex, and how easy it is for some people to exploit its complexity, particularly through the ever-increasing list of tax breaks.
A decade ago, when it seemed there might be a chance for large scale tax reform, The Century Foundation dove into the details, publishing Bad Breaks All Around the report of its Working Group on Tax Expenditures. While the numbers have changed since 2002, the logic of pursuing a simplification of our system of tax breaks remains.
Tax breaks are popular with politicians for a very simple reason: they allow the president and Congress to spend while appearing to cut taxes. They really are a form of tax expenditure, and should be referred to as such because they substitute for direct spending programs as a way of advancing federal policy goals. This form of “stealth spending” has a much larger impact on government revenues than most people realize. And, while some tax expenditures, such as the Earned Income Tax Credit (EITC) benefit the less well-off, tax breaks disproportionately benefit those who have wealth and power. The proliferation of tax breaks has not only increased the complexity and confusion in our tax code, it has been a threat both to good government as well as to the public faith in the institution of government.
There has been some lip service given to curtailing tax expenditures in the run-up to addressing the “fiscal cliff.” But as Peter Orszag recently wrote, current proposals to limit tax deductions are vague, and ignore the effects of such measures. Simply putting a low ceiling on the deduction for charitable giving, for example, would have a highly negative effect, in that it quite likely would reduce such giving. However, the complexity of our tax code results in that some charitable giving is “supercharged,” and a simplification might be merited. According to current rules, those who donate appreciated property get better tax treatment than straight cash donors, a situation that seems ripe for exploitation by those in the know, but one that might not yield much public benefit. So, while the system needs reform, what really matters is the details.
And, importantly, as Congress and the White House look to address our tax code this year, the report argues that simplifying our system of tax breaks might serve as common ground for some bipartisan cooperation:
The key element in tax reform must be a thorough reexamination of existing tax breaks that would lead to elimination of many of them. Such reform is fully compatible with maintaining a progressive income tax as a major component of our revenue system while providing needed tax simplification. It is fully compatible with reducing the level of tax collections to return some of an anticipated budget surplus to the public, as in the recent tax bill. It also is compatible with maintaining or increasing collections to support existing or expanded funding of social programs, defense, or homeland security, or setting aside more resources to pay for the retirement of the baby boomers.
Limiting tax breaks will be difficult. But, spending less on tax expenditures makes it easier to keep rates low and to provide additional relief for low- and middle-income families. Restraining spending hidden through the tax code serves the goals of both those who want government programs to be more effective and those who favor a smaller and less intrusive government.
The Century Foundation report goes on to list the “dirty dozen” tax expenditures: those that the working group believed should be eliminated because their expenditures, quite frankly, are unjustified. The report states that “most of these are narrowly targeted provisions that do not correct for market failures or help disadvantaged groups and could be eliminated or phased out without causing widespread disruption.” The dirty dozen:
- Export tax incentives (exclusion of income of foreign sales corporations and inventory property sales source rule exception)
- Excess of percentage depletion over cost depletion (fuels and nonfuel minerals)
- Regional economic development incentives (empowerment zones, enterprise communities, and others)
- Graduated corporate income tax rates
- Exemption of interest on private activity state and local bonds (small issue bonds, energy facility bonds, owner-occupied mortgage subsidy bonds, rental housing bonds, bonds for private, nonprofit educational facilities, hospital construction bonds)
- Tax credits for nonconventional fuels (alternative fuel production credit, alcohol fuel credit) and partial exemption from the motor fuels excise tax for alcohol fuels
- Medical savings accounts
- Exemption of credit union income
- Timber subsidies (expensing of multiperiod timber growing costs, capital gains treatment of certain timber income, and investment credit and seven year amortization for reforestation)
- Special rules for employee stock ownership plans (ESOPs)
- Small life insurance company deduction
- Exclusion of fringe benefits through cafeteria plans
The working group also identified a second list, which they called the “troublesome ten”—tax breaks that, while problematic, have some economic justification:
For example, the special tax rates for realized capital gains favor one form of capital income over others (dividends, interest), provide disproportionate benefits to high-income taxpayers, and, in our view, do not stimulate economic growth as their supporters claim. But they also can be defended as correcting (although imperfectly) for the failure to adjust gains for inflation, reducing the burden of the double taxation of corporate income, and mitigating a “lock-in” effect that occurs because the tax is imposed when gains are realized, not when accrued. We list the items in the troublesome ten because they are large in revenue terms and therefore merit careful scrutiny.
These “troublesome ten”:
- Tuition tax incentives (HOPE scholarship, lifetime learning credit, deferral of income on state prepaid tuition programs, education saving bonds)
- Capital gains preferences (preferential tax rates and step-up in basis at
- Accelerated depreciation of machinery and equipment
- Credit for low-income housing investment
- Exclusion of contributions and earnings for Individual Retirement Accounts (for individuals with pension coverage)
- Exclusion of interest on public purpose state and local bonds
- Expensing of certain small investments
- Exclusion of interest on life insurance savings
- Exclusion of income earned abroad by U.S. citizens
- Deductibility of state and local property tax on owner-occupied homes
If we do see significant work on tax reform in 2013, Congress and the White House should keep in mind these closing thoughts from the working group report:
Although some tax breaks promote useful purposes, their growth overall has harmful effects. Special provisions that promote selected activities or benefit certain categories of taxpayer make the tax law more complicated. By so doing, they make it more costly for taxpayers to comply with the law and for the IRS to administer it. By enabling many people to pay less tax than others with the same income, tax breaks add to the public perception that the tax law is unfair.
Tax breaks obscure the costs and consequences of government spending programs. Programs that would not pass muster as direct spending can be more easily enacted when disguised as tax cuts. Moreover, tax breaks are often less effective than direct spending in accomplishing program goals.
The Century Foundation Working Group on Tax Expenditures encourages . . . Congress to consider which existing tax breaks can be scaled back or eliminated and to exercise restraint in proposing new ones. Only by simplifying the tax code and cutting out those tax incentives that are no longer justified can we address the popular perception that our tax system is too complex and unfair for most citizens.
Reducing or even restraining the growth of tax breaks is always difficult. Yet, whatever future decisions are made regarding the optimal level of federal taxation overall, paring back preferences in the tax code will make it easier to achieve the fundamental goals of making tax policy simpler, more equitable, and less costly to the economy. With less money spent on tax breaks, there will be more funds available to keep marginal tax rates low, provide additional relief for low income families, or meet other pressing policy priorities. Restraining hidden spending through the tax code should be a goal that unites those who want existing government programs to be more effective and those who favor a smaller and less intrusive government.
A decade ago, The Century Foundation convened its Working Group on Tax Expenditures to help provide reasonable perspective at a time when it looked like we might have serious tax reform. Maybe ten years later those on Capitol Hill will finally roll up their sleeves and get down to business.
Download the Working Group Report and Background Papers.