With April 15 upon us, I’d like to talk about taxes. Not about the part of the tax code that generates revenues. You’ve already heard enough about the taxes you pay to last a lifetime, and the election campaign has just begun. Instead, I’ll focus on the less visited topic of the taxes we don’t pay, the part of the tax code that reduces revenues.
Budget officials call these tax expenditures. The rest of us call them tax breaks. They play the same role in government balance sheets as derivatives play in corporate balance sheets. They hide risks and cover up potential losses and deficits. In 2006, the Treasury Department identified over $900 billion in tax expenditures, about equal to all discretionary spending by the federal government that year. Put another way, we lose almost as much money from federal tax breaks each year as we generate in federal income taxes.
This is a huge sum. Yet we hear little about it. That needs to change for at least two reasons. One is that the vast majority of current tax breaks are destructive. The other is that this harm can be easily alleviated, if we have the political will.
But before I get to the solution, let me describe the problem.
The current state of affairs
Tax breaks as currently designed are fundamentally unjust. A $1,000 tax deduction might be worth $400 to a wealthy household in the 40 percent tax bracket, $200 to a middle-income household in the 20 percent tax bracket, and nothing at all to a family that pays no income taxes. (Keep in mind that almost 40 percent of all U.S. households have no income tax liability.)
Tax breaks are justified as encouraging socially beneficial behavior, such as buying a home, going to school, expanding renewable energy. But since they reward the rich far more than the middle class or the poor, they are based on the bizarre and nonsensical presumption that the rich have a higher propensity to engage in socially beneficial behavior. If you want to simply test this proposition, ask any waitress or waiter who tips them better -- the wealthy or the working class.
Michael P. Ettlinger, vice president for economic policy at the Center American Progress has pointed out the absurdity of current tax breaks that results from their being off budget by using the example of the tax deduction for the blind. It is of most benefit to a rich blind person and of no value to a poor blind person. As Ettlinger notes, it’s hard to imagine that a direct spending program based on the assumption that rich blind people are more deserving than those with more modest means would pass the smell test.
But tax breaks avoid the scrutiny given to direct spending programs because they are not part of the regular authorization and appropriations process. This may be why they have proven such a popular source of funding for big business. As the Congressional Budget Office has noted, "The federal government's efforts to promote business are heavily weighted toward tax preferences, with spending and credit programs accounting for a smaller share of federal efforts." Robert S. McIntyre, director of the Citizens for Tax Justice (CTJ) has observed, the total cost of business tax preferences, including those that benefit business investors or subsidize business products far outweighs direct spending on business subsidies.
The stealth of tax expenditures is evidenced by the fact that even as state legislatures desperately try to balance their budgets, tax breaks continue to expand. The Massachusetts Budget and Policy Center (MBPC) notes that spending in that state dropped by almost three percent but business tax breaks rose by over four percent.
Like the energizer bunny, tax expenditures keep going, and going, and going. MBPC identifies one reason: “Budget appropriations must be reauthorized by the Legislature each year, while tax expenditures remain in effect without the Legislature having to take action.”
Refunding tax breaks
I said there is a simple way out of this mess. There is. Make all tax breaks refundable. Even if you owe no taxes, the government will send you a check if you qualify for a tax break.
Doing this would bring tax expenditures out of the shadows and into the open, where they could be scrutinized and evaluated. And it would make them fair.
One major program already operates this way: the earned income tax credit for lower income workers. By all accounts it has been a major success, gaining widespread bipartisan support. But in the 30 years since it was enacted few imitators have been added.
Refundable tax credits, however, have several powerful advocates in the Obama Administration. Or at least they were advocates before they went in. Jason Furman, currently deputy director of the National Economic Council observes, "Not only is the use of refundable tax credits more equitable, but it is also a more effective and efficient use of government resources."
Peter Orszag, Obama’s budget director, in a paper published by the Brookings Institute in 2006 proposed, "…unless there is evidence that certain households are more responsive to the incentive than others or generate larger social benefits from engaging in the activity, tax incentives are most efficient if they provide the same incentive to all households-and that can only be accomplished in a straightforward manner through a uniform (and refundable) credit."
He, and coauthors Lily Batchelder and Fred Goldberg concluded, “The burden of proof should therefore be on those who prefer some other form of tax incentive to demonstrate that such deviations from a uniform refundable credit are justified by empirical evidence.”
In the housing sector the tax deduction for mortgage interest currently costs the government almost $90 billion a year. Economists Richard Green of George Washington University and Kerry Vandell of the University of Wisconsin examined the impact of a refundable tax credit that would cost the government no more than that. They estimated overall home ownership would increase by 3 to 5 percentage points. Even more impressive, it could increase home ownership by up to 8 percentage points among the lowest-income households.
In the energy sector, a refundable tax credit could usher in a vast democratization of energy ownership and production. Currently energy incentives have achieved a rapid expansion of the renewable energy sector, but their design encourages large scale and absentee owned projects and discriminates against small scale and decentralized projects because only large corporations have the tax liability to take advantage of the handsome tax benefits.
The renewable energy tax benefits to current corporate investors are worth about 30 percent of the cost of wind power and about 40 percent of the cost of solar. If that value were refundable the investor base for renewable energy would expand from a few thousand large corporate investors to millions of local investors. The result would undoubtedly be more dispersed and more widely owned generation. The cost to the federal government would be the same. The social and technological dynamic on the other hand would be dazzlingly different.
Making tax breaks refundable will make them visible and accountable. I suspect they would quickly become part of the regular appropriation process. Facing budget deficits and a stagnant economy, we would become much more conscious of getting the most bang for our buck. With a trillion dollars of tax breaks on the table, just at the federal level, I suspect many tax breaks would be eliminated or modified.
In the meantime, we could rest assured that a tax break used to encourage socially benign behavior, whether it is attending school, or buying a home or installing a solar array, is designed so that all of us can reap the same reward for the same behavior.