The Growing Problem of Tax Expenditures

September 29, 2006

The Congressional Research Service recently released a report examining criticisms of “tax expenditures”—the various deductions, credits and exemptions used by lawmakers to influence markets toward various political and economic goals. From the piece:

Criticisms of tax expenditures appeared when the term was first coined. Stanley Surrey, the Assistant Secretary for Tax Policy in the Johnson Administration, argued that tax expenditures were inferior to direct expenditures in achieving various social and economic goals, and were a barrier to tax reform that would restore fairness to the tax system.

Recent criticisms of tax expenditures often fall into one of three categories. First, there are those who identify the budget process as the source of the growth in the use of tax expenditures. Second, many analysts continue to argue that tax expenditures are less effective than direct expenditures in achieving social and economic goals.18 Third, some argue that tax expenditures increase the complexity and reduce the fairness of the income tax, thus undermining public support for the tax system. These criticisms are examined in turn. (Full piece here.)

The phrase “tax expenditure” may have been coined in the mid-1960s, but the practice of handing out what economists call “tax preferences” is much older.

The nation’s original 1861 income tax offered a host of tax preferences for items such as repairs, losses, and other taxes paid. Our current income tax has featured a wide array of exemptions, credits and deductions since its founding in 1913—a trend which has accelerated sharply in recent years.

The economist’s case against “tax expenditures” is simple. Because tax preferences are less visible to voters than direct spending programs, they reduce the transparency of the nation’s fiscal system. That’s bad policy because—as we’ve learned from recent debate about problems with congressional “earmarking”—lack of fiscal transparency inevitably promotes wasteful spending, shielding ineffective programs from the cleansing power of public scrutiny and budgetary daylight.

But perhaps more importantly, every additional tax expenditure carves out a portion of the nation’s income tax base, forcing up tax rates to compensate. And as any economist will testify, higher marginal tax rates aren’t bad simply because they make taxpayers “pay more.” They’re bad because they reduce the efficiency of the complex web of plans, contracts and relationships we call “the economy.”

Economists teach that the “deadweight losses” of taxes—that is, the pure economic waste that occurs as a side-effect of every tax—rise as the square of the tax rate. Here’s what that means. If tax expenditures erode half the nation’s tax base, and tax rates are doubled to raise the same revenue, the economic costs of the tax system don’t simply double as well. They rise by four times in those markets that remain in the tax base.

At its core, this argument against using the tax system as a substitute for spending programs is one lawmakers of all political stripes should embrace. The case for low marginal tax rates and broad tax bases—which is made more difficult by tax expenditures—does not require lawmakers to make a choice between larger or smaller government.

All it requires is that they favor a wealthier society over a poorer one. And that they have the willingness to enact a tax system that promotes that end.

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