The Hidden Side of Government Spending in the Limelight

In case you missed it yesterday, Martin Feldstein, director of the Council of Economic Advisors under President Reagan, had an excellent op-ed (subscription required) in the Wall Street Journal on reducing the budget deficit by examining and cutting tax expenditures. Tax expenditures have had increased scrutiny lately, as public concern over the deficit is increasing. As Feldstein describes:

[T]he Joint Tax Committee identified more than a dozen tax-based programs that subsidize education and training. These include small ones like the Coverdell education saving accounts (with a 2010 tax expenditure cost of $100 million) and much larger ones like the various tax credits for tuition (costing $11.7 billion). The hundreds of other tax expenditures include a $500 million annual subsidy for the rehabilitation of historic structures and a $4 billion annual subsidy of employer-paid transportation benefits.

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If tax expenditures are not cut, taxes on households and businesses will have to rise to prevent an explosion of the national debt, which is now projected to increase to 90% of GDP by 2020 from today's 63%. When benefits for Social Security and Medicare are set aside, the rest of the outlay side of the budget is too small — 7.5% of GDP — to provide much scope for reducing annual budget deficits that are now projected to average 5% of GDP for the rest of this decade. In contrast, total tax expenditures are now 6.4% of GDP.

As we've said previously, tax expenditures are federal spending hidden away in the tax code. Tax expenditures are properly viewed as government spending or subsidies funneled through the tax code instead of through appropriations bills and direct spending programs. Tax expenditures result in foregone revenue that the government would ordinarily receive through the income tax that is instead used to incentivize politically favored behaviors. Unfortunately, they rarely receive the same scrutiny as direct spending and are effectively hidden away from taxpayers. This violates transparency and distorts the actual size of government. If these activities truly deserve to be subsidized by taxpayers then they should be subjected to the same scrutiny as direct spending programs.

Ideally, a plan to eliminate tax expenditures would be made revenue neutral by simultaneously lowering tax rates. This would make the tax code simpler and less distortive. But in the current fiscal and political climate, with the federal debt projected to grow larger and larger, some form of tax increase is likely on the way. If a tax increase is part of the solution, cutting many tax expenditures would be one of the least economically damaging revenue raisers and would still make the system simpler and less distortive. While several of the tax expenditures are incredibly popular, such as the mortgage interest deduction, if we are serious about deficit reduction, some discussion of tax expenditures needs to be on the table. If you'd like to see the list of most tax expenditures in the federal budget, follow the link to the Joint Committee on Taxation's report.