President’s 2008 Budget Reveals Massive Holes in Tax Code

President Bush and the Office of Management and Budget released their fiscal year 2008 budget yesterday. Tax collections have been increasing much more rapidly than usual: 7.5% annually from 2002 to 2006. Therefore, the culprit in any deficit analysis is bound to be government spending, the rapid growth of which we’ve commented on elsewhere.

What we focus on here is the enormous size of the deductions, credits and exemptions that pockmark the tax code.

They are called “tax expenditures” in the Budget because they can be analogized to direct government spending. When deductions, credits and exemptions wipe out someone’s tax liability, or substantially reduce it, other taxpayers must eventually shoulder a heavier burden. If the government were not, in effect, paying people to do certain things with their money, the income tax system could raise the same amount of revenue at much lower rates.

Mostly enacted by congresses at the behest of politically powerful interests, these deductions, credits and exemptions are often without any sound policy basis, although never without rhetorical arguments for their preservation. They make the income tax code less efficient and create inefficiencies and inequities in the market.

For example, the mortgage interest deduction is one of the nation’s most long-enduring and popular tax deductions. It creates a powerful financial incentive for people to buy larger homes and to pay more for small ones. The net result for the federal government is that America’s homeowners will keep $89.4 billion in FY 2008 that they would have had to pay in tax if this deduction were not in the code. In fact, the 25% bracket could have been as low as 19.9% in 2004 if the mortgage interest deduction did not exist, according to the most recent figures from the IRS.

Table 1 shows ten famous deductions, credits and exemptions with a cumulative value of $483.6 billion in FY’08.

Table 1: Ten Forgiving Chapters of the Income Tax Code

Source: Office and Management and Budget, Analytical Perspectives

1) 401(k) plans are tax deferred so the actual tax expenditure may be less when they are taxed in the future.

2) This excludes the refundable portion of EITC. The full value of the EITC in FY 2008 is $42.9 billion including the refundable portion.

The true value of these expenditures is actually higher than the total shown, $483.6 billion, because the Child Tax Credit and Earned Income Tax Credit are refundable. Refundable credits function like normal credits, in that they reduce the amount of tax owed by a taxpayer. However, if a taxpayer’s liability is less than zero after taking advantage of these refundable credits, they are entitled to a check from the IRS for the difference.

In FY 2008 the IRS will dole out $14.9 billion for the Child Tax Credit and $37.6 billion for the Earned Income Tax Credit for a total of $52.5 billion.

We estimate that because of numerous deductions and credits such as the Child Tax Credit and the Earned Income Tax Credit 43.4 million tax returns will have zero tax liability in 2006.

Credits and deductions make the tax code more complicated and less economically efficient, costing the American economy billions in foregone production.

The economy and all taxpayers would be better off if all deductions and credits were abolished. If this occurred, a tax rate of just 9% on personal income would be all that was necessary to raise the revenue currently raised by the income tax code with its top tax rate of 35% according to Patrick Fleenor.