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Wednesday, Jan 2, 2013 10:58 PM UTC

The real way to fix the deficit: Stop coddling the rich

Instead of cutting aid to the poor, the president and Congress should focus on reforming costly tax expenditures

By , Next New Deal

Topics: Next New Deal, Tax Policy Center, Barack Obama, Mitt Romney, Affordable Care Act, ,

The real way to fix the deficit: Stop coddling the rich (Credit: Reuters/Jason Reed)
This originally appeared on Next New Deal.

Next New Deal While we often hear critics decrying the redistributive effects of American social spending, government aid does not always benefit households of limited means. Often, aid looks more like a million-dollar vacation home or a luxury health insurance plan than housing vouchers and food stamps. American social spending is more complex than a simple redistribution from high- to low-income households. Over time, the country’s tax and transfer system has adopted provisions that reward specific high-income households. These programs contribute to deficit growth and detract from spending targeted at alleviating poverty among working families.

The most generous social welfare programs are currently administered through the tax code. A list of itemized deductions on households’ income tax returns serves as the only indication of these benefits. Income tax deductions, exclusions, deferrals, and credits, known collectively as “tax expenditures,” amount to more than $1 trillion of federal spending (according to estimates by the Tax Policy Center), not including lower tax rates on capital gains and dividends to encourage investment.

Tax expenditures are the functional equivalent of direct spending. Consider two households with identical incomes of $200,000. Household A purchases a home with a mortgage. Household B rents an apartment. Household A likely receives $5,000-10,000 (depending on mortgage size and APR) through the mortgage interest deduction when filing taxes. Household B receives $0. This, in effect, is a subsidy for homeownership. If the IRS collected taxes without any exclusions or deductions and then distributed payments to those who purchased mortgages, we would most likely categorize this disbursement as a form of direct spending.

Beyond simply diminishing revenues, tax expenditures disproportionately favor high-earning households, thereby reducing progressivity of federal income taxes. One reason for this imbalance is that high-income households have relatively high marginal income tax rates. Consider the exclusion of $10,000 of earned income for two individuals. Taxpayer A is taxed at a rate of 20 percent. Taxpayer B is taxed at a rate of 35 percent. Excluding $10,000 means removing this sum from taxable income. Decreasing taxable income by $10,000 for both of these individuals will yield $2,000 for Taxpayer A and  $3,500 for Taxpayer B. Thus, two taxpayers who engage in identical behavior receive disparate rewards because of income differences.

High-earning households are also more likely to engage in behaviors incentivized through the tax code. This means that, in addition to gaining more from each dollar deducted from tax obligations, high-earning households also deduct more than their middle- and low-income peers. Having more resources, the top 20 percent of households are more likely to purchase homes and contribute to retirement savings plans than households in the bottom 20 percent. They are more likely to hold jobs that offer employer-provided health insurance. Further magnifying the divide, high-income households on average possess more expensive employer-provided health insurance. In subsidizing purchases of homes, retirement plans, and health insurance for all households, tax expenditures disproportionately assist those originally more likely to engage in these behaviors. Consequently, high-income households are in better positions to take advantage of tax deductions.

So if tax expenditures waste essential potential revenues on affluent households, why are they so difficult to reform? General support for simplifying the tax code is not difficult to find. What is difficult, however, is reducing or eliminating particular benefits that households already possess. Tax expenditure reform would be tantamount to a tax hike on households that itemize deductions. For this reason, politicians enthusiastic about tax code simplification become reticent when faced with the task of eliminating specific loopholes.

The first step to simplifying the tax code successfully is treating tax expenditures as spending. This distinction demands that Congress scrutinize expenditures to the same degree that it scrutinizes antipoverty spending. Congress should consider whether particular deductions or exclusions successfully incentivize a desired behavior. Further, it should assess whether social rewards from altered behavior exceed revenue lost. For example, it would be difficult to argue that any social gain from deducting mortgage interest on second homes for families earning more than $250,000 exceeds revenues lost. By simultaneously reducing revenues for means-tested entitlements and subsidizing home purchases of wealthy taxpayers, such a provision merely exacerbates income and wealth inequality. This provision is not worth revenue losses that it engenders.

While tax expenditures for high-income families would not survive this level of scrutiny, some expenditures for low-income families achieve desirable ends. This social value justifies revenues lost. For example, the Earned Income Tax Credit (EITC) supports low-wage workers with supplemental income, reducing the poverty rate for these workers and their families. EITC successfully incentivizes work, achieving a valuable social aim and warranting a degree of spending. Other existing expenditures might also be continued for lower- and middle-income households. For example, Congress might continue the mortgage interest deduction for low- and middle-income households on the margin of being able to afford homeownership. But Congress should only adopt such extensions if a clear argument can be made that social gains exceed revenues lost.

As President Obama and congressional leaders continue to negotiate long-term deficit reduction, the first programs that they trim should be those subsidizing high-income households. More than any other social spending category, tax expenditures for high-income households constitute frivolous spending. Both presidential candidates in 2012 supported reducing tax expenditures for high-income families. Governor Romney suggested setting a maximum deduction, while President Obama proposed setting deductions at lower tax rates. Each of these plans would limit tax expenditures for high-income households to some extent. In order to further decrease tax expenditures’ regressive effects, these proposals could be combined with reforms that target payments toward lower- and middle-income households. This would include restricting the mortgage interest deduction to primary residences and limiting exclusions for luxury health insurance beyond provisions already included in the Affordable Care Act.

Now it is time for the president and Congress to fulfill their promise to simplify the tax code, beginning with those at the top of the income scale. While tax expenditure reform for high-income households will not solve our fiscal problems single handedly, it represents an essential path forward for reducing the deficit without exacerbating the economic hardship of low-income Americans.

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