Turning Tax Expenditures Right Side Up

The federal government spends more than $1 trillion a year on “tax expenditures” — spending delivered through the tax code via credits, deductions, and other targeted tax breaks.  That’s more than it spends on Social Security, or on Medicare and Medicaid combined.  There’s growing bipartisan interest in curtailing tax expenditures as a way to help reduce deficits, and if done right, it could also make the tax code more efficient and equitable, as our new report explains.

About 70 percent of what’s spent each year on individual tax expenditures goes for tax breaks whose value is tied to the taxpayer’s income bracket.  As a result, the wealthiest households often receive the largest tax subsidies (since they’re in the highest brackets), while middle-class families receive considerably less — and many of the most vulnerable families are left out entirely.

This structure makes little sense.  Much of this “spending” is designed to encourage socially valued activities like owning a home, saving for college or retirement, or contributing to charity.  But high-income families generally would do these things with or without big tax incentives.  By contrast, families of more limited means often can’t afford to do these things without significant financial incentives.

In short, we spend a lot of money subsidizing behavior that would have occurred anyway, while we exclude the very families that likely would respond most to the incentive.  In other words, many of these tax expenditures are “upside-down.”

Unlike tax deductions, tax credits don’t link the size of the tax incentive to households’ marginal tax brackets, so they are often more economically efficient.  Refundable tax credits often are the most efficient of all because they’re worth the same amount for all households, regardless of their income or tax liability during the year in question (see table).

Therefore, by converting various existing tax deductions into tax credits of a fixed percentage for all filers, policymakers can make them more effective in boosting retirement saving, college attendance, and the like, while also helping reduce deficits and improving the progressivity of the tax code.

Recent bipartisan deficit commissions have proposed just these sorts of steps.  The Rivlin-Domenici commission proposed converting the mortgage interest deduction to a 15 percent refundable tax credit, available to all homeowners for mortgage interest of up to $25,000 on a principal residence.  In the same vein, the Bowles-Simpson commission proposed eliminating or restructuring many of the most “upside-down” tax expenditures, including itemized deductions, many exclusions, and preferential tax rates on capital gains and dividends, while maintaining or expanding key tax credits.

These proposals reflect a growing sentiment that as long as we continue to use the tax code as a vehicle to encourage socially beneficial behavior, we should do so as effectively and efficiently as possible.