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Posted on Oct 04, 2011

Spending and Tax Reform

Tax reform impact on small businessAs promised in my last tax reform guest post (What Tax Reform Should Be Focused On), I am following up in this post to explain the spending that exists in the tax law itself.  This spending has grown to almost equal the discretionary spending in the federal budget. Tax expenditures total about $1.1 trillion per year and discretionary spending about $1.3 trillion (see

The spending in the tax system exists in the form of special deductions, exclusions and tax credits. For example, individuals claiming a child credit of $1,000 per child have their tax bill reduced by that amount. They are in the same position they would be if instead of a tax credit to reduce their tax bill, the government wrote them a check each year of $1,000 per child. Similarly, a tax deduction for home mortgage interest expense reduces the homeowner’s federal income tax bill. That savings to the taxpayer (and “cost” to the government, that is, other taxpayers) could have been obtained via a check written to the homeowner.

“Tax expenditures” are also characterized by the fact that they are not crucial to defining what is taxed. For example, we could have an income tax without a home mortgage interest deduction, just as we have one that doesn’t allow other deductions, such as for costs of private tutoring your child may need and costs of commuting to work. In contrast, items that are key to a tax system are not considered tax expenditures. For example, the standard deduction and deduction for personal and dependency exemptions are not tax expenditures because an income tax should allow a deduction to reflect the fact that some income needs to be available for living expenses, rather than for paying taxes.

President Obama’s deficit commission (the one chaired by Simpson and Bowles) highlighted that one way to reduce the deficit was to cut out the $1.1 trillion of annual tax expenditures. They noted that this would not only help reduce the deficit, but could allow for much lower income tax rates (8%, 14% and 23% for individuals and 26% for corporations). Removal of many of these expenditures, such as for rapid depreciation, higher education expenses or savings, energy credits, etc., would also make the tax law simpler.

Elimination of some of the over 200 special tax deductions, exemptions and credits in the federal income tax law would also make the tax system more equitable for two reasons. First, special tax rules that lower the tax bills of some taxpayers, are, in effect, paid for by other taxpayers. Also, special tax rules, such as the home mortgage interest deduction, are worth more to taxpayers in higher tax brackets. For example, if two individuals each have mortgage interest expense of $10,000, the tax savings to the person in a 35% tax bracket is $3,500 while the savings to the lower-income person in a 20% bracket is $2.000.  Or, another way to look at this is the net, after tax, mortgage interest payment of the higher income individual is $6,500 but $8,000 for the lower income taxpayer.  If the deduction were instead structured as a credit, it would be worth the same amount to all taxpayers regardless of tax bracket. For example, a tax credit of 20% of your mortgage interest would yield a $2,000 tax savings to each of the taxpayers in the prior example.

Here is what the Simpson-Bowles Deficit Commission said about tax expenditures in their final report:

“America’s tax code is broken and must be reformed. In the quarter century since the last comprehensive tax reform, Washington has riddled the system with countless tax expenditures, which are simply spending by another name. These tax earmarks – amounting to $1.1 trillion a year of spending in the tax code – not only increase the deficit, but cause tax rates to be too high. Instead of promoting economic growth and competitiveness, our current code drives up health care costs and provides special treatment to special interests. The code presents individuals and businesses with perverse economic incentives instead of a level playing field.” (page 28)

When you hear talk today of “loopholes” in the tax law, people are most likely talking about the special tax deductions, exclusions and credits. The vast majority of them in terms of cost, are claimed by individuals, not corporations. This is due to the fact that there are more individual taxpayers and individuals pay more in taxes than do corporations, in the aggregate. (For more on this, see the IRS National Taxpayer Advocate 2010 report chapter – “The Time for Tax Reform is Now” – it is very good.)

So, there is spending in our tax system. As Congress and President Obama work on tax reform and deficit reduction, this spending will need to be looked at and most likely reduced. These actions can be taken in ways that would also make the system simpler and more equitable.

What do you think?

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Annette Nellen has been running the 21st Century Taxation website and blog for over four years.  Her focus is raising awareness on tax system weaknesses, possible solutions and the need to modernize tax systems and follow principles of good tax policy. She is a full-time professor in a graduate tax program (MST) at San Jose State University and an active member of the tax sections of the AICPA, ABA and California Bar. Annette has been actively involved in studying tax policy and reform for over 20 years – check out her website for more information.

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