You Decide: Should tax expenditures be part of a budget or a budget deal?
Can something called “tax expenditures” be the silver bullet to avoid
a fiscal cliff and put the federal government on a better financial
footing? Maybe so! Some think tax expenditures are the key to any
budget deal in Washington.
So what exactly are tax expenditures? The term is somewhat misleading
because logic suggests it means types of spending that are taxed.
Instead, just the opposite is meant. Tax expenditures are certain
kinds of spending made by households and businesses that are not
subject to the federal income tax. So tax expenditures reduce the
amount of tax revenue available to the federal government.
To see how tax expenditures work, here’s a brief tutorial on the
federal income tax. The initial calculation of your federal income tax
comes from multiplying your taxable income by the tax rate applicable
to that income. So, if Sally Smith’s taxable income is $40,000 and the
tax rate is 15 percent, then the federal income tax owed by Sally is
$6,000 ($40,000 x 0.15). Once the initial tax owed is calculated,
there may be a further adjustment to reduce that amount.
Tax expenditures can affect the tax owed in two ways. First, tax
expenditures can reduce a taxpayer’s taxable income. Continuing with
the above example, if Sally qualified for a tax expenditure of
$10,000, then her taxable income would be reduced to $30,000, and her
income tax bill would drop to $4,500. These kinds of tax expenditures
are called tax deductions.
Second, certain kinds of tax expenditures can directly reduce the
amount of tax owed after the initial calculation of that tax bill was
made. Therefore, if Sally was eligible for this kind of tax
expenditure at the amount of $2,000, her tax owed would fall to $4,000
($6,000 minus $2,000). Such a tax expenditure is termed a tax credit.
I’m sure you’re now thinking, what are some examples of these great
tax expenditures? The tax code is loaded with them, but a few of the
more prominent are the mortgage interest deduction, the deduction for
health insurance provided by businesses to their employees, deductions
for donations to charities, a tax credit for low-income workers and a
tax credit for child care payments.
Why do tax expenditures exist? There are two competing explanations.
One says they are the result of special interest lobbying to help a
particular part of the economy. Let’s say you manufacture widgets. If
you can get a provision placed in the tax code that says people buying
widgets get either a tax deduction or tax credit for the amount they
spend on widgets, then you’ll likely see your widget sales increase.
The alternative explanation says government uses tax expenditures to
encourage spending on products and services that benefit the public
good. The tax deduction for charitable contributions is a good
example. Supporters of tax expenditures for home-buying, health
insurance and energy efficient vehicles also argue their products
benefit society at large.
Which brings us back to today. The reason tax expenditures are
potentially part of a budget deal is because they are very costly to
federal coffers. If all the tax expenditures were eliminated, current
estimates indicate annual federal government revenues would increase
by near $1 trillion. That’s enough to eliminate the annual budget
deficit. And this revenue could be raised without increasing tax
rates, which is a sticking point for many elected officials.
It’s very unlikely all tax expenditures would be axed. Indeed, one
idea floating around -- that came up during the presidential campaign
-- is that all tax expenditures would be kept, but taxpayers would be
limited to the total dollar amount they could claim. Other ideas are
to keep some tax expenditures but reduce or eliminate others or reduce
the tax expenditures available to certain taxpayers, such as
Regardless of what kind of plan is put forward to revise tax
expenditures, it will be hotly debated for two fundamental reasons.
First, current users of tax expenditures will see their tax bill rise
if tax expenditures are curtailed.
Second, groups that benefit from tax expenditures -- such as
charities, the residential housing industry, child care centers and
alternative energy providers -- will likely be hurt if their tax
expenditures are curtailed.
To see how this could happen, consider Sally Smith making a $1,000
contribution to her favorite charity. With a tax deduction for that
contribution and using a 15 percent tax rate, Sally’s donation reduces
her tax bill by $150 ($1,000 x 0.15), meaning her $1,000 gift
effectively costs her $850. Charities worry that people like Sally
won’t donate quite as much without the tax deduction because the cost
of donating would be higher. Other groups benefiting from tax
expenditures have the same worry.
So keep your eye on the coming arguments over tax expenditures. You
decide if they should be a key part of any deal for fiscal frugality.
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Dr. Mike Walden is a William Neal Reynolds Professor and North
Carolina Cooperative Extension economist in the Department of
Agricultural and Resource Economics of N.C. State University’s College
of Agriculture and Life Sciences. He teaches and writes on personal
finance, economic outlook and public policy.