This article will appear in the Winter 2017 issue of The American Prospect magazine. Subscribe here.
Think, if you will, about taxing and spending.
The former—taxing—occurs when the government levies some claim on your income. It could be a local sales tax on a tube of toothpaste, a Medicare or Social Security deduction from your paycheck, or an income tax check to the federal IRS. Spending is what the government does with tax revenue. Local governments spend your property taxes on public schools; the feds finance social insurance, defense, the safety net, and so on.
Many people think that taxing and spending, while complementary, are entirely distinct.
Not so. There’s an important way in which the federal government spends through the tax code. The technical term is tax expenditures. These include tax credits, deductions, and exemptions. You can’t begin to understand the scope, the inequities, and some of the venerable benefits of our tax system without getting into these particular weeds. Moreover, in the age of Trump, we’re going to need to keep a very close eye on such provisions, which are almost certain to grow, and to grow even less equitable.
Tax expenditures reduce the amount of taxes owed based on some policy goal or preference. If you’re a homeowner, you probably deduct your mortgage interest from your tax bill. That’s a tax expenditure, one that diverted $75 billion from the coffers of the U.S. Treasury in 2016. If you get your health insurance through your job, the fact that its value doesn’t go into your tax base is another tax expenditure; in fact, it’s the largest single one, amounting to $216 billion forgone this year.
The chart below compares the combined cost of the tax code’s individual and corporate tax expenditures with other government spending. Tax expenditures cost about $300 billion more than either of the major government health-care programs (Medicare and Medicaid) or Social Security, and about as much as all federal discretionary spending on defense, other health-care programs, education and training programs, transportation systems, diplomacy, science, and much more combined.
In fact, the distinction between a tax expenditure and straight-up spending is sometimes meaningless. Consider the Child Care and Development Fund, a spending program that helps certain families pay for child care. Now consider the child-care tax credit. Both programs help families offset the cost of child care. Why do we have both, and what implications does that have on policy and politics?
First, given the conservative mantra of “spending bad, tax cuts good,” many politicians in both major political parties are much more comfortable with tax expenditures than direct spending. But that ideological bargain leads to a lot of spending through the tax code that’s both wasteful and inequality-inducing. As Suzanne Mettler has shown in her book The Submerged State, it also denies government credit for the instances of good policy, since a tax break is experienced as a refund rather than as a direct government benefit.
The waste comes from subsidizing actions that would happen even without the subsidy. Wealthy people would save, and buy houses and health care, without a tax break. And yet—and this is the inequitable part—not only do they get to take tax deductions for these activities, they get to take larger ones than lower-income people. A rich individual who faces a top marginal income tax rate of 39.6 percent would save $39.60 on her tax bill with a $100 deduction, for example, while an individual with a lower top marginal tax rate, say 25 percent, would only save $25 from the same deduction. The regressive result is shown in the next figure: Half of the benefits of the ten largest tax expenditures go to the richest fifth of households.
The mortgage interest and property tax deductions are two popular expenditures that have this regressive effect: 80 percent of total spending on these two deductions goes to households with incomes over $100,000. Households with incomes over $200,000 receive four times as much support from the federal government as households with incomes below $20,000. This is one way in which our tax system not only fails to offset, but exacerbates market-driven income inequality.
Such tax breaks litter the code. There’s bonus depreciation (a provision that allows businesses to deduct the cost of business investments faster than those investments lose value in real life), tax deferral for multinationals on overseas profits, and “like-kind exchanges” that enable real-estate owners to avoid paying capital gains taxes, among many others. Tax breaks are especially notorious in the real-estate industry.
Hmm … a real-estate owner who taps into such loopholes to avoid tax liability …. That sounds familiar.
President-elect Donald Trump and his merry band of billionaires are all too familiar with tax expenditures and are likely to use them to great—and by “great,” we mean “terrible”—effect. A perfect example is their infrastructure plan. Instead of the usual approach of allocating funds to pay for much-needed upkeep of our stock of public goods, they propose providing about $140 billion in tax credits for private infrastructure investments. Investors would shoulder only a $30 billion burden, “but would receive all the profits,” as our colleagues at the Center on Budget and Policy Priorities have explained, “effectively privately owning and operating the projects and charging the public to use them.” Since investors would only finance projects, like toll roads, with these spun-off user fees, such a plan would likely cause essential repairs to school facilities and interstate highways to fall by the wayside.
We expect the Trump administration to offer similarly bad tax-expenditure ideas in their quest to repeal and replace the Affordable Care Act. They’re likely to turn to Health Savings Accounts (HSAs), a tool that, as health expert Edwin Park points out, offers “unprecedented tax sheltering benefits to high-income individuals.” In an HSA, people with high-deductible health plans can make tax-deductible contributions to their accounts, earnings can grow tax-free, and withdrawals to pay for health care are also tax-exempt. Look for team Trump to expand these amped-up tax shelters by raising the maximum annual contribution to HSAs and allowing people to apply HSAs not just to out-of-pocket costs (which are all that HSAs currently cover), but to premiums as well.
Progressive tax wonks tend to prefer credits over deductions, as credits directly reduce individual or corporate tax bills by a specific amount. A $100 credit is generally worth $100 both to people with a top marginal tax rate of 39.6 percent and to those with a top marginal rate of 25 percent. Yet they, too, can be regressive. A family with a tax liability of only $20 will only get $20 worth of benefit from a typical $100 tax credit, thus making such a credit more valuable to families with higher incomes than to lower-income people.
The exceptions to this rule are credits that are refundable, meaning that if the size of the credit exceeds a taxpayer’s tax liability, the taxpayer receives a check from the government for the balance. The Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC), for instance, are effectively cash transfers that significantly reduce poverty—they lifted 9.8 million people out of poverty in 2015 and made 22 million more people less poor—while incentivizing work. These refundable credits could help even more people if policymakers strengthened the EITC for workers not raising children in the home and extended the CTC to the poorest families, especially those with young children.
Another refundable tax credit, the premium tax credit from the Affordable Care Act, helped make health insurance more affordable for more than nine million Americans as of early 2016. When you hear warnings about how the repeal of Obamacare is going to lead to millions losing coverage, the loss of this credit is one reason (as is the repeal of the Medicaid expansion).
In sum: There’s taxing, there’s spending, and then there are tax expenditures. For the most part, tax expenditures are inefficient, inequitable, opaque, and vulnerable to special-interest lobbying. The exception is refundable tax credits like the EITC, which are tantamount to direct income support for moderate-income, working Americans. (Guess which kind of tax expenditure is likely to increase under Trump?)
While spending through the tax code is not in every case problematic, the bulk of what goes on in that big, shady part of the code is wasteful and inequitable. Unfortunately, in the age of Trump, that part is sure to grow.