Tuesday, July 12, 2011

Some Truth on Tax Expenditures

The term tax expenditures has become all the rage, particularly on the left of late.  The purpose is to establish some rhetorical equivalence between preferences in the tax code and actual disbursals of money by Congress.  The validity of this line of thought is a topic for another day (or two).  Today’s purpose is to focus on a commonly argued perspective as it relates to tax expenditures, namely that they primarily benefit the rich.  DeeDee Meyers provides a common refrain:

Even tax breaks that are supposed to help the middle class too often skew toward the wealthy. Consider the mortgage interest deduction. While political leaders in both parties have long considered it untouchable, it actually helps those at the top of the income scale far more than those at the bottom.[1]

This is a pretty common (and pretty incorrect) point of view but it takes a little bit of understanding to get you there.  As a starting point, let’s look at the savings that come from certain popular tax expenditures.  As Meyers did, we’ll start with the home interest and property tax deductions.

The benefits of these deductions (according to the Tax Policy Center) accrue as follows[2]:

So at first blush, it does seem pretty progressive to eliminate the mortgage interest and property tax deductions.  After all, more than 90 percent of the benefits are given to those people in the top 2 quintiles of the income distribution.

It might appear that way until we add the following information from the CBO to the same picture.[3]

Clearly now the picture looks somewhat different.  In the chart, the red bars are as in the first chart and the green bars are each group's share of Federal income taxes.  The same group of people (the bottom 80 percent) who paid less than 10 percent of the costs of eliminating these deductions only pay currently 0.6 percent of the Federal income taxes.  Said differently, the bottom 95 percent of the distribution of income pays a higher share of the total tax burden under a system where the deduction is eliminated than they would pay under a system where it is sustained. 

The deduction for health insurance shows a similar picture only more so.  The top 20 percent of taxpayers would only pay 42 percent of the costs of eliminating the healthcare deduction and the top 1 percent would pay only 2.4 percent of the costs.  By contrast, these groups currently pay 86 and 39 percent respectively of the income taxes.  Remembering that the currently popular definition of “the rich” is the top 2% (or so), the elimination of these tax provisions would be very favorable to the rich relative to the current tax code.

Thus, the Obama administration has not proposed ending some of the larger tax breaks in the current income tax code.  This is for two reasons.  First, the tax breaks are very popular with large numbers of Americans.  More importantly, eliminating tax breaks makes the Federal income tax less progressive and raises taxes on people making less than $250,000 per year.

Instead, the administration proposes putting a cap on the amount that the rich can deduct which in the end is nothing different than a tax rate increase, just a much more complex one than simply changing marginal rates.

[2] http://www.taxpolicycenter.org/UploadedPDF/411922_expenditures.pdf
[3] http://www.cbo.gov/publications/collections/tax/2009/tax_liability_shares.pdf

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