Cut Tax Expenditures, and Taxes

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WASHINGTON-Tis the season for deficit reduction and tax reform plans. With advice pouring in from economists and commissions, such as Wednesday's report from President Obama's deficit reduction commission, cuts in tax expenditures promise additional revenue for Uncle Sam.

Tax expenditures, amounting to over $1 trillion in the government's 2010 fiscal year, are the money saved by taxpayers when they avail themselves of provisions in the tax code such as deductions or credits for mortgage interest, health insurance, state and local taxes, charitable contributions, and contributions to tax-favored retirement accounts. These offsets reduce taxable income and taxes owed.

According to the Committee for a Responsible Federal Budget, tax expenditures "are more similar to spending than tax cuts...Reducing these ‘tax earmarks' is a critical first step in fundamental tax reform since it would broaden the base and permit lower rates."

But tax expenditures and government spending are very different. With tax expenditures, individuals control more of their money, and most believe that they can make better use of it than does the government.

If we eliminate tax expenditures we should lower tax rates so that tax collections from Americans for their given income level remain the same. We should shrink or eliminate the deficit by cutting spending and by encouraging economic growth that would bring in additional revenues as Americans make more money.

Most deficit reduction plans, such as those put forward by President Obama's deficit reduction commission, the Bipartisan Policy Center Debt Reduction Task Force, and Harvard economist Martin Feldstein, to name but three, don't lower rates enough to make up for eliminating tax expenditures. Consequently, they raise Treasury revenues.

And if history is any guide, Congress uses the revenues to expand government functions, rather than putting the funds to deficit reduction, despite the best of intentions.

What Congress should do is take an even sharper knife to spending than deficit reduction commissions contemplate. Eliminate proposed high speed rail, devolve infrastructure spending and gasoline taxes to states, raise gradually the Social Security retirement age, leave slots of retiring federal workers unfilled, expand competitive bidding for Defense Department contracts, devolve Medicare into a private health insurance system. But that is the subject of another column.

Advocates of curtailing or eliminating tax expenditures say that they are not raising tax rates. True, but this is disingenuous because individuals pay substantially higher taxes on the same income. To put it more plainly, legislated increases in tax revenues are a poor idea because they choke economic growth. Our goal should be for economic recovery and high employment eventually to raise the ratio of revenue to gross national product.

Take, for example, Mr. Feldstein's plan. He wrote in the Washington Post on November 29 that limiting tax expenditures "would, however, reduce the deficit by hundreds of billions of dollars a year without raising tax rates and thus without reducing the incentive to work, to save or to expand businesses."

It's puzzling that Mr. Feldstein says that the government can raise taxes by trillions of dollars without affecting incentives to work or invest. If the government takes in more revenue for the same level of income, that's less for the private sector.

Take the cap on the mortgage interest deduction that Mr. Feldstein has proposed. Suppose that a family with adjusted gross income of $250,000, now at the 35% tax bracket, pays $50,000 in mortgage interest. Under Mr. Feldstein's proposal the tax benefit of all deductions, including the interest deduction, would be capped at 2% of adjusted gross income. The value of the tax savings would go from $17,500 to $5,000, and the family would have to pay higher taxes of $12,500 or more per year just for the lost mortgage deductibility.

The family would also be capped on the deductibility of other tax expenditures such as charitable contributions and personal business expenditures. The effect of Mr. Feldstein's proposal on just this one family could be tens of thousands of dollars in additional taxes a year.

Yes, the family's stated marginal tax rate on the tax form may be notionally the same, but the marginal taxes the family would pay for each additional dollar of income could be higher for two reasons. First, the family may be in a higher marginal tax bracket as its taxable income is higher with vanishing deductions. Second, for many types of small business income, vanishing deductions on incremental business activity may mean that each extra dollar of income is associated with an effectively higher marginal tax rate.

The report of the President's deficit reduction commission seeks to lower individual income tax rates to 8%, 14%, and 23% and the corporate rate, now 35%, to 26%, and eliminate all tax expenditures. It sounds like taxes would be lower, but this would raise $900 billion over 10 years.

The Debt Reduction Task Force, co-chaired by Alice Rivlin and Pete Domenici, would raise taxes by $2.5 trillion over the next decade by scaling back many tax expenditures. The report explains that "tax expenditures misallocate resources by promoting over-investment in tax-favored industries and over-consumption of tax-favored goods and services."

The Rivlin-Domenici team would allow everyone to save $20,000 per year free of taxes, but they would raise taxes on capital gains and dividends to ordinary income rates - even though such taxes on capital would discourage investment.

Higher taxes mean that families will have less money to consume and to cycle through the economy. Unless tax expenditures are balanced out with lower rates so that there is no net revenue gain to Uncle Sam, higher taxes and higher marginal tax rates mean that individuals will work less, hire fewer employees, invest less in their businesses, and look to invest more resources overseas.

Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is senior fellow and director of Economics21 at the Manhattan Institute. Follow her on Twitter: @FurchtgottRoth.   

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