ECONOMIC, POLICY AND BUDGETARY ASPECTS OF TAX EXPENDITURES Leonard Burman Director, Urban-Brookings Tax Policy Center Volcker Professor, Maxwell School,

ECONOMIC, POLICY AND BUDGETARY ASPECTS OF TAX EXPENDITURES Leonard BurmanDirector, Urban-Brookings Tax Policy CenterVolcker Professor, Maxwell School, Syracuse University

Prepared for Tax Administration Research Centre’s 3rd Annual Workshop20 April 2015

Note: Much of this presentation is based on joint work with Marvin Phaup, George Washington University

www.taxpolicycenter.org 2

Summary

·US Budget process biased in favor of tax expenditures- “tax cuts” good; “spending” bad

·Voters don’t perceive full cost of tax expenditures because they are mischaracterized as tax cuts rather than spending increases

·Result of this form of “fiscal illusion” is:- Government is bigger/less efficient that it would be

with fully informed voters- Public good allocation distorted in favor of tax

expenditures- Under plausible circumstances, even cash outlays

could increase

·Counting tax expenditures as spending, rather than negative taxes, could improve efficiency of government

www.taxpolicycenter.org 3

Tax Expenditures Defined

·“The income tax is composed of two distinct elements.

- structural provisions necessary to implement a normal income tax

- special preferences found in every income tax

departures from the normal tax structure and are designed to favor a particular industry, activity, or class of persons.

government spending for favored activities or groups, effected through the tax system.” (Surrey and McDaniel p. 3)

www.taxpolicycenter.org 4

History

·US Treasury first estimated tax expenditures in 1967

·Congressional Budget Act of 1974 mandated tax expenditure tabulation and display

·Canada, UK, and many other OECD countries quickly followed suit

·Germany invented the concept—if not the name— more than a decade before Surrey coined the term.

www.taxpolicycenter.org 5

It is a very old debate

·1863: William Gladstone, Tory member of the British parliament:

the charitable deduction would make no sense as a direct expenditure, conflicting as it would with efforts to bring “…the whole expenditure of the State…within the control, and under the eye, of the House of Commons. If this money is to be laid out upon what are called charities, why is that portion of the State expenditure to be altogether withdrawn from view… and to be so contrived that we shall know nothing of it, and have no control over it…?”

·Sir Strafford Northcote:“‘The right hon. Gentleman, if he took £5 out of the pocket of a man with £100, put the case as if he gave the man £95…’” (Brooks, 1985)

www.taxpolicycenter.org 6

Concerns about Tax Expenditures

·Like direct spending, they result in larger government and higher taxes or bigger deficits

- Similar effect on resource allocation- May raise concerns about efficiency, equity,

compliance and administration costs

·Tax expenditures also raise special issues- Complicating tax compliance and creating

opportunities for tax sheltering- Timing of payments- Often poorly targeted: they provide largest subsidy

to high-income taxpayers, little or nothing to those with low incomes

·Tax expenditures are not bad per se, but they should not be granted privileged status

www.taxpolicycenter.org 7

10 Largest US Tax Expenditures, FY2016In Billions of Dollars

  Provision Amount1 Exclusion for employer-sponsored health insurance 347.7

2 Capital gains 93.0

3 Exclusion of imputed rent on owner-occupied housing 82.4

4 401(k) plans (defined contribution retirement plans) 73.9

5 Tax deferral for multinationals 67.8

6 Angel of death loophole (step-up in basis for capital gains) 66.7

7 Earned Income Tax Credit 63.8

8 State and local tax deduction (excluding property tax) 51.2

9 Premium assistance tax credit 48.8

10 Charity deduction (other than education, health) 47.4

Source: US Budget, Analytical Perspectives, FY2016, and author’s calculationsNote: Health insurance estimate includes $131.6 billion payroll tax expenditure; EITC and premium assistance tax credits include outlays of $58.7 and $45.8 billion, respectively

www.taxpolicycenter.org 8www.taxpolicycenter.org 8

www.taxpolicycenter.org 9

Value and Number of US Tax Expenditures

0

1

2

3

4

5

6

7

8

9

10

0

50

100

150

200

250

Valu

e as

Per

cent

of G

DP

(sol

id) N

umber of Provisions (dashed)

Source: For tax expenditures as percent of GDP, GAO analysis of OMB, Analytical Perspectives, Budget of the United States Government, Fiscal Years 1985-2011; for count of provisions, Joint Committee on Taxation (annual tax expenditure compilations), and authors’ calculations.

www.taxpolicycenter.org 10

US Individual Income and Payroll Tax Expenditures Compared to Other Spending, FY 2016

Tax expenditures are large relative to the size of the budget

  Income Tax Expenditure Mandatory Discretionar

y Defense Non-defense

$ Billions 1,609.30 2,913 1,150 625 525

Percent 28.3 51.4 20.3 11 9.3

% of GDP 8.5 15.5 6.1 3.3 2.8

www.taxpolicycenter.org 11

US Tax Expenditures Compared to Other Taxes, FY 2016

 Income Tax

Expenditures

Net Individual

Income Tax

Corporate Income Tax

Payroll Tax Other

$ Billions 1,609.3 1,610 433 1091 296

Percent 31.9 31.9 8.6 21.6 5.9

% of GDP 8.5 8.5 2.3 5.8 1.6

www.taxpolicycenter.org 12

Tax expenditures are significant in many EU countries

Source: EU, “Europe 2020, Taxation,” http://ec.europa.eu/europe2020/pdf/themes/02_taxation.pdf

www.taxpolicycenter.org 13

Stylized model of political process with “fiscal illusion”

Assumptions:Voters value spending programs, whether delivered as cash outlays or TEsVoters dislike taxes and deficitsVoters may suffer “fiscal illusion” in the sense that they view new tax expenditures as reductions in taxes (i.e., they don’t perceive the full tax burden)

www.taxpolicycenter.org 14

Model sketch

Subject to

Votes are a positive function of cash outlays and tax expenditures, and negative function of perceived taxes

•X is cash outlays (mandatory and discretionary)•E is tax expenditures• is perceived taxes•) is the fiscal illusion parameter

www.taxpolicycenter.org 15

First-order conditions

www.taxpolicycenter.org 160 2 4 6 8 10 12

0

2

4

6

8

10

12

14

16

18

20E

𝑇 ̂� = X + E

𝑇 ̂� = X + (1 – α) E

X

V0

V1

Effect of Fiscal Illusion on Cash Outlays and Tax ExpendituresCobb-Douglas Case, Linear Cost Function

www.taxpolicycenter.org 17

0 2 4 6 8 10 12 140

2

4

6

8

10

12

14

16

18

20

A

B

C

X

E

𝑇 ̂� = X + E

𝑇 ̂� = X + (1 – α) E

𝑋_1^∗𝑋_0^∗

Effect of Fiscal Illusion on Cash Outlays and Tax ExpendituresPublic Goods are Substitutes, Linear Cost Function

www.taxpolicycenter.org 18

Increasing Costs

Constraint

FONC

www.taxpolicycenter.org 19

0 2 4 6 8 10 12 140

2

4

6

8

10

12

14

16

18

20

B

X

A

E

Effect of Fiscal Illusion on Cash Outlays and Tax ExpendituresX and E are Substitutes; Increasing Costs

www.taxpolicycenter.org 200 2 4 6 8 10 12 14

0

2

4

6

8

10

12

14

16

18

20

B

X

A

E

Effect of Fiscal Illusion on Cash Outlays and Tax ExpendituresX and E are Complements; Increasing Costs

www.taxpolicycenter.org 21

Implications of Fiscal Illusion re Tax Expenditures

·Too much spending through tax expenditures because voters underestimate the true price

·Larger government (inclusive of tax expenditures)

·Higher taxes and/or bigger deficits

·With increasing costs, shift to tax expenditures is somewhat muted, but there is also production inefficiency (i.e., per unit cost of government services increases)

www.taxpolicycenter.org 22

US Tax Expenditures as Upper-Middle Income Entitlements:TE as Percent of After-Tax Income, Selected Quintiles, 2011

 Lowest Quintil

e

2nd Quintil

e

3rd Quintil

e

4th Quintil

e80-90 90-95 95-99 Top 1 All

Exclusions 0.9 4.2 4.7 4.4 7.0 8.9 9.4 6.4 6.0

Capital Gains and Dividends

* * 0.1 0.1 0.2 0.4 0.9 4.5 0.9

Itemized Deductions * 0.1 0.4 1.2 2.2 2.8 2.6 3.0 1.7

Above-the-line Deductions

* 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

Non-refundable Credit * 0.2 0.2 0.1 0.1 0.1 * 0.1 0.1

Refundable Credits 6.0 5.5 2.0 1.0 0.6 0.2 * * 1.4

Other 0.1 0.3 0.4 0.5 0.7 0.8 1.1 1.6 0.8

All 7.5 9.8 8.1 8.4 12.2 15.0 15.9 19.8 12.3

www.taxpolicycenter.org 23

Reformed Budget Presentation for Tax Expenditures

Total revenues 4.0

Cash 3.0

Tax expenditures 1.0

Total outlays 5.0

Cash 4.0

Tax expenditures 1.0

Surplus (deficit) (1.0)

Borrowing from the public 1.0

Note that current budgeting only shows cash revenues, outlays.

www.taxpolicycenter.org 24

Accounting for a New TE

Change in total revenues 0.0

Cash -0.1

Tax expenditures +0.1

Change in total outlays +0.1

Cash 0.0

Tax expenditures +0.1

Change in surplus (deficit) (0.1)

Change in borrowing from the public +0.1

www.taxpolicycenter.org 25

Conclusion

·Exclusion of tax expenditures from budget process is one reason budget is out of control

·Budget politics are different in other countries, but clearly the political appeal of tax expenditures is pervasive

·Leads to bigger, less efficient government, higher taxes and/or bigger deficits

·Reducing tax expenditures also offers the possibility to raise net revenues while cutting marginal tax rates and promoting economic growth

·That is—classic tax reform