Monday, February 8, 2010

On Freezing Tax Expenditures

By John Maggs  

Len Burman

Public affairs professor at Syracuse University

Economy expert and Syracuse University professor Len Burman proposed in the Washington Post last week an alternative to the modest savings from President Obama's spending freeze -- a freeze in some "tax expenditures," those exemptions in the tax code for different groups that work effectively like spending programs for special interests.

The article raised a few questions that Burman answered in an interview with National Journal via e-mail. The complete exchange follows after the jump, and read more on the discussion at NationalJournal.com's Economy Expert Blog.

NJ: Say a bit more about tax expenditures and how they might be viewed by the public. You seem to suggest that the public might view reductions in these as less of a tax increase than, say, an adjustment in brackets.

Burman: Tax expenditures really are spending programs clothed as tax cuts. For example, John McCain proposed to give families $5,000 in refundable tax credits to pay for health insurance. The only difference between these credits and a voucher is that the credits would be disbursed by the IRS, whereas a health insurance voucher would presumably be issued by an agency of the Department of Health and Human Services. So why should the credit be considered a tax cut while the voucher is considered a spending program?

The confusion is more than semantic. During the campaign, then-candidate Obama accused Senator McCain of proposing to "tax you health insurance" because he would have financed the cost of the new credit by eliminating the current tax break for employer-sponsored health insurance. In fact, McCain was proposing to eliminate a tax expenditure that almost all health analysts believe to be inefficient and poorly targeted with a much more progressive and more efficient alternative. (McCain's health proposals had other shortcomings, but the credit was definitely a step up from the tax exclusion.) I suppose the Obama camp took some perverse pleasure in slamming McCain for "tax-and-spend" policies, but it didn't elevate the public debate.

NJ: What you propose -- and that's clear from your reference to 1986 -- is effectively comprehensive tax reform, with the great degree of political trade-offs required. But the idea of a freeze, which implies a first step, something to do to stop things from getting worse, seems like a relatively small benefit for the political will that will be needed. The 1986 reform would surely never have succeeded without its dramatic cut in income tax rates, paid for with big tax increases for some expenditures. If the political cost is comparable, why only a freeze?

Burman: Tax reform is never easy, but our federal finances are in a very precarious state. Unlike the 1986 tax reform, which was explicitly designed to be revenue-neutral, the next one should be intended to raise enough revenue to stabilize federal finances. Cutting tax expenditures is a much better way to do this than raising marginal tax rates since the former tends to improve economic efficiency by reducing economic distortions -- for example, among different kinds of investments -- while the latter increases the economic cost of taxation.

NJ: Does it make sense to target expenditures, a large share of which are the big subsidy for home ownership? Would you concede that any cut to these expenditures is off the table until housing recovers significantly?

Burman: The mortgage interest deduction is utterly irrational a policy since it encourages leverage (we can see how well that works) and bids up the price of housing. The majority of households that do not itemize deductions get not benefit from it. It would be at the top of most economists' hit list for reform, but I agree that significant changes are probably politically impossible now. (Note also that my proposal would not start to take effect until 2013.)

While the mortgage interest deduction is the second biggest tax expenditure, it is only about 10 percent of the total in 2011. Here are the 12 largest tax expenditures, as calculated by the Treasury Department for the FY2011 budget.

NJ: How do you imagine the process for selecting expenditures to cut might work? A commission? Should the idea be spread the pain across incomes, or hew to Obama's approach on doing nothing to affect the middle class?

Burman: A commission is a recipe for inaction. The president should be required to submit to Congress a budget that includes revisions to tax expenditures to meet the overall cap. In my proposal, the cap would not take effect until 2013, which would reduce the chance that it would stifle a nascent recovery. The delayed start would give Congress and the president time to hear from a tax reform panel charged with limiting tax expenditures and promoting fairness, simplicity, and economic growth. The congressional budget rules should be revised so that the budget process included a cap on overall tax expenditures. It would be up to the House Ways and Means Committee and Senate Finance Committee to propose tax changes to meet the cap, and the two legislative bodies would reconcile differences subject to the cap.

One intriguing possibility would be to combine this with a proposal by University of Virginia law professor George Yin to subject all tax expenditures to annual reauthorization. Professor Yin's theory is that sunsetting tax expenditures would convert them from virtual entitlements (like Social Security) into the equivalent of discretionary spending, subject to annual review and scrutiny.

How to choose what to cut? Presidents for as long as I can remember have explained proposed spending cuts by saying that some programs were ineffective, some were duplicative of other programs, and some were obsolete. Ineffective programs needed to be reformed so they could meet their objectives or eliminated. The other two categories clearly also deserve the axe. The same criteria should be applies to tax expenditures. Some are great and should be continued or even expanded, but many are inefficient or even counter-productive. They should be reformed or eliminated.

Just as it would make no sense to preserve a spending program because some middle-class family should benefit, the president's promise to spare middle-class families from tax increases shouldn't apply here. These are spending programs in disguise. We should remove the veil and then subject them to the same hard-headed scrutiny that the president has promised for direct spending programs.

NJ: How do you cap an expenditure? Presumably some estimate is made of how much the rules would have to be adjusted to keep the revenue constant. Isn't this a guess that will have to be adjusted later?

Burman: Budgeting is always a guess. The Joint Committee on Taxation estimates the size of all tax expenditures and can easily estimate how that total would change under various budget proposals and help Congress put together a package that meets the cap. (Treasury would do the same for the administration's budget.) This is no more (or less) difficult than putting together a tax bill designed to meet a particular price tag.