"Whew . . . following up on Len Burman's "Sigh" after receiving 9 responses to his proposal to freeze tax expenditures. I'm glad I've waited for others to weigh in to get the benefit of their comments and to piggyback on those observations I like.

First, there is the matter of the normal tax base which I think has been slighted in most discussions about tax expenditures. There is no "tabula rasa" that suggests the tax baseline should be an income rather than consumption. And yet, that is the crux of Len's proposal on the table. Contributions to 401 k plans or IRAs, lower or zero capital gains tax rates, expensing of business investment are considered a tax expenditure under Len's proposal but not under a consumption tax which is the tax regime which generates a sizable portion of the revenue in almost all the countries around the world.

Second, I believe, there is a consensus among economists and public policy experts that an income tax is biased against saving and investment and that a contributing factor to our current economic crisis is a lack of saving and investment.

Finally, Len in his Washington Post op-ed which generated the great debate on our blog, suggested President Obama domestic discretionary spending freeze be expanded to "tax expenditures." Why? Because "deficits (government dissaving) are an enormous threat to our prosperity." Since the long term health of the US economy is dependent on higher levels of total saving, , one doesn't make much progress by increasing the tax on personal and business saving tax expenditures. Rather, as we get out of the current recession we ought to move in the opposite direction by taxing consumption more, saving and investment less, to increase the odds for a prosperous US economy.

(For those who don't know me, I'm not a Johnny Come lately to my position. Albeit I'm not old enough to have debated Stanley Surrey the father of the income tax based tax expenditure concept but I did often debate it with the late distinguished Joe Pechman and as an editor of "The Consumption Tax: A Better Alternative" Ballinger, 1987)"

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Len Burman, one of the nation’s leading experts on the tax system, proposes to freeze federal tax expenditures. His freeze would be a companion to the one proposed by President Obama in his most recent budget. Like the President’s freeze on domestic discretionary spending, Burman’s freeze would not begin immediately but would be implemented in the not-too-distant future. Burman, like the President, would not impose his freeze in a mechanical, inflexible way. Under Burman’s plan Congress would be obliged to trim some tax expenditures and eliminate others in order to maintain an overall cap on tax expenditures. An ideal freeze would lead to the abolition or modification of unjustified tax preferences.

It’s easy to agree with Burman on the necessity for shrinking the long-term gap between federal revenues and outlays. It’s also clear that a good place to start is with a thorough reexamination of the loopholes and tax preferences that allow some taxpayers and forms of income to be more lightly taxed than others. Tax preferences deserve the same careful scrutiny as public spending in regular government programs. If a tax preference is ineffective, counterproductive, or unfair, it should be eliminated or modified. Burman and I would undoubtedly agree on a long list of tax expenditures that in a sensible system would be trimmed, transformed, or abolished.

While I warmly endorse the idea of pruning wasteful tax expenditures, I think Burman may be exaggerating the likely scope of potential deficit reduction. The simplest way to curtail tax expenditures is to cut marginal tax rates. If the typical marginal rate were cut from 20% to 15%, the tax expenditure for a particular exemption or tax deduction would shrink one-quarter. Only in a supply-sider's wildest dream, however, would a one-quarter cut in marginal taxes reduce the size of the deficit.

I see two other reasons to be cautious. First, the size of the tax expenditure “budget” cited by Burman probably overstates the true long-term cost of all tax expenditures. As the Office of Management and Budget points out, its tax expenditure estimates “… do not necessarily equal the increase in Federal revenues (or the change in the budget balance) that would result from repealing these special provisions.” One reason is that estimated tax expenditures on particular preference items may have reached their current level precisely because taxpayers have been encouraged to obtain certain kinds of favored income or incur certain kinds of expenses as a result of a tax preference. If the preference were eliminated, this kind of income or deductible expense would decline. Were Congress to eliminate the tax preference for retirement savings, for example, savings held in retirement accounts would probably begin to shrink, if only because some of the money currently held in the accounts would be taxed away.

The more basic issue is that several important tax preferences, such as the ones provided to capital income and worker savings, may be inherent components of an acceptable income tax system. These preferences may be politically necessary in order to make the income tax system palatable to middle class voters and economically efficient in maintaining appropriate incentives.

Consider how savings would be taxed in an income tax system that does not have any preference for retirement savings or capital income. A 21-year-old worker who earns a moderate wage and faces a 15% marginal income tax could consume all of her net earnings today or set aside part of her wages to pay for her future retirement. In the absence of any tax preference for capital income or retirement savings, she would pay 15% of her marginal earnings in taxes if she consumes all her wages today, or she could pay about 50% of her marginal earnings in taxes on the earnings she sets aside in a retirement account. The reason the latter tax rate is so high is that her investment income, if held outside of a tax-preferred account, would be taxed over and over again before her savings can be used to pay for consumption in old age. The pension tax preference allows contributions into a pension plan to be taxed only once -- when they are withdrawn from the account in retirement. Current tax preferences for pensions and some kinds of capital income represent reasonable accommodations to fix inherent flaws in a pure income tax system. Without such accommodations, an income tax can severely distort consumers’ choices about whether current income should be consumed today or set aside for future consumption.

I am not arguing that tax preferences for retirement saving and capital income should be treated as sacred or inviolable. Their design can certainly be improved. My point instead is that even though some tax preferences may be departures from a pure income tax, they are nonetheless crucial for keeping the tax system politically acceptable and economically rational.

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A long time ago, I read a book called The Policized Economy, by two socialist political scientists. They weren't fans of our democratic system and gave this as an example: conservatives hate government while liberals have never seen a program they didn't like, so they compromise on programs that don't work. That validates both of their world views.

Tax expenditures are completely consistent with that hypothesis. They vastly expand the reach and scope of government and, just like overt spending programs, they require higher tax rates or bigger deficits or both.

Although the name "tax expenditure" dates back to Treasury Assistant Secretary Stanley Surrey in the Johnson Administration, the concept and the conservative talking points date back at least to the mid-19th century. William Gladstone, then a Tory member of the British parliament, argued that the government should monitor the uses of the charitable deduction allowed under the income tax, just as it would any other spending program. The rebuttal from Sir Strafford Northcote could be lifted from the modern ultraconservative’s critique of tax expenditures: “‘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…’” (Quoted by Neil Brooks, 1986)

For what it's worth, many mainstream conservative public finance economists see a need for revenues to limit exploding deficits and would vastly prefer to limit tax expenditures than to raise income tax rates. For example, Harvard Professor, Martin Felstein, chairman of Ronald Reagan's Council of Economic Advisors, wrote in the Wall Street Journal on September 7: "The key to raising revenue without raising marginal tax rates or creating a new tax is to reduce or eliminate some of the 'tax expenditures' that now lower tax revenue by special deductions and exclusions." (His first candidate for the chopping block would be the tax exclusion for employer-sponsored health insurance.)

With respect to the more constructive comments, I agree with those who say that there are some significant implementation issues, although I think they could be addressed. Don Marron's point that investment subsidies are probably made less effective by their temporary nature is surely right. It would make sense to make the R&E credit permanent, especially since it has such overwhelming bipartisan support that there's no chance of ever allowing it to expire.

Don's also right that there are some serious issues about definition of tax expenditures. For example, some believe that the appropriate base should be a consumption tax rather than an income tax. Measured against a consumption tax baseline, for example, the taxation of capital gains would be considered a negative tax expenditure, whereas the reduced rate is considered a positive tax expenditure under the income tax base. However, there is a great deal of overlap between the income and consumption tax expenditures, and those provisions would be a great starting point for enforcing budget discipline.

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The very idea of a “tax expenditure” depends on the assertion that any dollar the federal government chooses not to take from you by force it has in fact given to you. The federal government owns your life’s work and its rewards and allows you to keep some—in its generosity. If a mugger fails to completely empty your wallet he or she has kindly “given” you that money.

Oddly, liberals tend not to include the “tax expenditure” of allowing some citizens to pay less than the present top rate of 35% of their income in taxes, but their logic would demand they do so. It would be the largest “tax expenditure.”

Attacking “tax expenditures” is an effort to avoid focusing on real expenditures by the federal, state and local governments. Nice try by the left, but not a serious way to deal with the costs of government spending.

I first saw this during the Carter years. WE see it again for the same reason. The big spending of the left is again becoming a political liability.

I like the idea of capping (even better, reducing) so called "tax expenditures," in general. It would be a desirable reform of our tax system to clarify and expose spending and special interest programs, which would help reduce spending growth, and permit lower tax rates for a given amount of revenue. Those are big pluses. One big practical problem is that tax expenditures reflect the stubbornly dishonest political process of Washington spending; politicians like hiding their special interest spending within the tax code and most of them will not be agreeable to this reform. Perhaps the idea could have a chance if, say, the Tea Party, were to focus on this and improve public awareness of its importance. In other words, to succeed this idea needs a "movement" (it could be part of a tax simplification movement, or a flat tax movement, for example, given the connection between lower marginal tax rates and this sort of tax reform). But the reform will never emerge from Washington-based political parties' compromises over the budget.

Another problem with the proposal is that not all experts will agree that the items that Professor Burman wants to cut really are pork. For example, is it really so obvious that the interest deduction on housing is a distortionary tax policy? People who rent their homes pay rent to the owner, who often finances that apartment building with debt, which is deductible as a business expense. In a competitive housing market the benefit of that deduction is passed on to the renter. If one does not permit home owners to also deduct interest on their mortgages, that amounts to a subsidy in favor of renters rather than owners. Indeed, the fact that mortgage interest is not deducted by all homeowners might be regarded as the true distortion. One could argue that a better reform would be to ensure that all homeowners (even those who do not itemize) get to deduct the mortgage interest they pay on their homes.

The real subsidization of mortgage risk in the US housing market comes from the over-leveraging promoted by Fannie, Freddie, the FHA, and various other government policies, not from the deductibility of interest provision of the tax code per se, which is better seen as neutral with respect to the decision to buy or rent. Similarly, the real tax incentive distortion that favors corporate leveraging results from the double-taxation of corporate income (via the corporate tax and the taxation of dividends as personal income). As we saw after 2003, a reduction in the dividend tax rate (even though it was not reduced to a fully tax-neutral rate) had its intended effect, namely a huge drop in corporate leverage. The right tax reforms to eliminate excessive leveraginng incentives should focus on making debt finance a neutral decision from a tax standpoint, not just eliminating tax deductions for the sake of increasing government revenue.

The mischaracterization of the deductibility of mortgage interest as pork illustrates the challenges economists face when trying to advocate sensible tax policy. The issues at stake are subtle, and distortions arise from the combination of taxes that affect a given stream of income, not from any particular tax rate in isolation. This observation further highlights the importance of tax code simplification. Eliminating the corporate tax altogether, and eliminating the estate tax, and focusing on the taxation of consumption rather than income (note that consumption taxation could be done progressively, of course, and could essentially replicate the current distribution to the ultimate burden of taxation within the population, if we wanted to do so), would be economically efficient (since consumption taxation is the least distortionary form of tax) and would also make it easier to explain the incidence of taxes and their distortions to the citizenry. Unfortunately, that is precisely why politicians will oppose that sort of reform. Economists will never get want we want (a simpler, clearer, less distorting tax code) until the public makes politicians who favor tax complexity pay for their intransigence at the polls.

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Len is right to focus attention on tax expenditures. They involve big money, distort our conception of the size of government, often disproportionately favor the affluent, and receive too little oversight.

He’s also right that they deserve special attention when Congress decides that it wants to increase tax revenues. As Len says in the interview: “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.”

Of course, there are some complications. In addition to the obvious political challenges, tax expenditure cutters face another problem: agreeing on what provisions should actually be characterized as tax expenditures. One could, of course, just use whatever definitions the Treasury and the Joint Committee on Taxation use. But analysts do not agree on which provisions are really spending programs in disguise.

Some cases are easy. Tax credits for using ethanol-blended motor fuels are clearly spending programs run through the tax code. But then there are items like the 15% tax rate on capital gains and dividends. That rate is scored as a tax expenditure in the current system because 15% is lower than the rates on ordinary income. It wouldn’t be viewed as a tax expenditure, however, by analysts who believe that a consumption tax, rather than an income tax, should be the lodestar for judging tax policies. My point is not to take sides on that issue, but just to point out that there is sincere debate about which items labeled as tax expenditures should be viewed as hidden spending programs and which as good tax policy.

In response to one question, Len raises the idea of subjecting all tax expenditures to annual reauthorization as one way to rein them in. I appreciate the desire for greater oversight, but I find this idea worrisome. We are already cursed with a tax system in which an enormous number of provisions are scheduled to expire. That creates needless uncertainty, placing a real burden on businesses and families and often undermining the very intent of the tax provisions. As a case in point, consider the research and experimentation tax credit, which Congress extends every year or two. That’s absurd. If the credit is good policy, it should be enacted on a permanent (or, at least, prolonged) basis so that it provides a clear signal to firms that engage in R&E. Conversely, if it’s bad policy, we should kill it. Revisiting it every year will just enrich lobbyists, distract legislators from more important issues, and weaken any incentives it might create.

I expect that the same holds true for many other tax expenditures. Some deserve to be enacted for prolonged periods to accomplish their goals. Some deserve annual review. And many deserve to be killed.

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I think the spirit of Len Burman’s argument in his Washington Post oped on tax expenditures is exactly right. Tax expenditures are just a form of back door spending. Although they may be used to favor certain types of spending, they also distort decision-making and lose a ton of revenue – over $1 trillion a year. They also tend to provide the biggest benefits to those in the highest brackets, tilting the tax structure in favor of the most affluent. Yet the public is only dimly aware of these key facts. Given the current political impasse caused by the fact that many Republicans refuse to put taxes on the table, a recognition that some tax provisions are spending programs by a different name could change the debate. In addition to the argument that tax expenditures are just another form of spending, most economists believe that tax expenditures are bad for efficiency and growth. Take the mortgage interest deduction; it encourages allocating savings to housing instead of to growth-enhancing innovative investments. Or take the exclusion of health insurance benefits from taxable income; this leads to overconsumption of health care and the growth of health care spending, now at 17 percent of GDP and growing rapidly with adverse effects on our competitiveness. So the old supply side argument that reducing taxes leads to greater efficiency or growth is simply wrong in these cases.

Could we simply freeze tax expenditures along with discretionary spending as Burman suggests? There are a whole host of practical problems attached to this proposal. It would be better, I think, to limit deductions and exemptions as the Administration proposed in both last year’s and this year’s budget – although I would limit them to 15% and not 28% both to raise additional revenue and make them even more targeted on the middle class. Unfortunately, even the Administration’s proposal was shunned by members of both parties on the Hill. There is no political courage anywhere these days.

Another idea that needs to be revived is eliminating the health exclusion – gradually perhaps but not in the wimpy way that it survived as part of health care reform. Perhaps it is time to start over so that we can get more cost control and more fundamental reform into the health care system. As many have argued, getting our deficits under control requires getting health care spending under control and the bills that emerged from Congress last year did far too little on this front. Yes, it is politically difficult but no more difficult than freezing tax expenditures. The elements of a more sensible approach exist: phase out the health exclusion, mandate coverage, reform insurance markets, and use the funds to partially subsidize that coverage. I envision McCain and Obama having a beer together and agreeing to these elements. And one thing they should agree to is that a tax credit and a subsidy are one and the same animal.

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I agree with the proposal completely.

With regard to the politics, one would have to see whether the phrase “cut tax expenditures” polls more like the phrase “cut expenditures,” which I assume polls well, or like the phrase “raise taxes,” which of course polls horribly. I have no idea.

With regard to the merits of the idea as economic policy -- in a context where strong measures to reduce the budget deficit will be necessary in coming years -- Len Burman is completely right. Agreeing to the general principle is easier than agreeing to all the detailed implications. Looking at the list of the actual 12 largest tax expenditures would give most people pause. But much less so for economists. The only one on the list that gives me serious pause, personally, is #7: the “charitable deduction (other than education and health).” But the top two deserve to be eliminated, as part of a larger fiscal package, not just to raise a lot of revenue but also to get economic incentives right: the exclusion for employer-sponsored health insurance and the mortgage interest deduction.

A proposal to eliminate the mortgage interest deduction would of course get zero support in Congress, because it is political suicide with the voters. A proposal to freeze the amount would not be popular either. The same with four other pro-housing tax expenditures out of Len’s list of 12: deduction for property taxes, exclusion of net imputed rental income, capital gains exclusion on home sales, and property tax deduction. All politicians and voters (excluding economists) continue to believe that that public policy should tilt in favor of home ownership. Notwithstanding the recession that began with the sub-prime mortgage crisis of 2007, economists have not made even a dent in popular perceptions, with out arguments against artificially tilting the field away from rental housing and the rest of the capital stock and toward (highly leveraged) owner-occupied housing. To take another example, whatever happens ultimately to Fannie Mae and Freddie Mac, they certainly won’t be abolished.

“Political impossibility” is not a reason not to try. After all, we won’t get through the next few decades fiscally unless we make some “politically impossible” changes. But I emphasized the housing issue in the preceding paragraph to make a different point. Almost all commentators on the financial crisis, whether from the left or right, talk as if the causes of the crisis are obvious and our leaders are idiots for not having acted to fix the problem ahead of time. Needless to say, those on the left blame the right, for deregulation, and those on the right blame the left, for moral hazard. And yet there is zero support for fixing the housing parts of the problem, on which economists have almost unanimous agreement (and did ahead of time).

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Here is a link to the paper by UVa professor George Yin, referered to by Len Burman in his postings:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1472106##

This is a naked, raw tax hike, pure and simple. If all these tax increases were to happen, it would score out as a $7 to $8 trillion tax hike over a decade. Mr. Burman doesn't even give taxpayers the courtesy of a rate reduction in exchange for these tax hikes. He just wants the government to get bigger. This would obviously be a clear violation of the Taxpayer Protection Pledge.

As to his assertion that these are really "spending programs," that's the same logic the Obama Administration uses when they lump in energy tax hikes in the same section of the budget as Labor Department employees shutting their computers down every night. A tax cut is a not a "spending program." A spending program is a spending program. Spending programs are funded by either taxing or borrowing first, then enlarging the government sector by spending the money. A tax cut deprives the government of revenue. It actually makes the government smaller, because it deprives the government of resources.

Just because you have to jump through a hoop to get a tax cut doesn't make the tax cut a government expenditure. It might be bad tax policy, but it certainly is not a government expenditure. There are many conservatives and former conservatives who fall into this trap. The result is higher taxes and more government spending. I'll prove it.

Let's say you think that all tax relief in the code is "just spending." OK. Let's make that explicit. Let's get rid of all of them, raising taxes by trillions of dollars. Let's take all that money, and run an identical government spending program out of HHS, HUD, etc. We'd be in the same place, right?

Wrong. Taxes have gone up from 18 to (say) 30 percent of GDP. Spending has gone up from 24 to (say) 40 percent of GDP. Taxes went way up. Spending went way up. We're not in the same place at all. We're in France. As an added "bonus" you need to hire hundreds of thousands of new government employees (at a career cost of $7 to $13 million each) to administer all these new social programs. But I guess that's OK because the IRS might get 5 percent smaller.

Enough. Tax cuts are not spending.

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