Why Reducing Tax Rates AND Tax Expenditures Might be a Good Thing
It’s that time of year again. Taxes are coming due. As we make these payments, the policies and principles that created them bear reflection. However, before arguing for a change, a critical rule must hold— tax policy should be a revenue neutral conversation. That means changing the marginal tax rates is fine, but the government must find a way to make up the difference.
To do so, politicians sometimes argue that reducing tax rates will increase GDP. Therefore, tax revenue won’t change because the tax base upon which the rate is applied is higher. Maybe. Opponents of this view may find common with ground with proponents by lobbying for a plan where a reduction in rates is accompanied with a reduction in tax expenditures.
What are tax expenditures? Tax expenditures are all those deductions and exclusions that tax payers record each year on their tax returns to calculate adjusted gross income from gross income. Tax expenditures can also be thought of as “hidden government” spending, hence why economists refer to them as tax expenditures. In fact, almost all tax expenditures could almost entirely be replaced by a similar direct spending program. Instead of providing the targeted benefit through a reduction in taxes, a direct expenditure program could provide the same effect through a simple check in the mail or a credit for a certain kind of spending. SNAP is a direct expenditure program, as an example.
Tax expenditures typically favor high income earners. This seems logical since high income earners pay the most taxes. However, a tax code with lower rates and less tax expenditures that favor higher income earners would be easier and more transparent. While there would be some winners and losers of course, the net effect in the aggregate would be the same.
It’s also true that not all tax expenditures favor higher earners. Certain tax credits, such as the dependent care credit, that phase out as incomes rise do exhibit ‘progressive’ features. While it’s possible for tax expenditures to be targeted and progressive, they often are not. In other words, it’s not that tax expenditures are entirely bad; it’s that they are often poorly designed.
In short, Congress could create a more bipartisan, effective, and efficient tax code through lower rates and a more equitable tax expenditures. Remembering that almost all tax expenditures could be replaced with direct spending programs, and acknowledging, they create inefficiencies in the economy through more lawyers and accountants arguing over them (deadweight loss), finding places to do so might be the best course of action.
