INTEGRATING TAX EXPENDITURES INTO THE BUDGET PROCESS

Leonard Burman, Maxwell School, Syracuse

Marvin Phaup, Trachtenberg School, GWU

January 21, 2011

Pew Subsidyscope

Washington, DC

Motivation• Exploding debt• Dysfunctional budget process• Need to control deficits without undermining economic

growth or eviscerating the social safety net• Timely: debt commissions all proposed major cuts in tax

expenditures

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 or persons.

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

History

• Concept has been around for a long time• Brooks cites David Gladstone (1867)

• 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

Tax Expenditures as Spending

• Comparable to direct (mandatory) spending• No discrete control via appropriations• Infrequent reauthorization or review• Once enacted, spending mostly on auto-pilot• Default option: growth

• Virtually any spending program could be converted into a tax expenditure• Low-income housing credit, e.g.• McCain health insurance voucher

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• Unless refundable, low-income families are left out

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

Unlike direct spending, largely invisible

• Never show up in main budget documents (except for refundable credits) and largely outside the budget process

• Unidentified in:• Total outlays and revenues• Functional displays of BA/outlays (separately)• Budget resolution• Allocations of spending to committees• Program accounts• Explanation of deficits

• New tax expenditures mischaracterized as tax cuts

Tax Expenditures Compared to Other Spending, FY 2011

Income Tax Expenditure Mandatory Discretionary Defense

Non-defense

$ Billions 1,177 2,165 1,415 744 671

Percent 24.7 45.5 29.7 15.6 14.1

% of GDP 7.6 14.0 9.1 4.8 4.3

Tax expenditures are not chump change!

Tax Expenditures Compared to Other Taxes, FY 2011

Income Tax Expenditures

Net Individual

Income Tax

Corporate Income Tax

Payroll Tax

Other

$ Billions 1,177 1,121 297 935 214

Percent 31.4 29.9 7.9 25.0 5.7

% of GDP 7.6 7.2 1.9 6.0 1.4

Shares of Non-Interest SpendingFY 1982-2015

19821983

19841985

19861987

19881989

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

0

20

40

60

80

100

Source: GAO (via Lori Metcalf), FY 11 Budget, and authors' calculations.

Defense

Mandatory

Tax Expenditures

Non-Defense Discretionary

“The tax expenditure concept relies heavily on a normative notion that shielding certain taxpayer income from taxation deprives government of its rightful revenues.” (Congressman Jim Saxton, 2002)

However, tax expenditure concept is controversial in some quarters

“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” (Sir Strafford Northcote rebutting Gladstone in British Parliament, 1867)

This is not a new argument

Source: Burman, Toder, and Geissler (2008)

Tax Expenditures are Upper-Middle Income Entitlements:TE as Percent of After-Tax Income, Selected Quintiles, 2007

Type Bottom Middle Top Top 1% All Exclusions 0.5 3.8 4.7 2.9 4.2 Above-line deductions 0.0 0.1 0.1 0.1 0.1 Capital gains, dividends 0.0 0.0 2.1 5.9 1.3 Itemized deductions 0.0 0.4 2.9 3.2 2.0 Nonrefundable credits 0.1 0.3 0.1 0.0 0.1 Refundable credits 5.5 2.2 0.3 0.0 1.1

All 6.5 6.8 11.4 13.5 9.6

Source: Burman, Toder, and Geissler (2009). Excludes effect of AMT.

Other concerns about tax expenditures

• Static • No interaction effects• Estimates highly uncertain• Choice of baseline (biased in favor of liberal tax policy?)• Need for additional JCT, Treasury staff

Tax Expenditures Improperly Accounted for in Current Budget• Equivalent to a) government collection of tax and b)

refund to taxpayers meeting eligibility criteria• Current accounting nets these two effects, understating both taxes

and spending• New tax expenditures appear to be reductions in revenues when

they are really increases in spending (holding revenues constant)

• This decomposition suggests changes in budgetary accounting and display

Example: Adding TE to Budget Totals

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.

Scoring an Increase in 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

Other Appropriate Changes

• Include TE in the functional tabulations of spending and as spending in budget resolution

• Group program accounts by sub-function and show TE as separate line items

• Cap TE in the budget resolution and allocate to tax committees

• Replicate cash treatment throughout: reconciliation

• Would it help? Necessary, but not sufficient. For major gain via process reform, must fix process

How would a TE Cap Work?• Not an across the board cut • Tax committees would be instructed to revise current tax

law so that total tax expenditures, as scored by JCT, are at or below the cap for each year

• Similar procedure could be applied to mandatory programs

Integrating Tax Expenditures in Reformed Budget Process• Reform presentation (discussed above)• Enact statutory, medium term target or constraint

(e.g., debt/GDP)

. Shared jurisdiction of TE by tax and authorizing committees to coordinate different spending forms

• Add TE to committee allocations and subject to reconciliation

• Strengthen Budget Committees • Put reconciliation and points of order back to work• Increase program evaluation, use and quality of

performance measures

Enforcement

• Statutory Limits• Super majorities for waivers• Periodic public scorekeeping reports• Presidential report on performance against statutory goals

• Expedited authority to reduce appropriations• Sequester: across board spending cuts and tax surcharges-- percent of total tax or lump sum

Potential Complementary Reforms• Make all TE explicitly temporary to make more like

discretionary spending (Yin)• Convert individual income tax exclusions, deductions,

and credits to refundable income tax credits to equalize value across income and increase transparency (Batchelder, Goldberg, Orzag)

Conclusion• Exclusion of tax expenditures from budget process is one

reason budget is out of control• It will be virtually impossible to control spending without

constraining tax expenditures and mandatory• 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