How Tax Expenditures Hurt the Economy -- and What to Do About It

April 16, 2012

As the federal government seeks solutions to closing its massive budget gaps, individual plans are increasingly steering away from politically unpopular tax rate increases, eyeing instead the $1 trillion in tax expenditures that government allows each year, says Diana Furchtgott-Roth, a senior fellow at the Manhattan Institute.

These expenditures, which directly reduce an individual's income tax burden, also have the effect of distorting consumer behavior to favor certain activities over others.

  • The tax-free status given to employer-provided health insurance (which reduced federal tax revenue by $109.3 billion in 2011) has undermined the creation of a true private market for health insurance like those that exist for car and life insurance.
  • Deductions from federal taxable income for state and local taxes reduced tax collections by $42 billion in 2011, and have the net effect of subsidizing state and local governments with high tax levels.
  • The mortgage-interest deduction that was put into place to encourage homeownership cost the government $76 billion in 2011, and had a large hand in the 2006 housing crash by over-stimulating home-buying behavior.

These provisions can be scaled back substantially, reducing their distortionary impact on the economy while harnessing the additional revenue power.  However, many current deficit-reduction plans would eliminate these provisions with no other changes.  This has the essential impact of a tax increase -- something that should not be considered while so many are still trying to climb out of the recession.

Rather, tax expenditures should be reduced with simultaneous adjustments to tax rates, in order that total policy changes would be revenue-neutral.

  • Those tax expenditures that are least valuable and most distortionary (such as those mentioned above) should be reduced or eliminated.
  • The additional revenue from those changes would allow across-the-board reductions in the individual income marginal tax rates.
  • This would initially keep revenue the same (which, combined with spending cuts, would reduce the deficit).
  • In the long run, the efficiency gains from fewer distortionary tax expenditures and lower income taxes would yield economic growth and more tax revenue.
  • Greater federal tax receipts would therefore be realized without nominal tax increases.

Source: Diana Furchtgott-Roth, "How Tax Expenditures Hurt the Economy -- and What to Do About It," Manhattan Institute, April 2012.

For text:

http://www.manhattan-institute.org/pdf/ir_9.pdf

 

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