A Less Taxing April

Say what you will about the Republican Path to Prosperity, it would make early April a lot less stressful. Last week the House Budget Committee approved Chairman Paul D. Ryan, Jr.’s fiscal year 2012 budget, which would dramatically curtail tax expenditures—special tax rules including credits, deductions, and exemptions that subsidize health insurance, pension contributions, mortgage payments, and a host of other private spending. This reform would substantially reduce the time and money people spend preparing their taxes, as well as the market distortions created by the tax code. But the resulting revenue increase would be used to lower tax rates. Ryan’s proposal gets it half right. While closing loopholes would make the tax code more efficient and equitable, the budget crisis demands that the new revenue be used mainly for deficit reduction.

Foregone revenue from tax loopholes doesn’t appear in appropriations bills, but the majority of nondefense discretionary spending is done through the tax code. Tax expenditures amounted to over $1 trillion in fiscal year 2010, compared to $2.2 trillion in total federal receipts.

Unlike increases in marginal tax rates, cuts in tax expenditures do not reduce incentives to work, save, and invest and can enhance efficiency by lessening distortions of private spending decisions. The exclusion of employer contributions to health insurance, one of the biggest loopholes, generates over-consumption of medical care by allowing employees to purchase insurance with pre-tax dollars, and has contributed to skyrocketing health care spending. The deductibility of mortgage interest has sparked excess demand for homes and helped cause the housing bubble of the past decade. Eliminating these and other perverse incentives would allow income to be allocated to its most efficient use.

Another efficiency gain comes from the reduction in tax compliance costs. The National Taxpayer Advocate, an independent office within the Internal Revenue Service, estimates that Americans spent $163 billion in 2008 preparing their income taxes, which amounts to 11 percent of tax receipts. Simplifying the tax code by eliminating special rules would reduce compliance costs, freeing up time and resources for productive activity.

While Ryan’s proposal has been roundly criticized for reducing the deficit on the backs of the poor, its broader tax base would come disproportionately at the expense of the wealthy. The Washington-based Tax Policy Center explains that tax expenditures raise after-tax income more for the wealthy than the poor, largely because high-income citizens are more likely to participate in subsidized activities like homeownership, consumption of employer-sponsored health insurance, and retirement saving. The bulk of the revenue gains from curtailing these programs would come from the top of the income distribution.

Ryan leaves the details of the tax reform effort to the House Ways and Means Committee, and some have criticized him for failing to identify tax expenditures he would cut. But targeting specific loopholes is unnecessary, says Harvard economist Martin S. Feldstein, since Congress could simply cap the total benefit taxpayers can receive from the combined effect of different tax expenditures. Feldstein and Daniel R. Feenberg of the National Bureau of Economic Research estimate that limiting an individual’s benefit from combined tax expenditures, excluding among others the earned-income tax credit that benefits the poor, to two percent of adjusted gross income could reduce the 2011 deficit by 17 percent. An across-the-board cap would substantially reduce distortions and compliance costs while avoiding the political difficulty of targeting specific tax rules that favor certain industries.

The problem with Ryan’s tax reform plan is that it would “not be for the purpose of increasing total tax revenues”—new revenues would be used to enhance growth by lowering tax rates. This would be a fine idea under less dire fiscal circumstances, since raising the same amount of revenue with a broader tax base and lower rates reduces the decline in production that occurs as a side-effect of every tax. But the complex challenge of bringing the budget into long-term balance, particularly with respect to health care spending, demands that most if not all the additional revenue be used for deficit reduction until the budget reaches a sustainable trajectory.

Of course, many Republicans do not concede that lower tax rates depress revenues. The Path to Prosperity identifies economic growth as the “biggest driver of revenue to the federal government,” an expression of the myth that cutting taxes from their current rates would actually boost revenue by stimulating economic growth. While this was certainly true of the Reagan tax cuts in the 1980s, the center-right Tax Foundation explains that “hardly any economists” would agree that cutting today’s comparatively low rates would increase revenues, and that the argument “amounts to little more than wishful thinking.”

Ryan has the right intuition that the goal of tax policy should be to maximize economic growth—not government revenue. In the coming years, however, continued growth depends critically on our ability to rein in the monstrous long-term deficit. Revenue increases in the form of reduced tax expenditures are part of the solution, along with postponement of rate cuts for the foreseeable future.

Peyton R. Miller ’12 is a government concentrator in Winthrop House. His column appears on alternate Tuesdays.