Raising Revenue by Limiting Tax Expenditures

The prospect of very large future deficits and a rapidly increasing national debt is an important fiscal challenge for the United States. Limiting those deficits, and therefore the growth of the national debt, requires slowing the growth of the retirement and health programs. Additional tax revenue could contribute to that process. Limiting tax expenditures would raise revenue without increasing marginal tax rates. It would also be equivalent to reducing government spending now done as subsidies through the tax code for a wide range of household spending and income. An effective way of limiting tax expenditures would be a cap on the total tax reduction in tax liabilities that each individual can achieve by the use of deductions and exclusions.The national debt of the United States is now 74% of GDP, double what it was a decade ago. The current annual deficit of about three percent means that the debt will grow at about the same pace as nominal gross domestic product (GDP), keeping the ratio of debt to GDP unchanged. Although that is likely to continue for the next several years, the Congressional Budget Office has recently warned us that the debt ratio will start rising again and will grow to very high levels during the CBO's long-term forecast period (Congressional Budget Office 2014).More specifically, under the "extended baseline," the CBO projects that the debt to GDP ratio will rise during the next two decades to more than 100% of GDP. When the CBO drops some of the unrealistic assumptions that are required to be used in its baseline analysis, the forecasts in its "alternative fiscal scenario" show the debt rising to as much as 183% of GDP in 2039. The rising debt levels reflect the greater interest payments on the national debt and the increased cost of the middle-class health and retirement transfer programs. Limiting and reversing the rise in the national debt requires only relatively small decreases in annual deficit ratios. If real GDP grows at 2.5% and inflation is 2%, an annual deficit of 4.5% of GDP will cause the national debt to rise to 100% of GDP, but lowering the deficit to 2% of GDP will reverse the direction of the debt, causing it to decline to less than 50% of GDP.There is little scope for reducing the deficit by cutting spending on the annually appropriated "discretionary" programs. While there is no doubt of substantial waste in many programs, total outlays for nondefense discretionary programs is now just 3.4% of GDP and is projected to decline to 2.5% of GDP in 2024. Similarly, the defense programs are projected to decline to just 2.7% of GDP in 2024. Therefore, reducing the annual deficit requires some combination of slower growth of the retiree and health programs and increases in tax revenue.Tax rates have continued to rise in the years since the Tax Reform Act of 1986. That legislation reduced the top marginal tax rate to 28%. Since then the top personal income tax rate has increased to 40%. An additional tax increase on investment income was part of the Affordable Care Act, and the overall payroll tax on wage and salary income was increased when the old ceiling on income subject to the 2.9% Medicare tax was completely abolished.It is a central tenet of public economics that raising marginal tax rates increases the distorting effects of the tax system and thus the deadweight loss to the economy.Fortunately, it is possible to increase revenue without raising marginal tax rates. The key is to limit the reductions in tax revenue that result from the use of tax rules that substitute for direct government spending.Some examples will illustrate the nature of these "tax expenditures." If I buy a hybrid car or a solar panel for my house, the government rewards me with a subsidy payment. The subsidy does not take the form of a check from the government, but of a reduction in my tax liability. If I pay more in mortgage interest or in local property taxes, the government subsidizes my spending by allowing those expenses to be deducted in calculating my taxable income and therefore my tax liability.According to the Joint Committee on Taxation, the tax expenditure subsidies in the personal income tax code reduces revenue this year by approximately $1.6 trillion (Joint Committee on Taxation 2014). Those tax rules (especially the exclusion of employer payments for health insurance) also reduce the income that is subject to the payroll tax, leading to an additional loss of government revenue.Eliminating any of the tax expenditures or limiting their use would shrink the size of the annual deficits. Although the effect would show up on the revenue side of the government budget, that is just an accounting convention. In terms of real economic impact, limiting tax expenditures should be viewed as a reduction in government spending.The ability to frame tax expenditures as either revenue increases or spending decreases should make limiting tax expenditures appeal to those Republicans who want to reduce government spending as well as to those Democrats who want to use additional revenue to help shrink fiscal deficits. Some of the revenue produced by limiting tax expenditures could also be used to reduce marginal tax rates.Any attempt to limit a particular tax expenditure will be resisted by those who now benefit from it. That suggests that a comprehensive approach may be more politically feasible because no group of taxpayers will feel that they have been unfairly singled out. It also suggests that it would be politically difficult to eliminate completely any of the major tax expenditures. Instead, the analysis in this paper focuses on a method of limiting the extent to which each individual can benefit by using the full set of current tax expenditures.The first section describes a potential basic cap on the benefit that individuals can receive from an extensive set of tax expenditures. Section II discusses several features of using such an overall cap. The third section examines several variations of the basic cap. Section IV considers two alternatives to the cap stated as a percentage of GDP: limiting the overall dollar amount of deductions and limiting the benefit of deductions and exclusions to the 28% marginal tax rate. There is a brief concluding section.