Who Benefits from Tax Expenditures?

By James Kwak

Ezra Klein points out a new tax expenditure database from The Pew Charitable Trusts. More attention to tax expenditures — exceptions in the tax code that reduce tax revenue or, put another way, subsidies channeled through the tax system* — is always a good thing. But Klein also says something interesting that I don’t agree with:

“they’re basically the welfare state for the middle class, cleverly arranged such that they don’t look like the welfare state for the middle class. If every year, the government sent every American — from the richest CEO to the greenest public-school teacher — a check covering 30 percent of their health-care costs, we’d think that a bit weird. We’d think it much weirder if we only sent the checks to the workers who happened to be at firms that offered benefits. . . .

“Yet that’s pretty much exactly what we do. We just hide it in the tax code rather than write it on a check.”

I agree with all of that, except the bit about the middle class. Tax expenditures primarily benefit the rich, for a few reasons.

  • First, most of them are deductions from taxable income, which means their value to you is proportional to your marginal tax rate. Not only do rich people have higher marginal rates than middle-class people, but remember that many middle-class people pay exactly zero in income taxes. (The average tax rate for people in the middle income quintile is 2.3 percent.) This is true, for example, of the deduction for employer-provided health insurance.
  • Second, because most of them are itemized deductions, you only get them if you itemize your deductions–which usually means either that you have a big enough house to have a big mortgage or you have enough income to pay a lot of state and local taxes.
  • Third, the size of the deduction is highly correlated with income. To take the most obvious example, rich people have bigger houses, and so they have bigger mortgages. (In another universe, they might buy the same size houses and pay for them with cash — but that’s not our universe.)
  • Fourth, there are the tax expenditures that you get on investments, which are disproportionately held by the rich. There’s the tax exemption for life insurance investments. There’s the big one: tax-advantaged investment accounts, including 401(k)s, IRAs, Roth IRAs, 529s, etc.  This is even leaving aside the question of whether lower tax rates for capital gains and dividends count as tax expenditures.
  • Fifth, there are the tax expenditures for businesses, since in theory those flow to their shareholders, who are disproportionately the rich. (I say “disproportionately” because someone with a net worth of $1 million has much more than ten times the capital market investments of someone with a net worth of $100,000.)

Tax expenditures are basically exhibit A for my pet theory of the tax code. And there should be broad support for getting rid of them. But there isn’t, because the median household does get some benefit from the mortgage interest tax deduction. They just don’t realize how much more benefit rich households are getting from it.

* You can have a debate about what is or is not a tax expenditure. You can even have a debate about whether the whole concept makes sense, since the identification of something as a tax expenditure presumes some baseline in which that particular loophole doesn’t appear. But the latter debate is, in my opinion, philosophical at best. It’s pretty clear that the tax code includes some basic principles (like taxing income) and some exceptions (like not taxing a portion of your income equivalent to the amount of mortgage you pay on your house and your vacation house); the latter are tax expenditures.

25 responses to “Who Benefits from Tax Expenditures?

  1. Garrett Wollman

    Don’t the really rich lose most of these deductions through the mechanism of the AMT?

  2. I tend to agree with most of what you write, but I’m uncomfortable with the notion of tax expenditure. Is it a tax expenditure not to charge a sales tax on food?

    Taxes are necessary—and not just a necessary evil. Taxes are important. They are one way we pay for what society does for us, which is a lot.

    I would much rather have that argument (that taxes are important and not just “the government taking your money”) than to try to do what seems to me to be sneaking in as an expenditure what is really a disagreement about what should be taxed.

  3. You’re talking about high-income earners, not rich people. Rich people buy same size houses with cash, and they make up a small part of all high-income earners.

  4. By definition you can only receive a tax deduction (expenditure) if you pay taxes. Consequently, the minority of people actually paying income taxes get all the expenditures.
    The term “tax expenditure” is very 1984ish and since the debt commission reported, it’s been cropping up more often. By claiming all deductions are actually expenditures, you redefine the relationship between government and taxpayers. Instead of the taxpayers paying a portion of their income to the government, the government now gives money to taxpayers through “tax expenditures”. All income staying with citizens is now an “expenditure”. A 25% income tax rate is now a 75% “tax expenditure” rate.
    I’m sure it helps to justify your desire for higher tax rates by claiming non-taxed income is an expenditure, but the logic is pretty scary. The next obvious step to equalize all “expenditures” and make our system “fairer”. That’s had a pretty good record over the last 100 years and not working so well right now in Venezuela. However, I’m sure you guys are alot smarter than statists of the past.

  5. I harp on this all the time as well, people confuse the “rich” with high income earners all the time. The “rich” are actually paying very little in income taxes thanks to munis, charitable deductions, cap gains rate, whereas the aspiring rich (working middle class) are getting fleeced. If you want to go after the upper class, you need to tax wealth and not income.

  6. GT4 is implying the historic and obvious end game: statists ultimately wish to have all income, all wealth, all assets (including all property rights), and all GDP directly “owned” by the central government. Having such ownership is the most efficient and powerful way for them to build and control the ralization of their vision of the better world.

    Through education and language, the statists plant and nuture the seed of their designs, and once done, the acceptable norm transforms to mirror their goals.

    “The American people will never knowingly adopt Socialism, but under the name of liberalism, they will adopt every fragment of the Socialist program until one day America will be a Socialist nation without ever knowing how it happened.” – Norman Thomas, American socialist

  7. CBS from the West

    “The term “tax expenditure” is very 1984ish…”

    Nonsense! And it becomes blatantly obvious when you put it in a different context.

    Suppose I am a merchant, and one of my regular customers receives defective goods. I could make amends by sending the customer a refund check. Or, since it is a regular customer, I could authorize the customer to deduct it from the payment for the next purchase.

    Those two transactions are entirely equivalent. Either way, the compensation is an expense that I have incurred and paid to my customer.

    And the situation is entirely analogous to the tax situation. There is no substantive difference between sending somebody a check vs allowing them to deduct the same amount from something they owe you. The only difference is the transparency.

  8. CBS there is one small difference.

    You and the merchant engage in a transaction voluntarily and you part with your money because have received something of value in return.

    The government takes your money at gunpoint.

  9. But you do recieve something of value for your taxes as well. Police and fire protection, protection from invasion, national parks, roads etc. The “its my money not the gov’t’s money argument would logically dictate no taxes at all, and the gov’t being funded entirely by charitable contributions. The gov’t is not the Red Cross.

  10. CBS from the West

    The fact that one transaction is voluntary and the other, in a sense, not, is irrelevant to the accounting. The point of your first post was to say that tax expenses are not expenditures: they clearly are and to say otherwise is just a load of crap.

    As for the involuntary nature of taxation, that is undeniable. But it is also true that we receive some essential services in return for our tax dollars, and the involuntary collection is necessary to prevent freloading on the commons.

  11. CBS from the West

    Let me elaborate more about the general nature of taxation, as I think that at bottom, this is what the discussion is really about.

    Unless you are an anarchist, you will agree that there are benefits to people of being part of organized societies, and that this entails that there are some necessary public services and also some restrictions on individual freedom. We may well disagree as to just which public services are necessary or desirable and which freedoms are acceptably impinged upon to what degree. It is the job of government to sort those differences out and arrive at suitable policies. I suspect you and I agree (though for very different reasons) that contemporary American government does that job extremely poorly. Nevertheless, government alone can do that. The root problem, then, is that we have dysfunctional government.

    Once those decisions about public services are made, the government has to fund those public services by collecting whatever taxes are necessary. Currently we are not doing that either: we are passing the bill on to future generations while we party on.

    At bottom then, the real issue to discuss is not the details of taxation. The real issue is how to get decent government that rules in the public interest, and then have it provide services, impose and enforce rules, and collect the corresponding taxes. (No, I don’t have an easy answer to that one.)

    The alternative is to have no government at all. If you really like that idea in the abstract, I suggest you visit Somalia to see how it plays out in real life.

  12. No, the really rich don’t pay AMT – mostly the upper middle class to well-off but not rich do – say $125K to $300K. Above that, the spread between the AMT rate and the ordinary rate times the income is too big to “spend” in disfavored deductions under the AMT.

  13. Michael Hudson in true acerbic form. Here he takes the anti-tax, anti-government-spending folks to a logical extreme. Pointing out this would empty out the FBI, stop the SEC from regulating, defenestrate all government regulation, and decriminalize white collar crime.

  14. Don’t forget the legal system. Until recently, property rights are, IMO, what has set the US apart from everyone else.

  15. We’ll know if he’s right by May.

  16. Effective Federal income tax rates are actually very lumpy due in large part to the AMT.
    Depending on individual circumstances, the AMT tax often kicks in around $200-250K incomeand continues to increase up to $450K of income. Over this income range, the tax payer’s marginal rate is 35%.
    Then from $450K to $600K (+/-) the AMT works differently — it melts away to zero providing tax payers in this range with a 28% marginal income tax rate.
    Above $600K the marginal rate returns to the 33- 35% range.
    Taxpayers already paying a significant AMT tax may benefit by converting traditional IRA funds into Roth IRAs as a way of taking advantage of the 28% AMT “sweet spot.”

  17. Good point! Is not having a high tax on gasoline (like many countries have, and with important pigovian benefits too) “tax expenditure”? It is an interesting concept, but pretty political. The economics of taxation are pretty well developed, except in the world of politics..

  18. No, if you are are rational as we know it, you will believe that we live under arrow-debreu conditions and then it does not matter what we try to do to free ride etc because everyone has perfect information and hence our little schemes will not be profitable, at least, after some equilibation work by the economy.

    But, if you believe in any other order of things, you want to have the benefits of Sweden, combined with the taxation of Somalia. And that state of happiness is inherently out of reach for the vast majority of people, no matter how you characterize them (poor, weak, middle class, etc).

    However, if one adopts an intergenerational perspective, maybe the state of happyness will be affected by the plausible belief that sooner or later the numbers that will be able to enjoy law taxation and great benefits will diminish so much that our own offspring maybe will miss the cut… Now, would that make us keener to be more taxable, less safe, or poorer? And what about all those poor people: would they migrate to Somalia?

  19. @ tippygolden press___Obviously the all knowing United States central planning federal reserve banking systems’ panoply has met its waterloo via the photon. The Fed’s generals have been outflanked by their own quartermaster allies. They’ve become cannabalistic, and a decease upon the fiscal skeleton of the world’s financial well being. Mr. Hudson, I dare say is telling the world that their demise will come swiftly once the intransigent esoteric sheild is vaulted by a divine diaphanous intervention, whereas the watering-holes of life reach the pinnicle equillibrium of justice – the ultimate equalizer. God save the Queen?

  20. Assume that Mortgage Interest Deductions and Property Tax Deductions were eliminated from the tax code to reduce these apparantly evil tax expenditures.

    The clear result would be that the cost to own a house would increase, so demand for housing would decrease.

    Now imagine what further declines in home values would do to business confidence, the number of homeowners with Mortgages larger than the value of their homes, etc.

    Seems to me like this is a prescription for the Next Financial Meltdown, probably one even larger than the last one.

    If anything, we need to be going in the other direction, finding ways to make housing more affordable thereby increaseing demand and increasing values so that fewer people are underwater on their mortgages, that construction of homes revives etc.

    It’s difficult to understand why these second order effects of changes in the so called tax expenditures don’t get more attention.

    Maybe the answer to to allow everyone to get a 30% to 35% credit on their mortgage interest and property taxes as a way to create more equality. That would seem to be a more sensible way to revive the housing market that seems to be one of the fundamental reasons this economy just does not seem to be recovering at the pace necessary to reduce unemployment and underemployment.

    Of course there would need to be an increase in tax rates so that the policy is revenue neutral. But the clear result would be that people would be more inclined to increase their participation in the housing market becase relative to other expenditures, these would be subsidized.

  21. Bayard Waterbury

    Of course, interestingly, James, there has been little discussion recently about completely trashing the current tax code in favor of enacting a flat tax. Back last summer, Steve Forbes was, once again raising the discussion, however, unfortunately, no one picked up the gauntlet at that time, and there’s been no mention of it recently, at least that has come to my awareness.

    It is unequivocally obvious that the present tax code is unalterably absurd. In fact, I dare say that no one, other than tax attorneys, CPA’s, and the IRS have any clue as to what is actually in it. However, I worry about anything going under the guise of tax reform. If it actually happens, it will simply add another layer to the infinate layers of opacity which already pervade this complex obfuscation of governance.

    The only arguable cure would be to completely get rid of it, and replace it with a simple, straight forward tax system which couldn’t be gamed endlessly. I don’t believe that taxing wealth is a valid answer, but taxing income under the present system is ridiculous to the max. Given the present climate of governance in theis country, meaning a plutocratic iron fisted rule, nothing of meaning will change, and things will continue as they are, or at least essentially so. It’s nice to make arguments, but we all know what will happen in the end. And, over that we have not control or even input.

  22. Re:The average tax rate for people in the middle income quintile is 2.3 percent.

    I’m always surprised when I see this, because my household income is solidly in the middle quintile but I always pay a lot more taxes than that. I can’t deduct my mortgage interest at all because it is too small, even though we just bought a house last year. If not for the new homebuyer credit, our INCOME tax would have been almost 9% of our GROSS income.

    The only thing I can figure out is that we pay so many taxes because we have no children, because our taxes are too simple for there to be any hidden deductions, etc. We just have wages, a house, no real retirement savings to speak of.

  23. Oh, and Russ, I also pay sales taxes on food and medications. So in Oklahoma, getting rid that tax would be an expenditure.

  24. I agree with you that tax expenditures are mostly for the rich. My state of Missouri is heavy into tax credit and other “economic development” programs.

    One particularly odious tax credit is the Distressed Areas Land Assemblage Tax Credit. It’s a $95 million pot of saleable tax credits that are supposed to encourage re-development projects in poor urban areas. Unfortunately the minimum amount of land needed to qualify for this program is 75 acres. Obviously the big operators are the only ones that need apply and it seems that it was written for one big well connected operator in particular.

    Adding insult to injury, the one qualifier no longer qualifies, but the law was worded so poorly that the state is continuing to hand out the tax credits. The recipient is also lots of money problems with other projects. The focus of his business is commercial real estate so that’s no surprise.

    In a just world people would be out in the streets protesting these things. They aren’t and the press really doesn’t do much in the way of calling attention to this. The occasional article when the next shoe drops is all we get. And no one ever dares to grill the responsible politicians about it.

  25. Whoops. It is 50 acres that must be acquired, it’s the redevelopment area that has to be at least 70 acres.