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.