The cost of tax breaks – or, as economists now more accurately describe them, “tax expenditures” – is $500 billion to $800 billion a year, about 5 percent of the gross domestic product.
Most of these tax deductions and tax credits are inherently unfair. A $1,000 tax deduction might be worth $300 to a wealthy household, $150 to a middle-income household, and not a penny to a poor family. Indeed, 37 percent of all households – home to almost half of all children – have no tax liability.
Why do we skew tax breaks to favor richer people and more profitable businesses? There is no evidence to suggest that these have a higher propensity to engage in socially beneficial behavior. Just ask any waitress or waiter who tips them better – the wealthy or the working class.
There is a way to avoid this bias and eliminate the inequality that results. Make all tax incentives refundable tax credits. Federal refundable credits have grown over time, from $10 billion in 1987 to $60 billion in 2004. Almost all of this is for the Earned Income Tax Credit. This program specifically focuses on reducing poverty by giving low paid workers a helping hand. The government will send a minimum wage worker a check even if he or she pays no taxes. The earned-income tax credit is now our largest and arguably by far the most effective antipoverty initiative.
More typical of our tax breaks is how we encourage home ownership. For all but the very rich, houses represent the single largest source of lifetime financial savings. A low rate of home ownership, and the resulting low rate of savings, is particularly high among blacks and Hispanics. In 2005, government provided $150 billion to homeowners in tax subsidies. But the way the subsidies were structured did little to raise home ownership among these groups.
Why not replace the housing tax deductions with a level refundable tax credit? It could be revenue-neutral, in this case by using the current Treasury loss for housing deductions as a cap.
Economists Richard Green of George Washington University and Kerry Vandell of the University of Wisconsin have examined such a system and predicted that it could increase overall home ownership by 3 to 5 percentage points. Even more impressive, a housing tax credit could increase home ownership by up to 8 percentage points among the lowest-income households.
Economists at the Brookings Institution and the Massachusetts Institute of Technology propose we replace the current tax incentives for contributions to retirement plans with a 30 percent government matching contribution. Under this scenario, worker contributions to 401(k) accounts would no longer be excluded from taxable income. Contributions to IRAs would no longer be tax-deductible. Employer contributions to the plan would be taxable, just as wages are now.
To the Treasury, the change would be revenue-neutral. To the recipient, the tax policy would be a great deal fairer.
As designed now, tax breaks are not only inequitable, they undermine other socially worthy goals. This is particularly striking with federal renewable energy incentives.
Owners of wind turbines qualify for a federal tax credit per kilowatt hour of electricity generated. But farmers and other rural residents very rarely earn sufficient taxable income to take advantage of this incentive. As a result, to enable “locally owned” wind turbines, which produce the same amount of wind energy while generating a far higher amount of local and regional economic activity, a cumbersome corporate structure is created. The locals become partners with Wall Street or corporate investment firms that take the tax incentives and provide the financing.
If the government converted the incentive into a refundable tax credit, the cost to the Treasury would be the same. But 100 percent of the incentive would reach the local owners, and the rural development impact would be far greater.
Every legislative session and political campaign is replete with debates about taxes. Tax breaks, on the other hand, largely travel under the radar. With hundreds of billions of dollars on the table, and a demonstrably unfair and inefficient system currently in place, one would hope that tax incentives would soon garner the attention they deserve.