Personal Income Tax Expenditures
Topic 13
Tax Expenditures
Having learned the main features of the US Federal income tax, we now return to economics in order to analyze how some of these features affect decisions made by taxpayers. Income taxation has wide-ranging effects on taxpayer behavior, including family decisions, such as marriage and children, human capital decisions, such as whether to acquire skills that increase earning capacity, and wealth allocation decisions, such as whether to hold safe or risky assets. State income taxes also affect location decisions. In this course, we consider only three economic effects of income taxation: 1) the effect of special tax provisions, often called “tax expenditures”, that encourage taxpayers to spend their incomes in certain ways (topic 13). 2) the effect of income taxes on labor supply decisions such as how much or how long to work (topic 14). 3) the effect of income taxes on retirement saving decisions such as how much retirement wealth to accumulate (topic 15). In this topic we consider features of the income tax system, deductions or exclusions, that encourage taxpayers to spend or earn their income in certain ways. I particular, we will see that the income tax system is designed to encourage taxpayers to spend more on charity, health insurance, and owner-occupied housing, among other things. These features are variably known as “tax breaks”, “tax preferences” or “tax subsidies”. Economists also call these features tax expenditures. The origin of the term “tax expenditure” The term tax expenditure was coined by the late Stanley Surrey, who was an assistant Secretary of the Treasury in the Lyndon Johnson Administration. Because of the simultaneous cold war with the Soviet Union, the Viet Nam war, and Johnson’s “Great Society” social spending, the Federal budget was in deficit. Although this deficit was laughably small by today’s standards, it was large at the time, and Surrey was charged with scouring the Federal budget for spending items that could be reduced or eliminated to reduce the budget 1
deficit. Similarly, today, a Congressional “super-committee” is charged with scouring the Federal budget to find ways of cutting over a trillion dollars from Federal spending. While carrying out his charge, Surrey had the insight that he was ignoring government “spending” that was embedded in the tax side of the budget. Such “spending” reflects the fact that when the government gives tax breaks or preferences to encourage or reward taxpayers for doing certain activities, it is effectively spending tax revenue. Surrey realized that the revenue lost through tax breaks is equivalent to government spending on the favored activities, such as would happen if the government subsidized the activity rather than giving it a tax break. Thus, the term tax expenditure was born. A good example of a tax expenditure is the tax exemption for certain benefits and allowance granted to military personnel. The purpose of this tax break is to increase the take-home incomes of military personnel and encourage them to enlist in certain activities. This exemption succeeds in doing that, but the cost the Federal government is over ten billion dollars. The same thing could be achieved by taxing these military allowances like other income and paying higher salaries. The difference is that, in the second case, budget spending would be increased by $10 billion, while in the first case an equivalent amount of government tax revenue is lost. Surrey defined this lost tax revenue as a tax expenditure. It became Surrey’s goal to have tax expenditures reported in the same way as regular budgetary expenditures, so that the two forms of government spending could be evaluated in the same way, subject to the same scrutiny, and put equally on the table when budget constraints require that government spending be cut, as in the current situation. He was only partly successful in this. Today, tax expenditures—revenues lost by certain tax preferences meant to achieve a government purpose—are reported in a separate tax expenditure budget. This table is hidden safely away in the Appendix to the Federal Budget where no one will notice. (The concept of tax expenditures drives some Republican politicians crazy, because they would prefer to view such items as tax cuts. For this reason, the reporting of tax expenditures was suppressed to varying degrees during Republican Administrations.) 2
Major Tax Expenditures in the Federal Individual Income Tax The following table shows some of the more important categories of tax expenditures and how much was “spent” (that is, revenue lost) on them in 2010. In this topic, we consider the tax expenditures for owner-occupied housing ($158 billion), health ($182 billion) and charity ($42 billion). We will return to the tax expenditures for retirement saving and state and local government in future topics. Major Tax Expenditures for Households 2010 (in $millions)
Category
$ (millions)
Owner Occupied Housing Mortgage interest deduction Property tax deduction Exclusion of capital gains Exclusion of imputed rent
157,630 79,150 15,120 22,160 41,200
Health excl. of employer-paid medical Other
182,260 160,110 22,150
Retirement Saving Employer plans 401(K), Keoghs, and IRAs
118,270 39,580 78,690
State and Local Government Excl. interest on municipal bonds state and local income tax deduction
57,330 30,440 26,890
Charity Education Health Other
42,040 4,030 3,930 34,080
Source: Statistical Abstract 2012 Table 477 http://www.census.gov/compendia/statab/2012/tables/12s0477.pdf
3
The Effect of the Charitable Gifts Tax Deduction All tax expenditures increase the tax-favored activity by reducing the price or cost of the activity to the taxpayer. As for any good where the price falls, the quantity demanded increases by an amount that depends on the slope (or elasticity) of the demand curve for the activity. An exclusion or a deduction from taxable income decreases the price of the tax-favored activity by the taxpayer’s Marginal Tax Rate (MTR), or effective MTR. A good example is the itemized deduction for charitable donations. Itemizing taxpayers can deduct the value of donations to qualifying charities1, which reduces their taxable income by the amount of the donations. The more they donate, the less their taxable income. Each dollar of donation reduces taxable income by one dollar and reduces tax paid by the taxpayer by her MTR. If the taxpayer is in the 35% tax bracket, each dollar of charitable donation saves her 35 cents in tax. Thus, the net price of giving a dollar to charity is only 65 cents to the taxpayer. The government (or, more correctly, the other taxpayers) pays the other 35 cents. Because the price of giving to charity is reduced, the taxpayer donates more dollars. The effect of the charitable donations tax deduction is shown in the figure below. The demand curve for charitable giving is downward sloping like any other demand curve. People give to charity because it gives them pleasure (utility), however the money they give is then not available for them to spend on other things that also give them pleasure. If the price of giving to charity is reduced, they give more to charity because it is a cheaper way of obtaining pleasure.
1
The IRS determines whether an organization is a qualifying charity and whether the expense in question is a donation. The rules seem quite liberal for both. For example, required donations to Seattle Opera to secure better subscription seats are deductible as a charitable donation. Any sensible person would view such an expense as a price for a better seat to an entertainment event. So much for common sense and the tax law.
4
Price of a Dollar of Charitable Gift
c
a $1
b $(1-MTR) Demand Curve for Charitable Gifts Charitable Gifts ($) G0
Gt
Without a tax deduction, the price of giving a dollar to charity is $1, and the taxpayer gives G0 dollars to charity. If the taxpayer can deduct charitable giving and reduce her taxable income, the price of giving to charity is now $1 minus the taxpayer’s MTR expressed as a fraction. For example, if the taxpayer is in the 35% tax bracket, MTR=.35 and 1-MTR is $.65, or 65 cents. At this lower price, the taxpayer gives more dollars (Gt dollars) to charity. The effect of the tax expenditure on the amount given depends on 1) the taxpayer’s MTR (the reduction in price) and 2) the price elasticity of the taxpayer’s charitable giving demand curve. The increase in charity is greater the higher the MTR and the more elastic the demand curve. The amount of tax saved by the taxpayer (and the revenue loss to the government) is the amount given to charity (Gt) times the MTR of the taxpayer, which is the area of the rectangle 1cb(1-MTR). This amount summed over all taxpayers is the revenue loss to the government ($42 billion in 2010).
5
An interesting question is whether charities receive $42 billion more charity as a result of the tax expenditure. The $42 billion is what the tax expenditure cost the government in lost revenue, not what the charities receive. In the diagram above, the charity receives ∆G=Gt-G0 more dollars of charity as a result of the tax deduction. I now demonstrate that ∆G is more or less than the value of the tax expenditure (the revenue lost by the government) depending on whether the charitable giving demand curve is elastic (εD-1). By definition, the elasticity of the charitable giving demand curve is D
G P G or G D P . Let G=Gt, P=1, and ∆P=-MTR, then P G P
∆G=-εD*[Gt*(MTR)]. Thus, if εD=-1, ∆G (the increase in charitable giving) is exactly equal to the government’s loss in revenue Gt*MTR. If the demand curve is elastic (εD
Tax Expenditures
Having learned the main features of the US Federal income tax, we now return to economics in order to analyze how some of these features affect decisions made by taxpayers. Income taxation has wide-ranging effects on taxpayer behavior, including family decisions, such as marriage and children, human capital decisions, such as whether to acquire skills that increase earning capacity, and wealth allocation decisions, such as whether to hold safe or risky assets. State income taxes also affect location decisions. In this course, we consider only three economic effects of income taxation: 1) the effect of special tax provisions, often called “tax expenditures”, that encourage taxpayers to spend their incomes in certain ways (topic 13). 2) the effect of income taxes on labor supply decisions such as how much or how long to work (topic 14). 3) the effect of income taxes on retirement saving decisions such as how much retirement wealth to accumulate (topic 15). In this topic we consider features of the income tax system, deductions or exclusions, that encourage taxpayers to spend or earn their income in certain ways. I particular, we will see that the income tax system is designed to encourage taxpayers to spend more on charity, health insurance, and owner-occupied housing, among other things. These features are variably known as “tax breaks”, “tax preferences” or “tax subsidies”. Economists also call these features tax expenditures. The origin of the term “tax expenditure” The term tax expenditure was coined by the late Stanley Surrey, who was an assistant Secretary of the Treasury in the Lyndon Johnson Administration. Because of the simultaneous cold war with the Soviet Union, the Viet Nam war, and Johnson’s “Great Society” social spending, the Federal budget was in deficit. Although this deficit was laughably small by today’s standards, it was large at the time, and Surrey was charged with scouring the Federal budget for spending items that could be reduced or eliminated to reduce the budget 1
deficit. Similarly, today, a Congressional “super-committee” is charged with scouring the Federal budget to find ways of cutting over a trillion dollars from Federal spending. While carrying out his charge, Surrey had the insight that he was ignoring government “spending” that was embedded in the tax side of the budget. Such “spending” reflects the fact that when the government gives tax breaks or preferences to encourage or reward taxpayers for doing certain activities, it is effectively spending tax revenue. Surrey realized that the revenue lost through tax breaks is equivalent to government spending on the favored activities, such as would happen if the government subsidized the activity rather than giving it a tax break. Thus, the term tax expenditure was born. A good example of a tax expenditure is the tax exemption for certain benefits and allowance granted to military personnel. The purpose of this tax break is to increase the take-home incomes of military personnel and encourage them to enlist in certain activities. This exemption succeeds in doing that, but the cost the Federal government is over ten billion dollars. The same thing could be achieved by taxing these military allowances like other income and paying higher salaries. The difference is that, in the second case, budget spending would be increased by $10 billion, while in the first case an equivalent amount of government tax revenue is lost. Surrey defined this lost tax revenue as a tax expenditure. It became Surrey’s goal to have tax expenditures reported in the same way as regular budgetary expenditures, so that the two forms of government spending could be evaluated in the same way, subject to the same scrutiny, and put equally on the table when budget constraints require that government spending be cut, as in the current situation. He was only partly successful in this. Today, tax expenditures—revenues lost by certain tax preferences meant to achieve a government purpose—are reported in a separate tax expenditure budget. This table is hidden safely away in the Appendix to the Federal Budget where no one will notice. (The concept of tax expenditures drives some Republican politicians crazy, because they would prefer to view such items as tax cuts. For this reason, the reporting of tax expenditures was suppressed to varying degrees during Republican Administrations.) 2
Major Tax Expenditures in the Federal Individual Income Tax The following table shows some of the more important categories of tax expenditures and how much was “spent” (that is, revenue lost) on them in 2010. In this topic, we consider the tax expenditures for owner-occupied housing ($158 billion), health ($182 billion) and charity ($42 billion). We will return to the tax expenditures for retirement saving and state and local government in future topics. Major Tax Expenditures for Households 2010 (in $millions)
Category
$ (millions)
Owner Occupied Housing Mortgage interest deduction Property tax deduction Exclusion of capital gains Exclusion of imputed rent
157,630 79,150 15,120 22,160 41,200
Health excl. of employer-paid medical Other
182,260 160,110 22,150
Retirement Saving Employer plans 401(K), Keoghs, and IRAs
118,270 39,580 78,690
State and Local Government Excl. interest on municipal bonds state and local income tax deduction
57,330 30,440 26,890
Charity Education Health Other
42,040 4,030 3,930 34,080
Source: Statistical Abstract 2012 Table 477 http://www.census.gov/compendia/statab/2012/tables/12s0477.pdf
3
The Effect of the Charitable Gifts Tax Deduction All tax expenditures increase the tax-favored activity by reducing the price or cost of the activity to the taxpayer. As for any good where the price falls, the quantity demanded increases by an amount that depends on the slope (or elasticity) of the demand curve for the activity. An exclusion or a deduction from taxable income decreases the price of the tax-favored activity by the taxpayer’s Marginal Tax Rate (MTR), or effective MTR. A good example is the itemized deduction for charitable donations. Itemizing taxpayers can deduct the value of donations to qualifying charities1, which reduces their taxable income by the amount of the donations. The more they donate, the less their taxable income. Each dollar of donation reduces taxable income by one dollar and reduces tax paid by the taxpayer by her MTR. If the taxpayer is in the 35% tax bracket, each dollar of charitable donation saves her 35 cents in tax. Thus, the net price of giving a dollar to charity is only 65 cents to the taxpayer. The government (or, more correctly, the other taxpayers) pays the other 35 cents. Because the price of giving to charity is reduced, the taxpayer donates more dollars. The effect of the charitable donations tax deduction is shown in the figure below. The demand curve for charitable giving is downward sloping like any other demand curve. People give to charity because it gives them pleasure (utility), however the money they give is then not available for them to spend on other things that also give them pleasure. If the price of giving to charity is reduced, they give more to charity because it is a cheaper way of obtaining pleasure.
1
The IRS determines whether an organization is a qualifying charity and whether the expense in question is a donation. The rules seem quite liberal for both. For example, required donations to Seattle Opera to secure better subscription seats are deductible as a charitable donation. Any sensible person would view such an expense as a price for a better seat to an entertainment event. So much for common sense and the tax law.
4
Price of a Dollar of Charitable Gift
c
a $1
b $(1-MTR) Demand Curve for Charitable Gifts Charitable Gifts ($) G0
Gt
Without a tax deduction, the price of giving a dollar to charity is $1, and the taxpayer gives G0 dollars to charity. If the taxpayer can deduct charitable giving and reduce her taxable income, the price of giving to charity is now $1 minus the taxpayer’s MTR expressed as a fraction. For example, if the taxpayer is in the 35% tax bracket, MTR=.35 and 1-MTR is $.65, or 65 cents. At this lower price, the taxpayer gives more dollars (Gt dollars) to charity. The effect of the tax expenditure on the amount given depends on 1) the taxpayer’s MTR (the reduction in price) and 2) the price elasticity of the taxpayer’s charitable giving demand curve. The increase in charity is greater the higher the MTR and the more elastic the demand curve. The amount of tax saved by the taxpayer (and the revenue loss to the government) is the amount given to charity (Gt) times the MTR of the taxpayer, which is the area of the rectangle 1cb(1-MTR). This amount summed over all taxpayers is the revenue loss to the government ($42 billion in 2010).
5
An interesting question is whether charities receive $42 billion more charity as a result of the tax expenditure. The $42 billion is what the tax expenditure cost the government in lost revenue, not what the charities receive. In the diagram above, the charity receives ∆G=Gt-G0 more dollars of charity as a result of the tax deduction. I now demonstrate that ∆G is more or less than the value of the tax expenditure (the revenue lost by the government) depending on whether the charitable giving demand curve is elastic (εD-1). By definition, the elasticity of the charitable giving demand curve is D
G P G or G D P . Let G=Gt, P=1, and ∆P=-MTR, then P G P
∆G=-εD*[Gt*(MTR)]. Thus, if εD=-1, ∆G (the increase in charitable giving) is exactly equal to the government’s loss in revenue Gt*MTR. If the demand curve is elastic (εD
