Which Tax Breaks Work, Which Don't, and What That Tells Us
Everyone in Washington loves tax credits and deductions. Politicians tout them as a painless way to help families pay for green energy, buy homes or lower the cost of health care. They're also politically irresistible: No one wants to be accused of "raising taxes" by trimming perks that voters now consider to be entitlements.
But for all their popularity, "tax expenditures" -- what budget experts call feel-good policies like the mortgage-interest deduction or education credits -- are among the most corrosive and costly features of the federal tax code. New evidence backs up this skepticism.
Economists have long known that tax expenditures make our taxes unnecessarily complicated, distort pragmatic economic decision making and mostly benefit hand-selected political constituencies. My Mercatus Center colleague Jack Salmon and I have spent time demonstrating that most tax expenditures don't offer broad-based relief but rather narrow carveouts that erode critical tax revenue while tilting the scales toward the special interests that sell whatever we're nudged into buying.
Tax expenditures stand in sharp contrast to a neutral tax system -- one that taxes income and consumption consistently and only once, trusts individuals to make buying decisions without manipulation and leaves resource allocation to markets. Special-interest tax credits should ultimately be terminated.
A new study by Indiana University's Bradley Heim looks at the issue from a different perspective: Do the largest individual tax incentives actually achieve their goals, and are they cost-effective?
Heim defines cost-effectiveness this way: For every dollar of tax revenue the government gives up, do we see at least a dollar's worth of additional activity result in the targeted area? If not, the expenditure is wasteful, and it would be better to subsidize the activity directly or, better yet, to lower tax rates across the board and stop micromanaging economic life through the tax code.
Some provisions do actually pass Heim's test. Although Salmon and I believe the charitable deduction should be reformed, it's been shown to encourage genuine new giving.
Not surprisingly, Heim finds that retirement-savings tax breaks in employer-based 401(k) plans have historically been effective. This isn't new knowledge. In the 1990s, research demonstrated that these accounts generated several dollars of additional savings for every dollar of lost tax revenue, making them pro-growth.
The finding dovetails with what Salmon and I argue: Provisions that remove the double taxation of savings, including 401(k)s, are not loopholes but essential features of a well-designed tax system. When we stop double- or triple-taxing savings, of course people will save more.
On the other hand, Heim finds that many of the most expensive tax expenditures fail miserably.
Deducting the interest on mortgage payments has virtually no effect on whether someone buys a house. It mostly leads to larger mortgages and bigger homes for wealthier households. That's a subsidy for the upper middle class.
Also failing are education credits, such as the American Opportunity Tax Credit. Decades of research show no measurable impact on college enrollment or completion rates. Colleges surely pocket some of the subsidies through higher tuition, but students are not attending in greater numbers. Here again, tax revenue vanishes with almost nothing to show for it.
The exclusion of employer-sponsored health insurance payments is the single largest individual tax break, costing in excess of $3 trillion over the next decade. Most employees would take the insurance their employers offer with or without this incentive. It ends up inflating the size and cost of plans, driving up health spending, making it more necessary to insure through one's employer and entrenching workers in their current jobs.
Salmon and I would argue to terminate these three expenditures on the basis that they're destructive special-interest tax breaks.
Interestingly, Heim finds that tax deductions for the self-employed to buy health insurance raise coverage rates and, hence, are cost-effective. Yet this deduction is not a healthy, neutral fix for saving or investment -- it's more like an attempt to level the health-coverage playing field between the self-employed and employees. If we got rid of the ineffective ESHI tax break, we wouldn't need this other one, either.
The implications are clear: Tax credits and deductions are generally not harmless ways to help taxpayers. They are costly, distortionary privileges captured by industries and interest groups. They complicate the tax code, mask the true size of government and fail to deliver the promised bang for the buck.
Worse still, they drain revenue in a fiscal environment where the United States is already loaded down by a debt of $37 trillion and rising -- making them anything but free gifts from the government. They are wasteful, and that's the last thing the country can afford. If politicians were serious about tax reform and fiscal responsibility, they would start by eliminating any tax expenditures that fail the tests of neutrality or cost-effectiveness.
Veronique de Rugy is the George Gibbs Chair in Political Economy and a senior research fellow at the Mercatus Center at George Mason University. To find out more about Veronique de Rugy and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate webpage at www.creators.com.
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