The papers in Volume 29 of Tax Policy and the Economy illustrate the depth and breadth of the taxation-related research by NBER research associates, both in terms of methodological approach and in terms of topics. In the first paper, former NBER President Martin Feldstein estimates how much revenue the federal government could raise by limiting tax expenditures in various ways, such as capping deductions and exclusions. The second paper, by George Bulman and Caroline Hoxby, makes use of a substantial expansion in the availability of education tax credits in 2009 to study whether tax credits have a significant causal effect on college attendance and related outcomes. In the third paper, Casey Mulligan discusses how the Affordable Care Act (ACA) introduces or expands taxes on income and on full-time employment. In the fourth paper, Bradley Heim, Ithai Lurie, and Kosali Simon focus on the “young adult” provision of the ACA that allows young adults to be covered by their parents’ insurance policies. They find no meaningful effects of this provision on labor market outcomes. The fifth paper, by Louis Kaplow, identifies some of the key conceptual challenges to analyzing social insurance policies, such as Social Security, in a context where shortsighted individuals fail to save adequately for their retirement.
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About the Author
Jeffrey R. Brown is William G. Karnes Professor of Finance and Director of Center for Business & Public Policy.
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Tax Policy and the Economy 29
By Jeffrey R. Brown
The University of Chicago PressCopyright © 2015 National Bureau of Economic Research
All rights reserved.
Raising Revenue by Limiting Tax Expenditures
Harvard University and NBER
The prospect of very large future deficits and a rapidly increasing national debt is an important fiscal challenge for the United States. Limiting those deficits, and therefore the growth of the national debt, requires slowing the growth of the retirement and health programs. Additional tax revenue could contribute to that process. Limiting tax expenditures would raise revenue without increasing marginal tax rates. It would also be equivalent to reducing government spending now done as subsidies through the tax code for a wide range of household spending and income. An effective way of limiting tax expenditures would be a cap on the total tax reduction in tax liabilities that each individual can achieve by the use of deductions and exclusions.
The national debt of the United States is now 74% of GDP, double what it was a decade ago. The current annual deficit of about three percent means that the debt will grow at about the same pace as nominal gross domestic product (GDP), keeping the ratio of debt to GDP unchanged. Although that is likely to continue for the next several years, the Congressional Budget Office has recently warned us that the debt ratio will start rising again and will grow to very high levels during the CBO's long-term forecast period (Congressional Budget Office 2014).
More specifically, under the "extended baseline," the CBO projects that the debt to GDP ratio will rise during the next two decades to more than 100% of GDP. When the CBO drops some of the unrealistic assumptions that are required to be used in its baseline analysis, the forecasts in its "alternative fiscal scenario" show the debt rising to as much as 183% of GDP in 2039. The rising debt levels reflect the greater interest payments on the national debt and the increased cost of the middle-class health and retirement transfer programs. Limiting and reversing the rise in the national debt requires only relatively small decreases in annual deficit ratios. If real GDP grows at 2.5% and inflation is 2%, an annual deficit of 4.5% of GDP will cause the national debt to rise to 100% of GDP, but lowering the deficit to 2% of GDP will reverse the direction of the debt, causing it to decline to less than 50% of GDP.
There is little scope for reducing the deficit by cutting spending on the annually appropriated "discretionary" programs. While there is no doubt of substantial waste in many programs, total outlays for nondefense discretionary programs is now just 3.4% of GDP and is projected to decline to 2.5% of GDP in 2024. Similarly, the defense programs are projected to decline to just 2.7% of GDP in 2024. Therefore, reducing the annual deficit requires some combination of slower growth of the retiree and health programs and increases in tax revenue.
Tax rates have continued to rise in the years since the Tax Reform Act of 1986. That legislation reduced the top marginal tax rate to 28%. Since then the top personal income tax rate has increased to 40%. An additional tax increase on investment income was part of the Affordable Care Act, and the overall payroll tax on wage and salary income was increased when the old ceiling on income subject to the 2.9% Medicare tax was completely abolished.
It is a central tenet of public economics that raising marginal tax rates increases the distorting effects of the tax system and thus the deadweight loss to the economy.
Fortunately, it is possible to increase revenue without raising marginal tax rates. The key is to limit the reductions in tax revenue that result from the use of tax rules that substitute for direct government spending.
Some examples will illustrate the nature of these "tax expenditures." If I buy a hybrid car or a solar panel for my house, the government rewards me with a subsidy payment. The subsidy does not take the form of a check from the government, but of a reduction in my tax liability. If I pay more in mortgage interest or in local property taxes, the government subsidizes my spending by allowing those expenses to be deducted in calculating my taxable income and therefore my tax liability.
According to the Joint Committee on Taxation, the tax expenditure subsidies in the personal income tax code reduces revenue this year by approximately $1.6 trillion (Joint Committee on Taxation 2014). Those tax rules (especially the exclusion of employer payments for health insurance) also reduce the income that is subject to the payroll tax, leading to an additional loss of government revenue.
Eliminating any of the tax expenditures or limiting their use would shrink the size of the annual deficits. Although the effect would show up on the revenue side of the government budget, that is just an accounting convention. In terms of real economic impact, limiting tax expenditures should be viewed as a reduction in government spending.
The ability to frame tax expenditures as either revenue increases or spending decreases should make limiting tax expenditures appeal to those Republicans who want to reduce government spending as well as to those Democrats who want to use additional revenue to help shrink fiscal deficits. Some of the revenue produced by limiting tax expenditures could also be used to reduce marginal tax rates.
Any attempt to limit a particular tax expenditure will be resisted by those who now benefit from it. That suggests that a comprehensive approach may be more politically feasible because no group of taxpayers will feel that they have been unfairly singled out. It also suggests that it would be politically difficult to eliminate completely any of the major tax expenditures. Instead, the analysis in this paper focuses on a method of limiting the extent to which each individual can benefit by using the full set of current tax expenditures.
The first section describes a potential basic cap on the benefit that individuals can receive from an extensive set of tax expenditures. Section II discusses several features of using such an overall cap. The third section examines several variations of the basic cap. Section IV considers two alternatives to the cap stated as a percentage of GDP: limiting the overall dollar amount of deductions and limiting the benefit of deductions and exclusions to the 28% marginal tax rate. There is a brief concluding section.
I. A Basic 2% Cap on Tax Expenditures
The tax expenditure cap that I have been studying would limit each individual's ability to reduce his tax liabilities by the use of deductions and exclusions to a fixed percentage of that individual's adjusted gross income (AGI). Note that the cap is on the reduction of tax liabilities and not on the amount of the deductions and exclusions.
For example, a tax expenditure cap of 2% of AGI implies that someone with a marginal tax rate of 25% can have deductions and exclusions totaling 8% of his AGI, whereas someone with a marginal rate of 40% would be limited to 5% of AGI.
To implement this cap, the taxpayer would calculate his taxable income in the usual way and find the corresponding marginal tax rate. He would then multiply his total deductions and other tax expenditures by this marginal tax rate. If the resulting amount is less than 2% of his AGI, there is nothing more to do. If the resulting amount exceeds 2% of his AGI, the excess amount is added to his tax obligation.
The basic cap that I have analyzed would apply to all itemized deductions except charitable gifts. Although it could also be applied to charitable gifts, there are both economic and political reasons that policymakers may wish to maintain the current treatment of charitable gifts, a point to which I will return below.
The cap also applies to the exclusion of interest on state and local bonds and the exclusion of employer payments for health insurance in excess of $8,000 per taxpayer.
The cap that I study in this paper would not apply to tax filers with AGI less than $25,000.
If that 2% cap had been in place in 2013 it would have increased personal tax revenue by $141 billion, about 1% of that year's GDP. The 2% cap would have been binding on about 22 million taxpayers or about 15% of the total number of tax returns.
As a rule of thumb, the annual revenue gain can be converted to a revenue gain for the next decade that is 13 times as large. The 10-year revenue gain would therefore be $1.8 trillion. The national debt would be reduced by more than this amount because of the interest saving each year on the reduced national debt.
A major advantage of the tax expenditure cap is that it would greatly simplify tax preparation for millions of taxpayers who would shift from itemizing their deductions to using the standard deduction. The 2% cap would reduce the number of itemizers from the current 46 million to just 15 million, or 10% of the 146 million annual returns. After one or two years experimenting with itemization, the 30 million who shift to the standard deduction would no longer bother to calculate their deductions.
These calculations assume that the alternative minimum tax (AMT) remains in place as under current law. The cap achieves much of the effect of the effect of the AMT. More specifically, if the AMT were eliminated, the 2% cap would recover two-thirds of the revenue lost by eliminating the AMT.
The 2% cap would also raise the progressivity of the individual income tax. The figures in table 1 show the increase in tax revenue as a percentage of the current net-of-tax AGI in each AGI group:
Of the $141 billion, $41 billion would come from individuals with AGIs below $100,000. Of the remaining $100 billion, $63 billion would come from individuals with AGI above $200,000.
The 2% cap would also lower the marginal tax rate of all the affected taxpayers. For anyone subject to the cap, a $100 increase in income would reduce the allowable amount of tax expenditures by enough to reduce taxable income by two dollars. As a result, the extra $100 of income would raise taxable income by only $98, implying that the marginal tax on the extra $100 would be reduced by 2%; for example, someone in the 30% marginal tax rate bracket would face an effective marginal tax rate of 29.4%.
II. The Political Economy of an Overall Cap on Tax Expenditure Benefits
The example of the basic 2% cap on tax expenditure benefits illustrates why this approach to limiting tax expenditures as a way of raising revenue may make this approach politically feasible.
It avoids focusing on any particular tax expenditure and therefore appears more equitable because it treats all major tax expenditures equally.
It encourages large numbers of individuals to shift to the standard deduction, simplifying tax compliance and reducing the distorting incentives associated with features like the mortgage interest deduction and the deduction for local property taxes. For those who continue to itemize deductions, a binding cap removes the distorting incentives that depend on marginal itemization.
Revenue is raised in a way that is progressive in the sense that it reduces after-tax income more proportionately for high-income taxpayers. The degree of progressivity can be modified by using different caps for lower-and higher-income taxpayers.
The limit on tax expenditures can begin with a higher cap and gradually reduced (tightened) over time to avoid hurting a weak economy.
III. Variations on the Basic 2% Cap
A. The Low Cost of Preserving the Charitable Deduction
The charitable deduction, unlike other deductions and exclusions, does not benefit the taxpayer directly, but is important for maintaining private support for universities, hospitals, and cultural institutions. That is why I preserve the charitable deduction in the basic plan and most other plans.
Extending the cap to include charitable contributions would increase revenue by only a relatively small amount (by $24 billion to $165 billion). It would also increase progressivity at the top of the income distribution because charitable gifts are relatively more significant than other deductions for high-income individuals.
With a binding cap on all tax expenditures, the cost to the taxpayer of additional charitable gifts rises from 1 – mtr (one minus the individual's marginal tax rate) to one. For a taxpayer with a 40% marginal tax rate, the increased cost of giving rises from 0.6 to 1.0, a 67% increase. Since a substantial body of research indicates that the elasticity of charitable giving with respect to the net cost to the donor is about one, that 67% increase in the net cost implies a two-thirds decline in giving by high- income donors. That would be a substantial blow to a variety of cultural and educational institutions.
More specifically, taxpayers claimed charitable deductions of $160 billion on individual income tax returns in 2011 of which $73 billion were claimed by individuals with adjusted gross incomes of more than $200,000. That group would have marginal tax rates of 40%, implying a reduction of their giving by some $49 billion. Additional reductions would occur from individuals with lower levels of adjusted gross income. (See table 2.)
Comparing these increases to those for the overall previous distribution of revenue shows that the increase in revenue would be particularly high for those with AGI above $200,000.
B. Excluding the Deduction for State and Local Income Taxes
State income taxes are similar to charitable contributions and unlike most other deductions in not benefiting the taxpayer directly. In contrast, most local taxes represent a payment for services (schools, maintenance, trash collections, recreation facilities). Although the IRS data combine state and local income taxes, the local income taxes are only about 10% of the total tax revenue collected by local governments.
Excluding the deduction for state and local income taxes from the cap would reduce the 2013 revenue from $141 billion to $102 billion, but would still reduce the number of itemizers from 47 million to 24 million.
The distribution of increased tax liabilities would be substantially less progressive than it would be if these state and local income taxes are subject to the cap. (See table 3.)
This shows that the progressivity declines above $200,000 because of the impact on individuals with more than $500,000 of AGI.
C. Alternative Treatments of Employer Health Insurance Payments
The basic plan and all of the previous variations treated employer payments for health insurance in excess of $8,000 as part of the tax expenditure subject to the cap. This section considers two alternative treatments: (1) subjecting all employer-paid health insurance to the cap and (2) subjecting none of it to the cap.
Subjecting All Employer-Paid Health Insurance to the Cap.
Subjecting all employer-paid health insurance to the cap would raise the 2013 revenue increase from $141 billion to $196 billion. The $8,000 exclusion thus reduces revenue by $55 billion.
The distribution of increased tax liabilities would still be progressive but substantially less progressive than it would be if the cap only applied to insurance in excess of $8,000. (See table 4.)
Excluding Employer-Paid Health Insurance from the Cap.
Excluding all employer-paid health insurance from the cap would reduce the 2013 revenue increase from $141 billion to $126 billion. Subjecting employer-paid health insurance to the cap, but only to the extent that the benefit exceeds $8,000 (i.e., the basic case), increases revenue by $15 billion. The revenue effect of subjecting all benefits to the cap is $70 billion.
The distribution of increased tax liabilities would be more progressive than it would be if the cap applied only to insurance premiums in excess of $8,000. (See table 5.)
D. Excluding Municipal Bond Interest from the Cap
The basic option and all of the previous alternatives subject all municipal bond interest to the 2% cap. Excluding municipal bond interest reduces the revenue increase by $18 billion (from $141 billion to $123 billion). The tax savings for taxpayers over $200,000 is $15 billion.
Excerpted from Tax Policy and the Economy 29 by Jeffrey R. Brown. Copyright © 2015 National Bureau of Economic Research. Excerpted by permission of The University of Chicago Press.
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Table of Contents
NBER Board of Directors,
Relation of the Directors to the Work and Publications of the NBER,
Introduction Jeffrey R. Brown,
Raising Revenue by Limiting Tax Expenditures Martin Feldstein,
The Returns to the Federal Tax Credits for Higher Education George B. Bulman and Caroline M. Hoxby,
The New Full-Time Employment Taxes Casey B. Mulligan,
The Impact of the Affordable Care Act Young Adult Provision on Labor Market Outcomes: Evidence from Tax Data Bradley Heim, Ithai Lurie, and Kosali Simon,
Government Policy and Labor Supply with Myopic or Targeted Savings Decisions Louis Kaplow,