Asking the right tax questions - Guest Post by Professor Annette Nellen

Originally Published on forbes.com on August 22nd,2011

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Most tax bloggers are more serious than I am.  Professor Annette Nellen of San Jose State University is no exception.  She previously appeared as a guest blogger before I started with Forbes.  Serious as she is, she was reckless enough to invite me on to her policy blog 21st Century Taxation. Professor Nellen was selected by the AICPA to tesitfy before Congress on the need for comprehensive tax reform. 

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The start of the 2012 presidential campaign and formation of a new congressional committee to propose a plan to reduce the deficit by $1.5 trillion over ten years, brings with them mention of spending cuts, tax changes, and no new revenues. Big dollars are involved – trillions (!), and our federal budget is complicated. But the issues are too important to let the rhetoric shape tax and budget reform. There are a lot of questions for which the answers can help us understand the problems and find workable solutions. I suggest one question here that is pertinent to talk of spending cuts or not increasing revenues. 

Question – Will spending cuts include reducing any spending that exists in the tax law?  

Over the past two decades, a growing amount of spending has been inserted into the tax law rather than as line items in an agency’s annual budget (or just not implemented in the first place). To explain, let’s first consider this basic budget concept: 

            Revenues – Spending = Surplus (Deficit) 

If the government wants to spend more (such as to fund a war) without creating a deficit, revenues must be increased or spending reduced.  Revenues come primarily from taxes; but when spending exceeds revenues, borrowing is needed to supplement the tax revenues. 

If taxes are cut, revenues go down. A tax cut might be in the form of a rate reduction, or a new or increased deduction, exemption or credit. To avoid a deficit, other revenues must be increased or other spending reduced. 

If the government decides it wants to encourage use of renewable energy, it could authorize more spending by the Department of Energy. Without any other changes, there would be a deficit. Alternatively, the government could enact tax credits for people who invest in renewable energy. A tax credit lowers a taxpayer’s tax bill (and thus, reduces government revenues). Under either approach, the budget effect is the same – a deficit (unless other changes are made to increase revenues or reduce spending). 

Our federal income tax has over 200 special deductions, exclusions and credits (called “tax expenditures”). Like the energy credits in the prior example, tax expenditures reduce revenues. In most situations, the tax expenditure could instead have been a line item in an agency’s budget. For example, consider a tax credit for higher education costs, such as the existing American Opportunity Tax Credit (AOTC). This credit reduces an individual’s income tax bill by up to $2,500 per college student (for each of the first four years of college subject to an income phase-out rule). This credit means that less revenue is collected. Alternatively, the government could have created agrant program to distribute these funds. Either way, the budget effect is the same (reduced revenues or increased spending). 

Yet, there are differences, including the following:

• Special tax rules are not reviewed regularly whereas agency budgets are subject to annual review.
• The true cost of the government assistance for a particular activity (such as subsidizing those paying college tuition) is not obvious. For example, you can find the cost of Pell grants in the Department of Education budget, but not the cost of the AOTC.
• Tax spending is affected by traits of a tax system. For example, a Pell grant for higher education can be obtained when tuition is due. The AOTC is not tied to that timing.  Also, tax benefits go to those with tax liabilities. Thus, the AOTC won’t help low-income individuals with incomes below the filing threshold, even though they may need the assistance more than individuals with over $100,000 of income. And, when the special tax provision is a deduction or exclusion, the tax benefit is greater for those in higher brackets. That is, a $1,000 deduction saves $350 of taxes for someone in a 35% bracket, but only $100 for someone in a 10% bracket (meaning that the higher income person is out-of-pocket $650 while the lower income individual is out of pocket $900). 

Today, non-defense discretionary spending (what’s available for cuts) represents 19% of total spending (CBO) or about $703 billion (CBO). In contrast, spending in the tax law totals about $1.1 trillion (Deficit Commissionreport page 28). Thus, a spending cut exercise that only considers the $703 billion overlooks a lot of other spending. 

There are at least two hurdles to cutting spending in the tax law beyond the fact that it is often overlooked as even being spending. First, taxpayers who claim the special deductions and credits don’t want to see them eliminated or reduced. Second, removal or reduction of tax expenditures results in an increase in revenue. Politicians who seek no increase in revenues have to ignore the big pot of spending in the tax law. In contrast, a reduction in the budget of any agency is labeled a spending cut. It is up to us to ask the right question – where are the cuts to the spending in the tax law to help reduce the deficit? 

And by the way, a related tax question to anyone calling for new tax deductions or credits is – how will you pay for that spending?

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