Curbing Tax Breaks Falls Short of Revenue Needed to Avoid Cliff

As the U.S. approaches the fiscal cliff on Jan. 1, curtailing some of the tax breaks that cost the Treasury $1.3 trillion a year is emerging as a seemingly easy way to end the impasse over budget reform.

House Speaker John Boehner favors broadening the tax base to generate more revenue without raising rates. President Barack Obama, while continuing to demand higher rates on top incomes, says limiting the use of tax breaks for the wealthy could be part of the solution.

Tax breaks are woven into the fabric of daily life: the home mortgage interest deduction, the favorable tax treatment for investment income, the break that leads so much of health insurance to be provided by employers. Some benefit the rich; others the poor. Some enhance growth; others, not so much, Bloomberg Businessweek reports in its Nov. 19 issue.

Tightening them up has potential, yet done wrong it could cause more problems than it solves. A botched spackling job could hurt the poor and the middle class and also remove incentives for businesses to invest and grow -- without producing a lot of revenue.

“It may prove difficult to gain more than $100 billion to $150 billion in additional tax revenues through base broadening,” Congressional Research Service economists Jane Gravelle and Thomas Hungerford wrote in a report earlier this year.

Tax Expenditures

Congress calls breaks “tax expenditures” because they have the same effect as spending on the government’s bottom line.

Econ 101 says that eliminating or curbing them allows the government to keep tax rates down, which gives people stronger incentives to work and invest.

“Higher marginal tax rates distort behavior and reduce activity,” Columbia Business School DeanGlenn Hubbard, an economic adviser to Republican presidential candidate Mitt Romney’s campaign, wrote in a Nov. 12 opinion piece in the Financial Times.

Unfortunately, there’s less to the case for curbing tax breaks than meets the eye. First, even if all the breaks were eliminated the government wouldn’t raise $1.3 trillion, because taxpayers “ould change their behavior to avoid higher levies.

Toll on Middle Class

Second, curbing tax breaks would be harder on the middle class and poor than simply raising taxes on the rich. That’s because to raise a lot of money, budget balancers would have to get rid of breaks that benefit the non-rich, such as the earned- income and child tax credits.

Reducing tax expenditures “will not raise nearly the revenue needed for sufficient deficit reduction without increasing taxes on the middle class significantly,” Robert Rubin, who was President Bill Clinton’s Treasury secretary, wrote in a Nov. 13 opinion piece in the New York Times. He called the pursuit of tax breaks “the policy equivalent of a wild-goose chase.”

Third, the supposed economic advantage of “broadening the base” -- subjecting more income to taxation -- is that it enables reductions in marginal tax rates. Yet cutting rates isn’t economic Miracle-Gro. All base-broadening does is change the mix: Some activities face a lighter tax, while others face a heavier one.

Research Credit

Fourth, and most important, some tax breaks serve vital public purposes. Take the research and development tax credit, which reduces the amount a company owes in taxes by a percentage of the R&D it performs.

The credit encourages companies to do more research, which has spillover benefits for their employees, other businesses, and ultimately customers and taxpayers. Left to their own devices, companies would do less R&D than is optimal for society as a whole.

The U.S. research and development tax break is less than a fifth the size of those given by countries such as India, France, and the Netherlands, according to the Information Technology & Innovation Foundation, a nonpartisan research group in Washington.

“We’re not even close” to the ideal amount of corporate R&D in the U.S., says Robert Atkinson, ITIF’s founder and president. Throwing the R&D credit out in the name of giving the budgetary balloon more lift would inadvertently harm the economy’s growth, says Atkinson: “The ballast is not actually ballast. It’s helium.”

Clean Slate

The urge to start with a clean slate is strong, though. A report by Republican Alan Simpson and Democrat Erskine Bowles, the co-chairmen of Obama’s deficit-reduction commission, offered as one option a “Zero Plan” that would wipe out all tax breaks, good and bad alike.

That would include breaks that are good for long-term growth such as the accelerated depreciation of business investment in equipment and the deduction for domestic production activities, which favors manufacturing in the U.S.

Economists don’t much like some of the biggest tax breaks, such as the mortgage-interest deduction, which cost the Treasury $78 billion in fiscal 2011, according to Congress’s Joint Committee on Taxation. That deduction induces people to load up on debt to buy more housing than they need.

Yet it’s popular with middle-class voters, and eliminating it abruptly would make homeownership less appealing, causing home prices to fall. That would yank the rug out from under families that figured the break into what they paid for their homes.

Capital Gains

Then there are the preferential rates for capital gains and dividends, which cost the government $91 billion last year. Those breaks largely benefit the wealthy, and economists disagree over whether they meaningfully encourage investment.

They’re also well-insulated on Capitol Hill. It turns out there’s little to no correlation between the economic value of tax breaks and their political viability.

Romney pointed to one way out of this box: an annual cap on the total value of the tax breaks that a taxpayer could claim. He tossed out caps ranging from $17,000 to $50,000.

That would have the biggest impact on the rich while sidestepping arguments about which tax breaks are most worthwhile.

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said on Nov. 13 that a cap deserves a closer look. Still, unless the cap were low enough to affect the middle class as well as the rich, it would only put a modest dent in the deficit.

Eventually the country will have to decide which tax breaks it can’t live without -- and how much it’s willing to raise taxes to cover their cost.

To contact the reporter on this story: Peter Coy in New York at pcoy3@bloomberg.net

To contact the editor responsible for this story: Wes Kosova in Washington at wkosova@bloomberg.net

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