Should Tax Expenditures Be Limited?

by: Jeffrey Frankel

The National Tax Journal asks for views on a recent proposal from Len Burman to limit tax expenditures. My answer: I couldn’t agree more.

With regard to the politics, one would have to see whether the phrase “cut tax expenditures” polls more like the phrase “cut expenditures,” which I assume polls well, or like the phrase “raise taxes,” which of course polls horribly. I have no idea. But at least there is a hope of breaking through the ridiculous artificial “Taxes versus Spending” rhetoric that dominates Washington.

With regard to the merits of the idea as economic policy — in a context where strong measures to reduce the budget deficit will be necessary in coming years — Len Burman is completely right. Tax expenditures tend by nature to be distortionary, on average.

Agreeing to the general principle is easier than agreeing to all the detailed implications. Looking at the list of the actual 12 largest tax expenditures would give most people pause. But much less so for economists. The only one on the list that gives me serious pause, personally, is #7: the “charitable deduction (other than education and health).”

But the top two deserve to be cut, as part of a larger fiscal package, not just because they would save a lot of money, but also to get economic incentives right: the exclusion for employer-sponsored health insurance and the mortgage interest deduction.

A proposal to eliminate the mortgage interest deduction would of course get zero support in Congress, because it is political suicide with middle class voters. A proposal to freeze the amount of the deduction would not be popular either. The same with four other pro-housing tax expenditures out of Len’s list of 12: deduction for property taxes, exclusion of net imputed rental income, capital gains exclusion on home sales, and property tax deduction.

All politicians and voters (excluding economists) continue to believe that public policy should tilt in favor of home ownership. Notwithstanding the recession that began with the sub-prime mortgage crisis of 2007, economists have not made even a dent in popular perceptions, with our arguments against artificially tilting the field away from rental housing and the rest of the capital stock and toward (highly leveraged) owner-occupied housing.

To take another example, whatever happens ultimately to Fannie Mae (FNM) and Freddie Mac (FRE), they certainly won’t be abolished. Americans believe too strongly in the dream of home ownership to absorb the point that you are not doing a family a favor if getting them into their own house means burdening them with debt that they will probably not be able to pay.

“Political impossibility” is not a reason not to try. After all, our country will not get through the next few decades fiscally unless we make some “politically impossible” changes. But I emphasized the housing issue in the preceding paragraph to make a different point.

Almost all commentators on the financial crisis, whether from the left or right, talk as if the causes of the crisis are obvious and our leaders are idiots for not having acted to fix the problem ahead of time.

Needless to say, those on the left blame the right, for deregulation, and those on the right blame the left, for moral hazard. And yet there is zero support for fixing the housing policy parts of the problem, on which economists have almost unanimous agreement (and did ahead of the crisis).

Disclosures: No positions

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