Tax expenditures

Martin Feldstein makes some great points in this column (subscriber only) featured in today's Wall Street Journal:

When it comes to spending cuts, Congress is looking in the wrong place. Most federal nondefense spending, other than Social Security and Medicare, is now done through special tax rules rather than by direct cash outlays. The rules are used to subsidize a wide range of spending including education, child care, health insurance, and a myriad of other congressional favorites.

These tax rules—because they result in the loss of revenue that would otherwise be collected by the government—are equivalent to direct government expenditures. That's why tax and budget experts refer to them as "tax expenditures." This year tax expenditures will raise the federal deficit by about $1 trillion, according to estimates by the congressional Joint Committee on Taxation. If Congress is serious about cutting government spending, it has to go after many of them.

For example, the Joint Tax Committee identified more than a dozen tax-based programs that subsidize education and training. These include small ones like the Coverdell education saving accounts (with a 2010 tax expenditure cost of $100 million) and much larger ones like the various tax credits for tuition (costing $11.7 billion). The hundreds of other tax expenditures include a $500 million annual subsidy for the rehabilitation of historic structures and a $4 billion annual subsidy of employer-paid transportation benefits.

President Obama's recent plan to expand the existing dependent care tax credit is a good example of how the welfare state grows through the tax code. At the same time he proposed a three-year freeze on all nondefense discretionary programs, Mr. Obama disingenuously called for an increase in the $3 billion tax credit for taxpayers who pay someone to look after their children or their aged parents while they go to work.

Eliminating these tax expenditures represents an excellent opportunity to raise revenue while paring back economic distortions caused by the tax code. Too many Republicans subscribe to the mistaken notion that any measure which deprives the government revenue is a tax cut deserving of their support. These loopholes, however, only further add to tax code complexity, empower the government and serve as another form of social and economic engineering which encourages decision-making that otherwise wouldn't -- and probably shouldn't -- occur (think of the role played by the mortgage interest deduction in fueling last decade's housing bubble). They are best viewed as subsidies rather than tax cuts.

Ideally the elimination of tax loopholes should be paired with slight reductions in tax rates which produces a net increase in revenue for deficit reduction purposes (although this presumes Congress would act responsibly with the new revenue, which is rather debatable). One possible model is the Tax Reform Act of 1986. Another, far superior, measure would be the adoption of a flat tax.

Update: Great minds think alike.