Loopholes: Spending Dressed Up as Tax Cuts?

 

Takeaway

  • Loopholes, or "tax expenditures," cost the government $1 trillion a year.
  • Loopholes distort the economy by channeling investments into products and industries the market wouldn't necessarily support.
  • Tax expenditures are generally easier to pass than tax increases.

Infographic: The Shelf Project recommends cutting these 10 tax loopholes

To Calvin Johnson, the trouble with the U.S. tax code can be summed up in four words: Grand Theft Auto IV.

“Grand Theft Auto IV is the most heavily-subsidized activity in America,” says Johnson, professor at the University of Texas School of Law, about the extremely popular video game. “We treat it, for tax purposes, as if it represents the highest American ideals.”

Because it’s computer software, he explains, the video game is entitled to several tax deductions and credits. It can deduct its entire cost of development in a single year (as “research and experimentation”), and along with 9 percent of sales revenue (for being made in America).

Unlike software and certain other intangibles (e.g., film and TV production), most products, from machines to CDs, are required to deduct development expenses over several years. This subtle distinction adds up to $50 billion of lost revenue annually for the U.S. Treasury, Johnson estimates.

Total up all the tax breaks for favored industries and Uncle Sam is losing at least $1 trillion a year, he says. That’s enough to cover most of the $1.3 trillion federal deficit.

Such tax breaks, loopholes, shelters, and subsidies are really government spending by another name, most economists say. Congressional budget rules call them “tax expenditures” and define them as, “Those revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”

Sandy Leeds, senior lecturer in finance at the McCombs School of Business, describes the phenomenon more succinctly: “Whenever you give me some benefit, someone else is paying for it. So we’re just shifting the burden.”

The insidious thing about tax expenditures, says Leeds, is that they’re easier to pass than tax increases.

“A politician says he’s got an idea for a new program. If you want to spend money for it, people say, ‘I hate you.’ Instead, if you say you’ll do it by cutting taxes, then you’re a great American. Someone else is paying the taxes, but you’ve gotten votes.”

Loopholes Multiply

That’s why tax expenditures have proved to be the kudzu vines of tax policy. In 1986, the last time the tax code was significantly revised, many shelters were wiped out, in exchange for lowering the top tax rate from 50 percent to 28 percent. But new ones have grown back with each Congress. Today, they total more than 7 percent of gross domestic product.

What makes good politics makes bad economics, both professors agree. Besides padding the federal deficit, tax expenditures often cause unintended consequences. They distort the economy by channeling investments into products and industries the market wouldn’t support on its own.

Johnson cites one of the tax code’s most sacred cows: the home mortgage interest deduction. It benefits mostly the richest third of taxpayers, because they’re the ones who itemize, and the ones paying the highest rates. By deducting mortgage interest, a taxpayer in the 35 percent bracket can afford to spend a third more on a house than they would without the subsidy.

“It’s making people build far larger houses than they would otherwise,” says Johnson. “The only justification for a subsidy is to pay for things that the general public benefits from. With 5,000 square-foot houses, I don’t think the public in general would be willing to pay for it, if they knew what they were doing.”

Doing Away with Deductions?

Deleting the mortgage interest deduction, estimates the congressional Joint Committee on Taxation, would net the Treasury $94 billion a year. For Johnson, it’s just one of 64 tax expenditures he’s identified as expendable. With the help of other academics and tax lawyers, he oversees The Shelf Project, which makes a detailed technical case for each of the cuts.

The name comes from the notion that his proposals are sitting on the shelf, awaiting the day that some financial emergency forces Congress into fiscal reform. Says Johnson, “We have contingency plans for thermonuclear war, for Ebola in the subway system, for Russian tanks rolling across the German plains, but not for a real contingency like a financial crisis.”

With special-interest deductions stripped from the tax code, he says, government could raise extra revenue while lowering tax rates. Companies would have less incentive to use accounting tricks to hide income. Taxes, he says, should be “low, wide and unavoidable.”

A stint last year at a Washington think tank, the Tax Policy Center, left Johnson mildly hopeful that some proposals could come off the shelf. In recent months, both President Barack Obama and some Republican members of Congress have suggested trimming back some itemized deductions. But Johnson cautions, “I’m within a great consensus on the platitude level. Once you get down to the way people act, there’s not much of an independent constituency for it.”

For both scholars, the ideal is to eliminate as many tax expenditures as possible and use some of the new revenue to reduce the deficit. In a perfect tax code, Leeds would remove them all.

“I think we shouldn’t have tax expenditures, period,” he says. “I think that when any tax incentive leads us to change our behavior, we should argue that it’s inefficient. We’re not doing what we want to do, but what we’re incented to do. In addition, we lose all transparency when we spend taxpayer money in this way.”

Click the graphic below to enlarge.

Infographic: The Shelf Project recommends cutting 10 tax loopholes

 

Faculty in this Article

Calvin H. Johnson

Andrews & Kurth Centennial Professor School of Law, University of Texas at Austin

Calvin H. Johnson has been a member of the University of Texas Law School faculty since 1981. His research is currently focused around the...

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

Comments

#1 Interesting study. While I

Interesting study. While I agree that tax preferential treatment for specific activities distorts marketplaces and creates inefficiencies, I wonder if the author has the same attitude about specifically taxing certain products, such as fuel and tobacco. After all, it creates the same distortions. If some one does not have the same attitude about both, you know they are just big government liberals trying to usurp more power and control for the central government. 20% of the "revenue enhancements" cited are temporary, capitalizing intangibles and mark to market only change the timing of revenues. Please do not tell me this is your solution for our long term deficit spending projections. Second, I think eliminating deductibility of local taxes is theft. (I live in Texas and do not even pay this type of tax!) Requiring me to pay taxes on income I earned only to pay other taxes is theft. Period. All taxes paid: property tax, sales tax, state/local income tax, fuel tax, social security and medicare tax should be deductible from federal income tax. Taxing me twice (or three times in some cases) on income earned is immoral. These deductions should be above the line, i.e. direct offsets to income. Lastly, the tax gap category looks like fuzzy math to me. Exactly what rules could be tightened? Every "rule tightening" leads to more record keeping and report filing, usually by companies. It rarely works out as forecast.

#2 I would echo what Adam S.

I would echo what Adam S. said above and continue to say that some of the math used above is misleading. In the first example given, Grand Theft Auto IV being able to epxense their developmental expenses immediately vs. capitalizing those costs is not a question of revenue dollars to the treasury, rather the timing of those revenues. The government isn't "losing $50 billion each year", they're just receiving less in the first year, and they'll receive more in the following years. I too am for simplifying the tax code, but if you don't realize that spending is this country's problem, then you need to review the basic math of our tax base vs. our deficit. The mortgage interest deduction is already subject to phase outs above $166,800, as are a great many other tax deductions. Further, a great many of tax deductions and exemptions are done away with for higher income earners under the Alternative Minimum Tax (A misleading name, because it's not really an "alternative" at all unfortunately...). By the way, if you remove the mortgage interest deduction, the home ownership levels in this country would plummet... I would rather be subsidizing people owning a home than just about anything else the government would spend my money on. The reality is that while simplifying the tax code and doing away with some deductions is much needed, spending is the problem. We have to make cuts at federal pensions, healthcare, and defense, and those cuts are going to hurt - that's why no one in politics have the backbone to suggest it. No one wants to tell government employees, that they'll actually have to work until the age of 65 like everyone else. No one wants to tell seniors that I'm sorry, we can't subsidize $50k a month cancer treatment for someone in their 70s. No one wants to tell the war mongers that the cold war is over - we won - we don't need the same military resources anymore. Those three areas make up over 70% ($2.65T) of our $3.8T budget. $1.3T of our total budget will be financed. That problem is not going to go away through tax code changes alone, but by making hard decisions on what we can actually afford as a country, instead of kicking the can down the road to the next generation.

#3 I suppose actual government

I suppose actual government spending is considered to be cut to its lowest level and the only place left to focus is on so-called "tax-spending". If it is accepted that people and businesses actually do take action on opportunities to lower their taxes, it should be clear that raising taxes (particularly on "the rich") will have an impact on behavior. Perhaps we should be seeking to shrink the size of the federal government and allowing all of the spending to happen within the states, if the citizens of that state so chooses. I am looking forward to articles on how we can cut actual federal government spending in order to reduce the federal budget deficit.

#4 The two professors are on the

The two professors are on the money with regard to the simplification of the tax system. What we have now is silly. Having said that, giving the government more money to waste isn't the answer. The other thing to think about is the increases in taxes to corporations will simply be shifted to the consumers that buy the goods they produce. In some cases that is a good thing (making the consumers of Grand Theft Auto pay more is a good thing). In other cases, not so good.

#5 So naturally spending would

So naturally spending would also be cut on the govt side when they receive all these new sources of revenue correct? If not, and it doesnt appear spending will be touched, the last thing the govt needs is more sources of "revenue". But yes the tax code needs to be simplified. The reason so many weird deductions exists is because of the complexity of the code. 20% flat income tax and a 20% corporate tax would be a good start. The rates also cant go up, only down.......

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