Power & Market

“Tax Expenditures” Is a Misnomer

The April 18 deadline for Americans to file their 2022 income tax returns had hardly passed before House Republicans began to talk about reviving three tax breaks for businesses that had lapsed or begun to phrase out under the Tax Cuts and Jobs Act (TCJA) that the Republican-controlled Congress passed, and President Trump signed into law, in 2017.

The TCJA

The TCJA temporarily lowered individual tax rates (until certain provisions expire after 2025); set the tax brackets at 10, 12, 22, 24, 32, 35, and 37 percent; eliminated the personal exemption; effectively ended the ACA (Obamacare) mandate that established tax penalties for individuals who did not obtain health insurance; raised the standard deduction; expanded the child tax credit; limited the mortgage interest deduction; increased the alternative minimum tax exemption; capped state and local tax deductions; ended the deduction for alimony payments; raised the estate tax exemption; doubled the estate tax exemption; and suspended some itemized deductions.

The TCJA lowered corporate tax rates permanently (from a high of 35% down to 21%) and temporarily allowed full expensing of short-lived capital investments rather than requiring them to be depreciated over time; limited the net interest deduction to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA); raised the cash accounting threshold from $5 million to $25 million; eliminated net operating loss (NOL) carrybacks; eliminated the domestic production activities deduction; eliminated the corporate alternative minimum tax (already restored for 2023 in the Inflation Reduction Act of 2022); and allowed full expensing of research and development (R&D) costs in the year that those costs occur.

The three business tax breaks up for restoration include upfront expensing of research and development costs instead of over a five-year period, tax deductions for 100 percent of the costs for short-term investments in the first year they are purchased instead of just 80 percent, and a net interest deduction of 30 percent of earnings before EBITDA instead of just before interest and taxes.

But even as they planned to revive certain tax breaks, House Republicans sought to eliminate others. On April 26 — without a single Democratic vote — they passed the Limit, Save, Grow (LSG) Act of 2023 (H.R. 2811) to increase the federal debt limit in the present while promising to decrease spending in the future. Included in the legislation was a repeal of several energy tax credits that were included in the Inflation Reduction Act of 2022 (H.R.5376) that passed without a single Republican vote and was signed into law by President Biden on August 16, 2022. Even though the vast majority of current GOP House members signed Grover Norquist’s “no new tax pledge” — which includes a commitment to “oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates” — the LSG Act eliminates tax credits with no offsetting tax rate cuts. House Ways and Means Committee Chair Jason Smith (R-MO), supported by House Speaker Kevin McCarthy (R-CA), issued a letter defending the elimination of the tax credits because they were “green” corporate welfare designed “to function like direct government spending.” The technical term for this is “tax expenditures.” But Rep. Smith should know better since the Ways and Means Committee is the House committee that writes the tax code. The tax code is riddled with scores of tax expenditures, most of which Republicans support.

Tax Expenditures

According to the U.S. Department of the Treasury, Office of Tax Analysis, “Tax expenditures describe revenue losses attributable to provisions of 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. These exceptions are often viewed as alternatives to other policy instruments, such as spending or regulatory programs.” Some tax expenditures are in effect direct spending programs even though they appear to be tax breaks. Tax expenditures reduce the income tax liabilities of individuals or businesses that undertake certain activities. As explained by the Tax Policy Center of the Urban Institute and Brookings Institution:

Some promote broad social goals such as health insurance coverage or saving for retirement. Others supplement the federal social safety net by providing tax relief for certain groups of people, such as low-income working families, families with children, and seniors. Still others are incentives for activities that Congress has deemed worthy of support, including regional economic development, renewable energy use, provision of low-income housing, and investment in research and development

The Congressional Budget Impoundment Control Act of 1974 (Public Law 93–344) requires that a list of estimated tax expenditures be included in the federal budget, but only provisions that affect individual or corporate income taxes. Consequently, the Office of Management and Budget (OMB) and the congressional Joint Committee on Taxation (JCT) publish annual lists of tax expenditures. Tax expenditures are treated in the budget as revenue losses instead of spending. Only the portion of refundable tax credits that offsets individuals’ income tax liabilities are labeled as tax expenditures; the refundable portion over and above this is counted as spending. Tax expenditures may take the form of credits, deductions, exceptions, allowances, exclusions, exemptions, preferential tax rates, or deferral of tax liability. Most tax expenditures are not subject to a direct appropriation process by Congress each year, and come with no budget ceiling.

The Treasury Department lists 165 tax expenditures as of March 2023 under the headings of national defense; international affairs; general science, space, and technology; energy; natural resources and environment; agriculture; commerce and housing; transportation; community and regional development; education, training, employment, and social services; health; income security; Social Security; veterans benefits and services; general government; and interest. The largest tax expenditures are:

  • Exclusion of employer contributions for medical insurance premiums and medical care ($3,366,320 million)
  • Exclusion of net imputed rental income ($1,679,550 million)
  • Defined contribution employer plans ($1,535,700 million)
  • Capital gains (except agriculture, timber, iron ore, and coal) ($1,492,400 million)

Some of the most well-known tax expenditures are tax-exempt state and local bonds, tax exempt life insurance proceeds, the mortgage interest deduction, the state and local tax deductions, the student loan interest deduction, the adoption tax credit, the charitable contributions deduction, the credit for child and dependent care expenses, education tax credits, the child tax credit, the earned-income tax credit, tax-deferred interest earned on U.S. savings bonds, the medical expenses deduction, tax-free employer contributions to health savings accounts, additional deductions for the blind and elderly, the exclusion of scholarships and fellowships from taxable income, and the individual contributions to health savings accounts exclusion. And we are just talking about federal income tax. For example, individual contributions to health savings accounts not only lower income subject to income tax but also income subject to payroll taxes.

So, are tax expenditures good? Mainstream economists disagree on which tax expenditures are “worth it” and which have insufficient benefits to society to justify their “cost.” But their determinations are quite arbitrary. Typical is a Tax Policy Center report by Frank Sammartino and Eric Toder (“Are Tax Expenditures Worth the Money?”). Some tax expenditures “provide a significant share of government assistance to many worthwhile activities,” while others “provide unwarranted special benefits to certain industries and individuals.” However, sometimes they are undecided, like when they muse, “Whether the mortgage interest deduction serves a needed public purpose is unclear.”

The Problem

“Tax expenditures” is a misnomer. Tax expenditures are not expenditures. They are not subsidies. They are not spending programs. They are not outlays. They are not transfer payments. They are not “departures from an income tax with a comprehensive base.” They do not have to be financed. And they are not revenue losses unless you consider Americans keeping all of their income to be a loss to the government. The income tax, as Old Right stalwart Frank Chodorov (1887–1966) explained in his book The Income Tax: Root of All Evil (1954), means that the state says to its citizens, “Your earnings are not exclusively your own; we have a claim on them, and our claim precedes yours; we will allow you to keep some of it, because we recognize your need, not your right; but whatever we grant you for yourself is for us to decide.”

Economists and politicians have things backwards. Every so-called tax expenditure allows Americans to keep more of their money in their pockets and out of the hands of Uncle Sam. Taxation is government theft. Acquiring someone’s property by force is wrong, whether done by individuals or governments. If someone claims that taxation is not theft because Americans pay their taxes voluntarily, then why does the Internal Revenue Service (IRS) have armed special agents “who shouldn’t be afraid of using ‘deadly force’,” as a recent IRS job posting said? What percentage of Americans would voluntarily pay their taxes if there were no consequences for not doing so? Thanks to withholding and payroll taxes, Americans are forced to “pay up” with every paycheck.

Try being in business in the United States and refusing to withhold a portion of your employees’ paychecks and see what happens. And if someone retorts that although taxation is theft, it is a necessary evil because the federal government could not function without it, I would remind them that for the majority of American history, there was no income tax, and the government functioned just fine until it decided to intervene in European wars. In addition, the case could also be made that over 90 percent of what the government spends income tax revenues on is blatantly unconstitutional.

One economist who recognized the nature of tax expenditures was the libertarian theorist Murray Rothbard (1926–1995). In his seminal article “The Myth of Tax ‘Reform,’” he tackles the subject of tax subsidies and loopholes:

But what about, say, deductions for payment of interest on mortgages, tax credits for investment, or deductions for payment of state and local taxes? In what sense are they “subsidies?” Instead, what is really happening here is that some people — homeowners, investors, or state and local taxpayers — are graciously allowed by the government to keep more of their own money than they would have otherwise. I submit that being allowed to keep more of your hard-earned money is not a subsidy in any true sense; it simply means that you are being fleeced less intensely than you would have been. If a robber assaults you on the highway, and is about to run off with all of your funds, and you persuade him to let you keep some bus fare, is he “subsidizing” you? Surely not. Being allowed to keep your own money can scarcely be called a subsidy.

The great free-market economist Ludwig von Mises once rose up in a conference on taxation that devoted much energy to the closing of tax loopholes, and asked the crucial question: “What is a loophole?” He answered that the assumption of the loophole theorists seemed to be that all of everyone’s income really belongs to the government, and that if the government fails to tax all of it away, it is thereby leaving a “loophole” that must be closed.

Rothbard also recognized the true nature of taxation:

We have to look differently at taxation. We have to stop looking at taxes as a mighty system for achieving social goals, which merely needs to be made “fair” and rational in order to usher in Utopia. We have to start looking at taxation as a vast system of robbery and oppression, by which some people are enabled to live coercively and parasitically at the expense of others. We must realize that from the point of view of justice or of economic prosperity, the less people are taxed, the better. That is why we should rejoice at every new loophole, new credit, new manifestation of the “underground” economy.

Rothbard concludes:

Every economic activity that escapes taxes and controls is not only a blow for freedom and property rights; it is also one more instance of a free flow of productive energy getting out from under parasitic repression.

That is why we should welcome every new loophole, shelter, credit, or exemption, and work, not to shut them down but to expand them to include everyone else, including ourselves.

The principle should be clear: to support all reductions in taxes, whether they be by lower rates or widening of exemption and deductions; and to oppose all rate increases or exemption decreases. In short, to seek in every instance to remove the blight of taxation as much as possible.

One would think that libertarians of all people would get this.

Libertarians for Higher Taxes

But some libertarians just don’t get it. They join with conservatives — who have no philosophical objection to taxation — and argue, in the name of simplicity and fairness, that certain tax deductions and credits are “loopholes” that need to be “closed” because they “distort” the tax code, “subsidize” high-income taxpayers, benefit “special interests,” “misallocate” resources, and encourage people to make “economically unwise decisions.” These libertarians would strenuously object if the income tax rates were increased, but at the same time are quite adamant that certain tax breaks should be eliminated even though doing so would accomplish the exact same thing: increase the taxes of some Americans.

Tax deductions serve to reduce the amount of one’s income subject to taxation. Tax credits serve to reduce the amount of tax owed on one’s income. Either one allows Americans to keep more of their money and the government to take less of it. Therefore, all tax deductions and credits are good; it doesn’t matter whom they benefit, why Congress enacts them, or how much revenue they cost the federal government. Yet, some libertarians have spent an inordinate amount of time reproaching tax deductions and credits, especially the deduction for state and local taxes paid — the SALT deduction. According to the Tax Policy Center:

State and local income and real estate taxes make up the bulk of total state and local taxes deducted (about 60 percent and 35 percent, respectively), while sales taxes and personal property taxes account for the remainder.

State and local taxes have been deductible since the inception of the federal income tax in 1913. Initially, all state and local taxes not directly tied to a benefit were deductible against federal taxable income. In 1964, deductible taxes were limited to state and local property (real and personal property), income, general sales, and motor fuels taxes. Congress eliminated the deduction for taxes on motor fuels in 1978, and eliminated the deduction for general sales tax in 1986. It temporarily reinstated the sales tax deduction in 2004, allowing taxpayers to deduct either income taxes or sales taxes, but not both. Subsequent legislation made that provision permanent starting in 2015.

The TCJA capped the SALT itemized deduction at $10,000 for tax years 2018 through 2025. Prior to the 2018 tax year, all eligible state and local taxes paid during the year, including real estate, personal property, and income or sales taxes, could be deducted. The SALT cap, then, amounts to a tax increase. It is a tax increase on the middle class and the “rich,” but, after all, they are the ones who actually pay income taxes. According to the IRS, the bottom 50 percent of taxpayers (taxpayers with AGI below $44,269) pay just 3 percent of the income taxes collected, and the top 1 percent pay more income taxes than the bottom 90 percent combined.

Because libertarians maintain that the government is not entitled to a portion of any American’s income, and that Americans should be free to keep the fruits of their labor and spend their money as they see fit, libertarians should be saying that no one’s taxes should be increased, and that everyone’s taxes should be decreased.

Tax expenditures don’t cost the government revenue; rather, they allow Americans to keep more of their money. As long as Americans have an income tax, and as long as the chances are slim that the tax rates will be substantially reduced, tax breaks like deductions and credits are the only way that Americans can hang on to more of their money.

This article was originally published in the August 2023 edition of Future of Freedom.

image/svg+xml
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
Support Liberty

The Mises Institute exists solely on voluntary contributions from readers like you. Support our students and faculty in their work for Austrian economics, freedom, and peace.

Donate today
Group photo of Mises staff and fellows