Tax Expenditures, the Size and Efficiency of Government, and Implications for Budget Reform

NBER WORKING PAPER SERIESTAX EXPENDITURES, THE SIZE AND EFFICIENCY OF GOVERNMENT, ANDIMPLICATIONS FOR BUDGET REFORMLeonard E. BurmanMarvin PhaupWorking Paper 17268http://www.nber.org/papers/w17268NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138August 2011 Revised October 2011 Forthcoming in Jeffrey Brown, ed., Tax Policy and the Economy, Volume 26. We thank Charles Alamo,Thomas Barthold, Jeffrey Brown, John Buckley, Mihir Desai, Elizabeth Garrett, Laura Kalambokidis,Pam Moomau, John Palmer, Leslie Reinhorn, Robert Rozen, Dan Shaviro, Reed Shuldiner, John Spry,Eric Toder, Roberton Williams, Johnny Yinger, and seminar participants at the George WashingtonUniversity, New York University, the University of Pennsylvania, and Pew Subsidyscope for helpfulcomments and discussions. The views expressed herein are those of the authors and do not necessarilyreflect the views of any of the organizations with which we are affiliated, or the National Bureau ofEconomic Research.© 2011 by Leonard E. Burman and Marvin Phaup. All rights reserved. Short sections of text, not toexceed two paragraphs, may be quoted without explicit permission provided that full credit, including© notice, is given to the source. Tax Expenditures, the Size and Efficiency of Government, and Implications for Budget ReformLeonard E. Burman and Marvin PhaupNBER Working Paper No. 17268August 2011, Revised October 2011JEL No. H21,H24,H50,H62ABSTRACTOne possible explanation for the difficulty in controlling the budget is that a major component of spending—tax expenditures—receives privileged status. It is treated as tax cuts rather than spending.This paper explores the implications of that classification and illustrates how it can lead to higher taxes,larger government, and an inefficient mix of spending (too many tax expenditures). The paper thenanalyzes alternative budgeting approaches that would explicitly incorporate and measure tax expenditures.It concludes by analyzing ways to control tax expenditures (and other spending) and the special challengespresented by tax expenditures.Leonard E. BurmanCenter for Policy Research426 Eggers HallSyracuse, NY 13244and NBERleburman@maxwell.syr.eduMarvin PhaupTrachtenberg School of Public Policy and Public AdThe George Washington University601K Media and Public AffairsWashington, D.C. 20052MPhaup@gwu.edu 1. Introduction It has become almost a cliché that the projected growth of public debt in the United States is “unsustainable.” If current policies continue, the imbalance between spending and revenues will grow relative to the size of the economy, a path that may ultimately lead to a debt crisis. An explicit or implicit default by the largest economy in the world could have dire consequences for the economies of the US and the rest of the world. (Auerbach and Gale, 2011; Burman, Rohaly, Rosenberg, and Lim, 2010) While many political leaders seem to understand this, controlling the debt has so far proven elusive. One reason is that two of the prime drivers of the debt—mandatory programs such as Social Security, Medicare, and Medicaid, and tax expenditures such as the tax subsidy for employer-sponsored health insurance—are very popular, not subject to the regular controls of the budget process, and growing fast. Although mandatory spending and tax expenditures are similar in the sense that they are generally open-ended entitlements and operate outside the annual appropriations process, the costs of tax expenditures have the additional feature of being largely invisible to policy makers and citizens. Their cost is simply netted out of overall tax revenues. Tax expenditures are not treated as spending at all, but as reductions in taxes. Their hidden nature has made tax expenditures irresistible to policymakers of both parties—many political or policy goals can be achieved through stealthy spending programs that are framed as tax cuts. The late economist, David Bradford, famously pointed out that virtually any spending program could be transformed into a tax expenditure. (Bradford 2003) To illustrate the point, he proposed a Weapons Supply Tax Credit, which would allow arms manufacturers to sell their ordinance to the pentagon in exchange for tax credits rather than cash. Instantly, the Defense Department’s budget would decline by the amount of transformed spending. Tax revenues would decline by a similar amount (or more, if weapons suppliers demanded a premium on account of the complexities and uncertainties associated with the tax credit mechanism). But government would be doing exactly the same thing. Only the accounting would change. 2 A real world example is the low-income housing credit. Enacted as part of the Tax Reform Act of 1986, it was modeled on HUD programs that subsidized the construction and rehabilitation of affordable housing. The credit replaced existing tax incentives that were extrem