Outside of entitlements and defense, the biggest category of federal government expenditure — roughly $1 trillion a year — is all but invisible to the public. This stealth category doesn't show up as a line item in the budget. Congress doesn't debate it or vote on it. The news media rarely report on it. Yet it is driving the country to fiscal ruin.
I'm talking about tax expenditures — credits and deductions for which some taxpayers qualify but others do not. Certain tax expenditures benefit millions of people, such as the child credit, the mortgage deduction, and the health care exclusion. Others target a narrow group of beneficiaries like redevelopers of historic properties. But in the estimation of Martin S. Feldstein, former advisor to President Reagan and now a Harvard economist, they are the functional equivalent of government spending. As he says in a newly published paper, “Tax expenditures are features of the tax code that reduce tax revenue in order to achieve effects that might otherwise be done by explicit outlays.”
In “Preventing a National Debt Explosion,” Feldstein outlines his ideas for bringing the U.S. budget back into balance. To my mind, the most interesting part of his analysis focused on tax expenditures. The phenomenon is insidious because its converts spending that would be subject to annual Congressional appropriation into ink in the tax code that Congress rarely revisits. Similar to entitlements, tax expenditures put spending on auto-pilot.
Although individual members of Congress have tried to address the issue, neither the Republican nor Democratic parties has focused on it, Feldstein says. Democrats like dispensing favors to people. Republicans, suffering from conceptual confusion, equate eliminating tax breaks with actual tax increases.
There is no way to balance the U.S. budget without tackling the issue of tax exemptions head on. And it won't be possible to tackle tax exemptions without bitch slapping Republicans into understanding that cutting tax deductions is not the same as raising taxes. (That's me talking, not Feldstein.)
Here's why the GOP should get over its phobia and treat tax breaks for what they really are: a claim on government resources and taxpayers generally. Tax credits, deductions and exemptions shift the cost of governance from the lucky few to the general public. That $1 trillion a year could be applied to reducing tax rates. Lower rates would benefit all taxpayers, and they would reward socially beneficial behavior like hard work, saving and entrepreneurial risk taking. Alternatively, revenue gained from eliminating the tax breaks would raise enough money to bring the budget back into rough balance over the course of the next business cycle.
Moreover, tax credits and deductions distort the marketplace and lead to the inefficient allocation of resources. Case in point: The mortgage deduction, costing $85 billion a year, fed the real estate boom by making it easier for homeowners to borrow. Case in point: The health insurance exclusion, costing $150 billion a year, effectively makes employment a condition of obtaining medical insurance.
While Republicans and Democrats in Congress all give lip service to the need to balance budgets, there is little sign that either party is serious about it. Most Democrats yearn to spend more money in the hope of goosing economic growth. House Republicans have committed to cut spending by only $100 billion a year, about one-tenth of what is needed. Neither party wants to offend powerful constituencies like homeowners or even obscure groups like historic preservationists who benefit from the tax expenditures. But, as Feldstein warns, failure to bring the budget back into balance will lead to a massive expansion of indebtedness and put the fiscal fate of the country in the hands of China, the oil-exporting states and foreign creditors who could care less whether we can sustain our social contract between citizens and government. A sudden halt in the willingness of foreigners to keep lending money, he says, could precipitate another financial crisis.
Take the heat now or take it later. There is no avoiding the confrontation with reality.