The Income Tax has made more liars out of the American people than Golf has: Even when you make one out on the level, you don't know when it's through if you are a Crook or a Martyr.
No area of policymaking "taxes" the brain more than taxation. Although the nuances of tax reporting and accounting are mind-boggling, they reflect the implementation of a much wider, sometimes disenchanting, but ever engaging policy process. Sound tax policy and administrationlike a trustworthy judiciary and reliable financial accounting systemis one of the pillars of modern governance. In examining those nations that aspire to be republics but have not yet firmed up this pillar, you will find crumbling or barely viable government.
When policymakers decide to change the economy or society's behavior, the tax code is usually their tool of choice.1 Most fundamentally, taxes are collected to support the activities of government agencies. Oliver Wendell Holmes, Jr., was referring to this basic function when he stated that taxes are the "price we pay for a civilized society."2 Today, however, raising revenues to support government's direct-expenditure programs and operations in society is only the tip of the iceberg.
There are tax breaks for homeownership that by themselves provide more subsidies than the entire budget of the Department of Housing and Urban Development (HUD). The Earned Income Tax Credit (EITC)3 is now larger than any other welfare program, such as Food Stamps or Temporary Assistance to Needy Families (TANF). The tax break for employer-provided health insurance, which costs more than $150 billion per year, represents the largest health subsidy granted to the nonelderly anywhere in the federal budget and is growing faster than almost all other domestic programs. Meanwhile, every recent U.S. president has proposed expanding the use of tax subsidies for health. Tax breaks abound as a favored mechanism to "provide energy independence," subsidize energy producers, and promote energy conservationeven when extra production works at cross purposes to conservation. In other words, to understand housing, welfare, health, energy, or almost any government policy, you have to look at what is going on in the tax code.
Today, tax breaks rather than direct expenditures account for one-fourth to one-third of the benefits and subsidies granted to the public. As if that situation weren't enough to overburden the tax agenda, in recent decades politicians have decided that taxes are a primary instrument for dealing with growth and recession and implementing macroeconomic policy. Further, presidents and Congresses constantly try to use taxes to change the distribution of income and affect behavior among farmers, research firms, energy suppliers, the poor, or hundreds of other groups that benefit from various tax grants and subsidies. Finally, taxes powerfully influence how we all consume, work, save, and invest.
Various U.S. agencies, such as the Treasury Department, sometimes formally assess these non-revenue functions of the tax system, in part through an accounting system known as the tax expenditure budget. This controversial budget attempts to calculate the size of tax provisions that operate essentially like direct expenditures even though they are put forward as tax breaks. Because such a large chunk of government subsidies or expenditures are in the form of tax breaks, elected officials often turn to the Treasury and the congressional tax-writing committees to resolve budget and deficit problems.
The Budgetary Myths Surrounding Tax Policy
Everyone is an expert on three subjectsmedicine, education, and taxes. After all, each of us has firsthand, sometimes harrowing, experiences dealing with doctors, teachers, and tax officials. But just as there are "quack" medical practices and bad educational theories, so too are there pieces of conventional wisdom about taxes that are highly questionable or downright wrong. Those closely associated with one political party can develop a mythical view about what the other party has done wrongly in the past. These myths need to be dispelled, or at least put in perspective, as they have been pervasive throughout the recent history of tax policy.
Of course, tax cuts and increases often influence the magnitude of government. But a lot of other factors also have to be weighed. For instance, tax cuts can actually expand (or tax increases reduce) the government's size. If additional debt is incurred to finance a tax cut, then future taxpayers have to pay more to pay off that additional debt. Consider, for example, a new tax cut to dairy producers that might provide a tax credit of 5 cents for every gallon of milk delivered, yielding a total subsidy of $100 million. There is little difference between this tax cut and a direct spending program giving 5 cents per gallon to dairy producers and also costing $100 million. In effect, an expenditure increase to dairy producers can be designed or disguised as a tax cut. But the end result is the sameeven if the dairy subsidy shows up as a negative tax rather than a positive expenditure in the budget. Either way, this expenditure must also be paid for through higher tax rates.
Disguised expenditures such as this hypothetical dairy subsidy are a political favorite. Since our elected officials prefer to be characterized as increasing expenditures and reducing taxes, it is not surprising that they like to talk about the benefit and not the cost side of their actions.
Tax-rate cuts for both individuals and corporations may also reduce government's size, depending upon what happens to expenditures. Higher deficits from a reduced revenues might discourage future Congresses from increasing expenditures. Although this "starve the beast" strategy can add to deficits, there is evidence that Congress tends to increase spending when taxes are higher and to restrain spending when they are lower. While empirical evidence on how tax changes drive expenditure changes is inconclusive, the accounting truth is undeniable: the nation's fiscal system is a balance sheet, and the tax or expenditure side can be looked at separately only by closing one eye.
Budget myths about tax policy have prevailed throughout the history covered in this book, and we should begin by dispelling some of their various manifestations.
The Reagan Budget Myth: Reagan's 1981 tax cuts created the deficits in the 1980s. As you will see, the large revenue cutbacks of the early 1980s added significantly to deficits at that time. But broader factors also contributed to the budget deficit. A temporary and significant increase in the defense budget as a percentage of Gross Domestic Product (GDP) coincided with the early 1980s tax cuts. Also in that time period, the inexorable growth in health and retirement programs absorbed larger and larger amounts of national income. In fact, the extraordinary surge in so-called entitlement spending has become the dominant budget force in the past few decades. Essentially, the budget numbers didn't add up in the early 1980s, and there wasn't enough money around to pay for the tax cuts of 1981, the defense increases, and the automatic increases in entitlement spending. For example, if several cars play "chicken" and all crash together, it is less useful to blame one carin this case, Reagan's tax cutsthan to address the broader process that led to the game in the first place.
The Clinton Budget Myth: Clinton's 1993 tax increases were responsible for the elimination of the deficit by the late 1990s. Despite the tendency of Republicans to attack the Clinton tax increases for being historically large and Democrats to praise them for leading to extraordinary deficit reduction, the increases were moderate. Indeed, the deficit-reduction package under George H.W. Bush was larger in magnitude as a percentage of GDP than was the one President Clinton pushed through.
Again, a broader perspective is required. The 1990 budget enforcement rules helped maintain enough discipline in the mid-1990s so that few large expenditures or tax cuts were added to the budget even as the economy grew. This constraintalong with a pleasant economic upturnhelped to temporarily reduce the deficits.
The George W. Bush Budget Myth: Bush's tax cuts recreated large deficits in the first years of the 21st century. Once again, talking about taxes in isolation does not make sense. The 2001, 2002, and 2003 tax cuts, especially if eventually made permanent, were large. But spending increases from 1997 through 2004 were quite large, toonot only for defense or national security, but also for discretionary and entitlement spending as well. In fact, Congress and the president went on a wild legislative "spending" spree, authorizing both tax cuts and increases in expenditures while adding to, rather than containing, the large, automatic, growth in retirement and health spending already scheduled. Meanwhile, independent from the tax cuts, revenues fell dramatically with changes in the economy as the unusual revenue gains of the 1990s failed to continue. Yet, with the retirement of the baby boomers a few years away, the long-term budget issue was ignored.
And Some Realities in Tax Policy
Some factors or trends have long played important and continual roles in tax policy evolution:
Fact 1: Reliance on principles seems to go up when times are tough. Almost all changes to the tax law seem to be called "reform" by their sponsors, but true reform is based on principles. Many believe that principled reform requires budget surpluses. The "good times" rationale is that unwarranted tax breaks can be eliminated only when those people formerly benefiting from the breaks can be compensated some other way. For instance, suppose Tom unjustly pays less tax than Harry when in principle they should pay the same. With a surplus, Tom's tax break can be eliminated and tax rates lowered for both Tom and Harry. In that way, Harry's taxes can be reduced to the level of Tom's, but Tom won't pay any more because the rate reduction will roughly offset his loss of a special tax break.
The history of modern tax policy belies the notion that such easy exchanges are possible. Instead, when Congress has to show directly how it is taking something from someonei.e., when it is reducing the deficitit is more likely to appeal to the public on grounds of equal justice or some other principle. When there is no budgetary pressure, Congress is less compelled to remove anyone's tax break. Indeed, when Congress is engaged in additional give-aways, it is often indiscriminatenot worrying whether Tom gets more than Harry or Harry more than Tom as long as neither is hurt and perhaps campaign contributions go up.4 Of course, it is hard to adhere to all principles at the same time. For example, an attempt to create equity or parity can at the same time cause complexity. Nonetheless, though the coming chapters highlight important exceptions, concern for principles in general seems to wane when Congress's or the president's feet are not held to the fire.
Fact 2: Both political parties like to provide subsidies and expenditures through the tax system. Providing subsidies and expenditures in the form of tax breaks gives the appearance of reducing government's size since the measure of net taxes goes down even as government interference in the economy increases. For this reason, tax subsidies have strong political appeal.
Many tax subsidies in the 1960s and 1970s were delivered as business tax breaks and deductions that higher-income taxpayers found more valuable. In that earlier period Republicans tended to embrace such breaks more than Democrats (although, as in the case of the investment credit, they were often proposed first by Democrats). But even as some of these business preferences were cut back, social tax expenditures increased and credits expanded even for those with no tax liability. Eventually, support for using the tax code to accomplish social and economic policy, not simply to raise revenues, became increasingly bipartisan.
Fact 3: The Internal Revenue Service doesn't just collect revenues; it administers social policy and children's programs. A corollary to the bipartisan embrace of tax subsidies and expenditures has been the expanded use of the earned income tax credit, child tax credits, and other tax benefits targeted toward lower-income families, especially those with children. Because Republicans embraced helping families with children as a family issue and Democrats embraced family as an issue of progressivity, there has been bipartisan movement on this front.
Fact 4: The investment and business tax policy debate evolves toward ever more complex issues. Although tax policy is crucial for investment and saving policy, rules are neither always steadfast nor adhered to. Broad-based incentives, such as investment tax credits, eventually got abandoned in favor of lower rates, but selective incentives for such items as research and energy remained or expanded. One heated and unresolved debate concerns the ways that taxpayers "arbitrage" differences in the treatment of different assets, income sources, or taxpayers. Government seems to have limited ability to prevent new "tax shelters" born of complex forms of arbitrage, forcing Congress constantly to rewrite the law or the Treasury Department and the Internal Revenue Service (IRS) to reinterpret the regulations. Such shelter opportunities arise from many sources, including variations in tax rates by country, limitations on loss deductions that may be avoided when companies merge, the tax exemption for charitable activity, and the differential taxation of equity and debt. Tax professionals' growing skillfulness in exploiting every differential in the tax system, the computerization of tax accounting, and the emergence of split-second electronic transfers of billions of dollars all perpetuate the tax shelter crisis.
Fact 5: The real postwar growth in taxes occurred at the state, not the federal, level. Although most tax policy fights are over federal taxesfederal income taxes in particularstate taxes took larger and larger shares of national income over the post-World War II era. The state and local share grew relative to the national, while the states themselves took over much larger shares of the combined state/local budgets.
Fact 6: The tax code must change with the times. Among tax lawyers, accountants, and practitioners, this is heresy. They are right that change is complex, and that there is an administrative, as well as efficiency, cost to constantly retooling (Feldstein 1976). Many of the changes of the past few decades have also made the tax laws permanently more complexincreasing the time and transaction costs of dealing with tax preparers and tax professionals, filling out tax forms, and adjusting portfolios and other parts of our lives to minimize taxes.5
Nonetheless, the tax code is a major instrument of U.S. policy. No one argues that expenditure policy should be left alone. As an evolving society develops new needs and new information sources, institutions must change, and government must spend its money differently. The same holds true for collecting taxes. Certainly, some aspects of the tax code should be changed only gradually, especially those that involve complex accounting matters. But an equal claim for a modest pace of reform can be made for many expenditures, such as deposit insurance. Other expenditure provisions, such as size of the armed forces, must evolve more rapidly. Thus, the tax code will evolve not just because politicians can't keep their hands off of it, but also because they should not.
Fact 7: Controlling the budget plays an increasingly dominant role in the evolution of tax policy. In terms of causal direction, tax policy has always been a handmaiden to budget policy. A nation raises taxes to pay for government functions. Read almost any history of the United States that covers financial matters, and it will become clear how much of the nation's successand at times, its survivalwas made possible by coming up with the necessary money at the right time.6 Taxes have been raised to meet such budget policy goals as reducing debt obligations arising from the Revolution, building roads and other infrastructure for westward expansion, paying for wars, and restraining the growth in national debt; they have been lowered to reduce distortions and the drain of government on the economy.
Compared to most of the nation's history, it is only in the contemporary period covered here that deficit reduction or surplus spending has largely defined policy. During this period, Congress has paid limited attention to the underlying purposes of tax or expenditure programs, which is unfortunate, since a government doesn't exist to reduce deficit or spend surplus. In any case, tax bills have played a vital role in both deficit and surpluswith success often defined politically by the simple standard of whether enough money was raised or spent.
The name of the game in Washington in recent decades has been to "spend" or use up money before someone else does. On the expenditure side, entitlement programs like those for retirement and health are precommitted to absorb ever-larger shares of revenue in an automatic fashionthat is, even in the absence of legislation. Not to be outdone, those who favor lower taxes have legislated tax cuts into the future. The net result is gridlock. Never in the nation's history have dead and retired officials been able to exert such control over current and future budgets, as you will read.
1. One former deputy assistant secretary for tax analysis at the U.S. Treasury claimed that "tax policy is an extraordinarily poor instrument for rapid reaction to short-term policy problems" (Burman 2002).
Contemporary U.S. Tax Policy, by C. Eugene Steuerle, is available from the Urban Institute Press (paper, 6" x 9", 332 pages, ISBN 0-87766-720-9, $24.00). Order online or call (202) 261-5687; toll-free 800.537.5487.
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