Five Questions for Donald Marron on About How Cutting Tax Preferences is the Key to Tax Reform

Donald Marron, Tax Policy Center director, answers five questions about how cutting tax preferences is the key to tax reform. Marron testified about tax reform before the Senate Budget Committee, saying that reducing, eliminating, or redesigning tax preferences would make the tax system simpler and fairer and would raise revenues to pay for tax rate cuts and deficit reduction.

March 3, 2011

There are really two separate issues in tax reform. One is fixing the tax code, which is too complicated, unfair, and a burden on the economy. The second is raising revenue to help address our long-run budget challenges. Our budget is so far out of balance that extra revenue will likely be needed even if Washington shows remarkable spending restraint. Rolling back tax preferences is the best way to raise that revenue.

The income tax is riddled with tax preferences, many of which are spending programs in disguise. Suppose you want to encourage people to put solar panels on their homes. You could set that up as a subsidy paid by the Department of Energy or as a tax credit. Both increase the deficit, but one would be called a spending increase and the other a tax cut. Tax cuts have better odds of getting passed into law, so tax preferences have been a popular tool in recent decades. These spending-like tax provisions should get the same scrutiny that we give to traditional spending programs.

2. Can you give us some examples of tax preferences? And how do we tell which provisions are preferences?

Politicians and commentators often lament the “loopholes” and “special interest” provisions in our tax code. And they certainly exist. In the corporate income tax, for example, you can find provisions designed to favor specific activities or industries. The oil industry, for example, gets particularly favorable tax treatment. But it’s difficult to tell a public interest story of why that should be true. We should have a tax code that levels the playing field among different types of businesses.

The broader reality, however, is that the really large tax preferences benefit many people. Rather than being loopholes or special interest provisions, they are effectively entitlement programs run through the tax code. The most famous is the mortgage interest deduction, which allows some taxpayers to deduct from their income the interest they pay on their mortgage. It’s a very popular feature of the tax code. But it appears to do little or nothing to encourage homeownership. Instead, it encourages people to take out bigger mortgages and go deeper into debt—and it’s hard to see a good social purpose to that, especially after what we went through with the housing bust. Something more targeted and narrow could do a better job of encouraging homeownership, if that’s our goal. Also, there’s a good argument that the provision isn’t fair. It’s only valuable to homeowners who itemize their deductions, and it’s worth more to people who are in high tax brackets.

Identifying particular tax provisions as preferences is, of course, in the eye of the beholder. The Treasury Department does it on behalf of the executive branch, and the Joint Committee on Taxation does it for Congress. Their lists of “tax expenditures” aren’t identical but are very similar. What they do is compare the tax code we have to an idealized version of an income tax and look for deviations. This is a logical place to start, but it does raise some difficulties. Not everyone agrees that a comprehensive income tax is the ideal tax system. Some believe that a consumption tax is preferable, and what may be considered a tax preference under one system might not be under the other. In addition, there are also disagreements about how to best design an income tax. As a result, not every provision identified as a “tax expenditure” is really a spending program in disguise.

3. If you could get rid of one tax preference, which one would it be?

I would start with the biggest one—the exclusion of employer-provided health insurance, which totals more than $200 billion a year. That’s a phenomenal amount of money, even by Washington standards. If you get your health insurance through your employer, it’s exempt from income and payroll taxes. As a result, insurance is favored over other forms of compensation. While you might think that’s beneficial because it helps people get health insurance, the reality is that most of the tax savings go to relatively well-paid people, many of whom would have gotten insurance anyway. We could replace it with something more targeted that would still help people get insurance but that costs the government much less. We could then use the resulting revenue for a combination of deficit reduction and lowering tax rates.

4. Even if we clean tax preferences out of the tax code, what’s to stop policymakers from adding new ones? Should we amend the tax code to prevent this?

That’s a hard question. I don’t have a good answer about how to protect the tax code from the introduction of future tax preferences. If anyone out there has any good ideas, we’re all ears.

The last time we did a wholesale clean-up of the tax code was in 1986. A lot of tax preferences were reduced or eliminated and, in turn, tax rates were cut. But since 1986, many tax preferences have returned to the tax code. People have talked about creating some budget process that forces Congress to re-examine these programs, but it’s difficult to design an approach that would work.

Currently, there are more than 100 tax preferences that expire every year or two. In Washington, D.C., they go by the name “the extenders” since they are expected to get extended each time. They should be reevaluated when they’re up for renewal, but in practice, it’s not clear how much reevaluation they really get. And, of course, the really big tax preferences—for mortgages, health insurance, etc.—do not expire and thus get even less oversight.

5. Many tax preferences, such as the mortgage interest tax deduction, are very popular. Is cutting or reducing them politically feasible? What will it take to reform taxes?

Fundamental reform will require a catalyst—some combination of rising frustration with our broken system and growing concern about our perilous fiscal outlook. The President’s Fiscal Commission and the Domenici-Rivlin task force (on which I served) both thought that large-scale tax reform should be a fundamental piece of getting our deficit and debt under control. Both panels proposed reducing tax preferences and then used the resulting revenue to bring down tax rates and to reduce the deficit. The trade-off for raising overall tax payments is that Americans would have a simpler, fairer, less economically harmful tax code.

I hope that we can find political leadership for such broad-based reform in the next few years. If not, another strategy would be to fix specific parts of the tax code. For example, there’s broad political interest in reforming corporate taxes. When Japan cuts its corporate tax rate in April, the United States will have the highest corporate tax rate in the world. We also have a lot of corporate tax preferences, however, so the average corporate tax burden isn’t as high. Still, there’s a good deal of interest in bringing the rate down, reducing or eliminating some of the tax preferences, and having a corporate tax rate that more closely resembles that of other nations. In his State of the Union address, President Obama said he wanted to level the playing field by getting rid of corporate tax loopholes and simplifying the system. That’s important economically. But in the grand scheme of budget issues, most of the action is on the individual income tax side.