Key Points
- Reforms to certain tax expenditures considered in this paper can increase tax revenue by as much as $366.3 billion in 2016, equal to almost half of the budget deficit. Smaller reforms produce less revenue.
- The method of limiting certain tax expenditures, however, can have substantially different impacts on the distribution of taxes paid by income.
Economic and Distributional Effects of Tax Expenditure Limits
Editor’s Note: This article is part of a series of tax-related articles sponsored by the Penn Wharton Budget Model and the Robert D. Burch Center at Berkeley. All of the articles in this series are forthcoming in a book by Oxford University Press, co-edited by Alan Auerbach and Kent Smetters.
Tax expenditures are tax deductions, tax exclusions, tax credits, and reduced tax rates for certain activities, industries, or taxpayers. Some popular tax expenditures include deductions for employer-sponsored health insurance, home-mortgage interest, state and local taxes, charitable contributions, and interest on municipal bonds. Eliminating certain tax expenditures would raise revenue and could reduce distortions to the allocation of capital and labor. The reduction of tax expenditures could also be used to reduce tax rates by broadening the tax base, reduce the deficit or pay for new programs.
Economic and Distributional Effects of Tax Expenditure Limits examines the effects of limiting tax expenditures and the income distribution of tax expenditures. The study’s authors, Len Burman, Eric Toder, Daniel Berger and Jeffrey Rohaly (2016), find that plans to eliminate or limit tax expenditures can make the tax system more progressive or more regressive while reducing marginal tax rates on work and saving.
Lost Tax Revenue
In 2016, tax expenditures are estimated to cost the U.S. almost $1 trillion. The number of tax expenditure categories has expanded from 140 in 1987 to 202 in 2009.
Burman et al. (2016) does not analyze the impact of eliminating all of the $1 trillion of tax expenditures in 2016. Rather the authors initially focus on a fairly broad-based reform that would increase tax revenues by $366.2 billion. This number is less than $1 trillion for several reasons. First, the authors repeal only the subset of “certain tax expenditures” (itemized deductions, exclusion from income of employer-provided health benefits, interest on state and local bonds and tax benefits for higher education). Second, the authors pair decreasing tax expenditures (raising revenue) with partially offsetting tax cuts (reducing revenue). They also eliminate the alternative minimum tax (AMT) and current-law limits on itemized deductions because those policies are generally intended to limit tax expenditures.
Most popular ideas of reforming tax expenditures, however, consider only limitations to them, rather than their wholesale elimination. The authors, therefore, use the Tax Policy Center microsimulation model to consider the distributional impact of three more modest tax-expenditure reform proposals: 1) limiting certain tax expenditures to 2 percent of income; 2) limiting the value of deductions and exemptions to 28 percent of the amount deducted or excluded from income; and 3) capping total tax deductions and exemptions that can be claimed at $16,300.
Policy Option 1: Limiting Tax Expenditures to 2 Percent of Income
The first reform limits certain tax expenditures to two percent of modified adjusted gross income (AGI). Modified AGI is AGI plus employer-provided health insurance and interest on state and local bonds. This reform eliminates the AMT and current limitations on itemized deductions. Limiting tax expenditures to 2 percent of income increases tax revenues by $204.7 billion. To make the change roughly revenue neutral, they then reduce federal marginal tax rates by 12.8 percent. So, for example, the top marginal tax rate is reduced from 39.6 percent to 34.5 percent, while the bottom rate is reduced from 10 percent to 8.7 percent.
The distribution of the tax burden is shown in Figure 1. Overall, this reform is projected to be regressive. For example, average tax rates increase for the bottom 90 percent of households while decreasing by 1.45 percent for the top 1 percent of the income distribution. One reason this reform is regressive is because households with incomes in the top 95 percent of the income distribution benefit more from the elimination of the AMT than households with lower incomes. The impact of limiting itemized deductions to 2 percent of modified AGI is spread more broadly across the income distribution.
Figure 1: Distributional Impact of Limiting Tax Expenditures to 2 Percent of Income
Projected change in average tax rates by income, 2016
Source: Burman et al. (2016)
Policy Option 2: A 28 Percent Maximum Deduction
The second reform limits the value of certain tax expenditures to 28 percent of the amount deducted or excluded and is estimated to reduce tax revenues by $14.3 billion in 2016. This reform eliminates the AMT and current limitations on itemized deductions. This reform is modeled as a surtax of 11.4 percent on modified AGI (excluding long-term capital gains and qualified dividends) above the current law 33 percent tax bracket. The surtax means that this reform has the same impact on revenue as the reform that limits tax expenditures to 2 percent of modified AGI. As with Policy Option 1 discussed above, this reform is paired with an across-the-board reduction to marginal rates of 12.8 percent.
Figure 2 shows that this reform is projected to increase average tax rates on people located in the top 1 percent by 2.28 percent while average tax rates on people with income in the lowest quintile would fall by 0.07 percent. Naturally, this reform has the greatest impact on high-income households with income that is taxed at rates above 28 percent. However, average tax rates for people with income in the 90th to 95th percentile of income distribution would fall by 1.49 percent more than average tax rates for those with lower incomes. This outcome is driven by the fact that higher-income households are more likely to take advantage of tax expenditures. For example, higher-income households are more likely to be homeowners and hold jobs that offer generous benefit health packages.
Figure 2: Distributional Impact of Limiting Tax Expenditures to a 28 Percent Deduction
Projected change in average tax rates by income, 2016
Source: Burman et al. (2016)
Policy Option 3: A $16,300 Cap
The third reform caps total tax deductions and exclusions that an individual can claim to $16,300. When combined with eliminating the AMT and current limitations on itemized deductions this reform has the same impact on revenue as the reform that limits tax expenditures to 2 percent of modified AGI. This reform includes an across-the-board cut in marginal tax rates of 12.8 percent to make the reform revenue neutral.
Figure 3 shows that, with this reform, all households, except for those with income in the 80th to 95th percentile, will pay less in taxes. Average tax rates for people with income in the lowest quintile will fall by 0.07 percent while average tax rates for people in the top 1 percent will fall 0.26 percent. The distributional impact of this reform is largely neutral. Higher-income households will pay lower tax rates because of the elimination of the AMT while the value of tax expenditures for households in the middle of the distribution will be limited.
Figure 3: Distributional Impact of Limiting Tax Expenditures to $16,300
Projected change in average tax rates by income, 2016
Source: Burman et al. (2016)
Conclusion
In summary, eliminating certain tax expenditures can increase tax revenue. However, the method of eliminating certain tax expenditures is quite material for the distribution of the tax burden. In particular, limiting the certain tax expenditures to two percent of modified AGI would be more regressive than limiting the value of certain tax expenditures to 28 percent of the amount deducted or excluded. Limiting tax expenditures to $16,300 appears to have the most neutral impact on the distribution of taxes paid.
A discussion of this paper is provided by Louis Kaplow .