Various U.S. agencies such as the Treasury Department sometimes formally assess these nonrevenue 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 and expenditures is in the form of tax breaks for selected people, businesses, and activities, 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 subjects—medicine, 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 medicine and bad educational theories, so too are there pieces of conventional wisdom about taxes that are highly questionable or downright wrong. Especially for those closely associated with one political party, a mythical view can develop over 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 have to be weighed. Tax cuts can actually expand (or tax increases reduce) the government’s interference in the economy. Consider 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 same—even 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 shown giving something away without increasing taxes, it is not surprising that they like to talk about the benefit and not the cost side of their actions.
A tax cut may not be a “cut” at all but a shift in who pays: if additional debt is incurred to finance it, then future taxpayers might pay higher taxes to pay for lower bills for current taxpayers. Much depends upon what happens to future expenditures. Higher deficits from reduced taxes might lead to reduced expenditures, but this “starve the beast” strategy has a mixed record. In the first few years of the 21st century, large spending increases accompanied tax cuts, so future taxpayers might pay for those actions through both higher taxes and reduced expenditures. While the empirical evidence on how tax changes drive expenditure changes is necessarily 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 presidential tax policy have prevailed throughout the history this book covers, 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. 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 period, the inexorable growth in health and retirement programs absorbed more and more national income. In fact, the extraordinary surge in so-called entitlement spending became the dominant budget force over the past few decades. Essentially, the budget numbers didn’t add up in the early 1980s: there wasn’t enough money to pay for the tax cuts of 1981, the defense increases, and the automatic increases in entitlement spending. If several cars play “chicken” and all crash together, it is less useful to blame one car—in this case, Reagan’s tax cuts— than 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 Clinton’s predecessor, President 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, during a time of divided government, that few large expenditures or tax cuts were added to the budget even as the economy grew. This constraint—along with a pleasant economic upturn—helped to temporarily reduce the deficits.
The George W. Bush Budget Myth: President 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 tax cuts, especially if eventually made permanent, were large. But spending increases from 1997 through 2006 were quite large, too—not just for defense or national security, but for discretionary and entitlement spending as well. In fact, Congress and the president went on a wild legislative “spending” spree of 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, but temporarily, early in the new century due to a recession and stock market plunge. Most importantly, with the upcoming retirement of the baby boomers, the long-term budget issue was ignored.
And Some Realities
Some factors or trends have long played important and continual roles in how tax policy has evolved.
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 a favorable period of budget surpluses. The “good times” rationale is that unwarranted tax breaks can be eliminated only when those people formerly benefiting from the breaks don’t have to take a hit when others are compensated. For instance, suppose Tom unjustly pays less tax than Harry when in principle they should pay the same. Then 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 someone—that is, when it is reducing the deficit—it has been 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 it is engaged in additional give-always, it is often indiscriminate—not worrying whether Tom gets more than Harry or Harry more than Tom as long as neither is hurt and perhaps campaign contributions go up.
Of course, it is hard to adhere to all principles at the same time. As only one example, some 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 defend 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 steadfast nor consistent. 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 type of taxpayer (e.g., corporation, individual, or charity). 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 and 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 taxes—federal income taxes in particular—state taxes have taken larger and larger shares of national income over the post–World War II era. The state and local share grew relative to the national share, while the states themselves took over much larger shares of the combined state and 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 complex—increasing 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.
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 success—and at times, its survival—was made possible by coming up with the necessary money at the right time. Taxes have been raised to meet budget policy goals of 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, only in the contemporary period covered here has deficit reduction or surplus spending largely defined policy. During this late 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 played a vital role in both deficit and surplus—with 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 the other person 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 fashion—that 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.
