Are tax expenditures reaching their goals? A view from the fiscal cliff.

• Author: Lewis, Richard Q., III

Taxes are what we pay for civilized society ...: (1) What Supreme Court Justice Oliver Wendell Holmes may have been implying when he wrote those famous words is that nobody enjoys paying taxes, but we do enjoy an elevated standard of living. However, in light of the so-called "fiscal cliff," there is endless debate about whether some taxes are necessary and whether the money assessed is actually used for the purpose for which it was received. It is indisputable that the federal government uses tax expenditures to promote certain activity among targeted groups of people. The ideological goal of tax expenditures is to create a more financially stable taxpayer and prosperous society, which will translate into a steady stream of tax revenue for the government. The government attempts to achieve this goal by providing many individual tax expenditures to middle- and low-income taxpayers to encourage spending. However, many of the tax expenditures fail to meet their goals and create an unintended economic reality of a small tax base and decreased revenues.

Notwithstanding, over the past few decades, tax expenditures have become the tool of choice by the government to stimulate the economy. (2) They are politically favorable because they are economically equivalent to direct spending, but are disguised as tax breaks. (3) This article will examine two primary areas of expenditures that affect the broadest range of taxpayers and explore whether those expenditures actually accomplish the desired results: expenditures for real estate and education.

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What Are Tax Expenditures?

Tax expenditures are defined as "revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption or deduction from gross income or which provide a special credit, a preferential tax rate or a deferral of liability." (4) They operate to reduce the income tax liabilities of individuals and businesses that undertake certain types of activities. (5) They are not neutral, but targeted to specific taxpayers to promote a particular behavior or response.

Tax expenditures are sometimes referred to as "backdoor spending" through the tax code because the same result might otherwise be accomplished through a direct outlay. (6) They benefit hundreds of different types of activities and individuals and currently account for one-fourth to one-third of all benefits and subsidies granted to the public. (7) Unlike direct outlays or entitlement programs on the spending side of the budget, most tax expenditures do not go through a direct appropriations process each year. (8) Consequently, they continue and often expand with no congressional vote or oversight. (9) In 2008, the Office of Management and Budget (OMB) estimated the tax expenditure budget to total $878 billion. (10)

In 2012, the tax expenditure budget is estimated to reach $1.1 trillion in revenue losses. This accounts for approximately 6.7 percent of the projected gross domestic product (GDP) for that year. (11) Of these estimated expenditures, about $900 billion (5.8 percent) of the GDP goes to support social services program activities, which include, among other items, housing and education. (12)

By their very nature and design, tax expenditures violate the three goals of any balanced tax regime: neutrality, equity, and simplicity. An ideal tax regime should be neutral in its application, equitable in its effects, and simple to administer. One would assume, with almost six percent of the federal budget going to fund these tax expenditures, the significant motivation to the taxpayers to take advantage of these incentives would justify this unbalanced tax structure. However, the two large tax expenditures, housing and education, do little more than widen the gap between low- and high-income taxpayers.

Real Property Tax Expenditures

The federal government provides about $180 billion in tax expenditures to homeowners in the form of tax incentives as the mortgage interest or real estate tax deduction, and the exclusion of capital gains from home sales. (13) In 2008, the mortgage interest deduction accounted for $88.5 billion dollars of the federal tax expenditure budget. (14)

Through the use of the tax code, the federal government allows mortgage interest payments to be deducted for itemizing taxpayers (15) for interest allocable to a...