GIVING CREDITS WHERE CREDITS ARE (ARGUABLY) DUE: A HALF CENTURY'S EVOLUTION IN THE DESIGN OF PERSONAL TAX EXPENDITURES.

• Date: 22 September 2020
• Author: Zelenak, Lawrence
• Published date: 22 September 2020
• Author: Zelenak, Lawrence

1. INTRODUCTION 52 II. THE SHIFT FROM DEDUCTIONS TO CREDITS: AN OVERVIEW 59 III. THE EVOLUTION OF PERSONAL TAX EXPENDITURES: SOME CASE STUDIES 67 A. The Home Mortgage Interest Deduction 67 B. The Charitable Deduction 70 C. The State and Local Tax (SALT) Deduction 76 D. The Exclusion for Employer-Provided Health Insurance (and the Medical Expense Deduction) 81 E. The Premium Assistance Credit 88 F. Tax Benefits for Childcare Expenses 91 G. Tax Benefits for Adoption Expenses 99 H. The Earned Income Credit 103 I. Tax Benefits for College Tuition 108 J. The Dependency Exemption Becomes the Child Tax Credit 114 K. Exclusions, Deductions, and Credits for Retirement Savings 122 IV. DEDUCTION, EXCLUSION, OR CREDIT? 134 V. TAXABLE CREDITS 143 VI. CONCLUSION 148 I. INTRODUCTION

   Stanley Surrey, then Assistant Secretary of the Treasury of Tax Policy (and once and future Harvard Law School professor), first propounded the tax expenditure concept in a 1967 speech. According to Surrey, the federal income tax features:

   a system of tax expenditures under which governmental financial assistance programs are carried out through special tax provisions rather than through direct government expenditures. This second system bears no basic relation to the structure of the income tax and is not necessary to its operation; it is simply grafted on to that structure. (1) As Surrey explained, a tax expenditure could take the form of a tax exemption for a particular type of income, a deduction for an expenditure that would not be deductible if the goal of the tax system were simply to measure a taxpayer's economic net income, or a credit reducing tax liability by the amount of the credit. (2)

   The following year, responding to Surrey's plea that "[w]e need a much higher degree of accounting for the dollars that the tax expenditure programs which grew up in the past are now absorbing," (3) the Treasury Department issued the first set of federal tax expenditure estimates, for fiscal year 1968. (4) In the personal category, the major expenditures identified by Treasury included the deductibility of interest on consumer credit (revenue cost $1.3 billion), the deductibility of interest on home mortgages ($1.9 billion), the deductibility of property taxes on owner-occupied housing ($1.8 billion), the deductibility of other nonbusiness state and local taxes ($2.8 billion), the deductibility of charitable donations ($2.37 billion), the deductibility of medical expenses not covered by insurance ($1.5 billion), the exclusion of employer-provided health insurance (EPHI) ($1.1 billion), and the exclusion for employment-based retirement savings ($3.0 billion). (5) Personal credits were almost nonexistent; the only item in that category was the retirement income credit, at a revenue cost of only $200 million. (6)

   Focusing for the moment on tax expenditures designed to subsidize cash outlays by taxpayers (and thus setting aside the exclusions for employment-based health insurance and retirement savings), a striking aspect of these estimates is the utter dominance of deductions over credits. The big-four personal deductions of 1968 (for interest, charitable donations, state and local taxes, and medical expenses) totaled $11.67 billion. By contrast, there was not a single dollar of tax expenditure in the form of a credit for some stated percentage of outlays for tax favored purchases.(7)

   Surrey was tremendously successful in institutionalizing the concept of tax expenditures and the annual publication of official tax expenditure budgets (TEBs). Despite the absence of a legislative mandate for the preparation of TEBs in the early years, in 1970 Treasury produced a second TEB, (8) and in 1972 and 1973, Treasury and the Joint Committee on Taxation cooperated in the production of updated TEBs. (9) In 1974 Congress enacted legislation requiring the annual production of TEBs by both the executive branch and the legislative branch. (10) Pursuant to that legislation, for almost half a century (and counting) there have been two annual TEBs, one from the Joint Committee on Taxation and one from Treasury. (11)

   In Surrey's view, to identify a provision as a tax expenditure was to stigmatize it. His hope was that focusing congressional attention on tax expenditures by means of mandated annual reports would lead Congress to conclude that many tax expenditures were indefensible and should either be repealed outright or replaced with better-designed direct spending programs. Despite Surrey's impressive success in institutionalizing the tax expenditure concept, the annual publication of TEBs has failed to produce the effects for which Surrey had hoped. Surrey also had, however, a fallback position--that, if Congress was unwilling to cleanse the Internal Revenue Code of a particular tax expenditure, it should at least reform the expenditure to eliminate the "upside-down effect" of tax subsidies structured as deductions and exclusions. (12)

   The upside-down effect follows from the fact that, in a tax system with progressive marginal rates, the tax benefit of a dollar of deduction or exclusion is a function of a taxpayer's marginal tax rate. Deducting or excluding $100 produces a tax saving of $37 for an affluent taxpayer in the 37% bracket, but deducting or excluding the same amount is worth only $ 10 for a lower income taxpayer in the 10% bracket. As Surrey explained, "the higher the individual's income and thus the higher the individual's income tax rate, the larger is the tax benefit-the tax reduction--brought about by the deduction [or exclusion]." (13) Surrey contended that a credit equal to some specified percentage of credit-eligible taxpayer outlays--for example, a credit equal to 20% of the amount a taxpayer donated to charity--would be a policy improvement over a deduction, especially if the credit was refundable (that is, allowed as a transfer payment to the extent the credit amount exceeded the taxpayer's pre-credit tax liability) and if the credit amount was itself included in the taxpayer's taxable income. (14)

   In the decades since Surrey's indictment of tax expenditures in the late 1960s, the contemporaneous production of the first TEBs, Surrey's 1973 publication of Pathways to Tax Reform expanding his indictment to book length, (15) and the 1974 congressional mandate of annual TEBs, there has been a dramatic shift in the relative significance of personal deductions and personal credits. Although all of the big-four personal deductions of 1968 (call them the legacy deductions) still exist today, they are greatly diminished--partly because of new direct statutory limitations on the deductions, and partly by the indirect effect on itemized deductions of a large increase in the standard deduction (resulting in more taxpayers forgoing itemized deductions in order to claim the standard deduction). Over the same decades, although Congress has never been sufficiently impressed by Surrey's upside-down critique of deductions to convert any of 1968's big-four deductions to credits, it has been sufficiently impressed to legislate as if it had adopted a new default rule, to the effect that any new personal tax expenditure should be enacted as a credit rather than as a deduction.

   There has been a remarkable shift in the design of personal tax expenditures--from deductions dominating credits in the late 1960s to the dominance of credits over deductions today--in the half century since Surrey introduced the tax expenditure concept. (16) Exclusions, meanwhile, have been relatively unaffected; they continue to play a role similar to their role in the late 1960s. As noted earlier, in 1968 the tax expenditures for the big-four personal deductions ($11.67 billion) were almost 60 times greater than the tax expenditure for the lone personal credit ($200 million). (17) In sharpest contrast, in 2019 the tax expenditures for five major personal credits (none of which existed in 1968) totaled $269.4 billion, (18) while the sum of the tax expenditures for the four legacy deductions was only $97.2 billion. (19) Personal tax expenditures in the form of credits amounted to less than 2% of personal tax expenditures in the form of deductions in 1968; in 2019, credit tax expenditures are over 275% of deduction tax expenditures. Although there is a different story of the decline of each legacy deduction and of the introduction and growth of each new credit, there are striking similarities across the stories. Perhaps the most significant similarity is the pervasive influence of Surrey's upside-down critique of tax subsidies in the form of deductions. In fact, Surrey's critique has been as influential in areas where it would not apply if properly understood as it has been in areas where it does properly apply. Other themes common to many of the stories include: (1) that Surrey's argument for credits over deductions has been more influential than his argument that credits should be refundable and taxable; (2) that the upside-down critique has been much more influential with respect to the design of new tax subsidies than in the rethinking of the design of the legacy deductions; and (3) that the legacy deductions--still in existence, but greatly diminished relative to their heyday five decades ago have been much more politically vulnerable than the major personal exclusions (for employer-provided health insurance (EPHI) and for employment-based retirement savings) of the late 1960s.

   Part II of this Article provides an overview of the shift from deductions to credits in the past half century. Part III consists of case studies of a number of personal deductions, credits, and exclusions, including both legislative changes over the decades and significant unsuccessful reform proposals. The case studies in Part III cover all of the big-ticket personal tax expenditures (deductions, credits, and exclusions), as well as an illustrative selection of smaller tax expenditure items. In the order...