Taming Welfare for the Rich: A Reconsideration of Tax Expenditures

11/17/21

A tax expenditure is defined as anything that serves to reduce or eliminate a tax obligation that would otherwise prevail. Thus, any taxpayer who qualifies for and benefits from a tax expenditure essentially receives a form of government support or subsidy — i.e., a form of welfare. So how do tax expenditures come about, and who gets to benefit from them?

Tax expenditures derive from four sources: income exclusions, preferential rates, deductions, and tax credits. The amount of any tax expenditure would be the amount of tax revenues not collected. A tax credit directly offsets an initial tax obligation, thereby generating a dollar-for-dollar tax expenditure. For deductions and exclusions, on the other hand, the tax expenditure would be the amount saved on taxes, rather than the deduction or exclusion, itself. Using the mortgage interest deduction as an example, a taxpayer in the 25% tax bracket claiming a $1,000 mortgage interest deduction would generate a tax expenditure of 0.25 x $1,000 or $250.

By increasing or decreasing tax expenditures, the government can decrease or increase aggregate tax collections; but by implementing a policy involving tax expenditures (as opposed to, say, changing tax rates), the impact is targeted to satisfy some particular societal objective. Again, using the interest deduction on mortgages, this tax expenditure incentivizes home ownership.

By way of comparison, tax expenditures currently aggregate to something on the order of $1.5 trillion annually, which represents about a third of government expenditures or around 6.8 percent of the GDP. The Joint Committee on Taxation identifies the broad categories of tax expenditures as (a) income security, (b) commerce and housing, (c)health, (d) education, training, employment, and social services, (e) international affairs, and (f) other.

Something on the order of 90 percent of these tax expenditures benefit households and individuals, with the remainder applying to businesses. As to who benefits from these tax expenditures, the chart at the top of this page shows that benefits of tax expenditures increase with rising household incomes; and an explosive increase accrues for those in the top quintile of income, with about a third of that quintile’s allocation going to the very top 1 percent. Put another way, those in the top 1 percent end up receiving greater benefits than those going to the entire lowest income quintile.

I supposed the world divides into two camps — one thinking that this distribution of benefits is just fine, and the other thinking it’s deplorable. Put me in camp number 2. Tax expenditures are effectively government subsidies, and these subsidies benefit the rich more generously than they do the poor. That’s a condition that deserves redress.

Correcting this situation need not require a drastic overhaul of all the various tax expenditure provisions in the tax code. Rather, we can sharply reduce the benefits going to the richest taxpayers by simply adjusting the rules relating to the already-in-place alternative minimum tax (AMT). AMT applies a minimum tax rate of 26 percent beyond a critical level of income with a subsequent step-up to 28 percent. Under the terms of this provision, tax credits and deductions get phased out as incomes rise above $539,900 for singles or $1,079,800 for married couples filing jointly.

This construct is a smart idea; but the above chart tells me that the existing schedule for phasing out these tax expenditures isn’t fast enough. As it stands, AMT rules allow AMT taxpayers to enjoy subsidies that are far too generous. Current rules should be amended to accelerate the phase out of allowable deductions.

Making the tax system fairer should be a priority for all of us, and this adjustment to the AMT provisions would be an excellent place to start.