Reforming Tax Expenditures to Enhance Fiscal Sustainability and Equity

 Reforming Tax Expenditures to Enhance Fiscal Sustainability and Equity

Introduction

Tax expenditures, including deductions, exemptions, and credits, are a significant but often overlooked component of federal spending. These provisions, embedded within the tax code, function as indirect subsidies for specific activities, industries, or groups. While tax expenditures can incentivize beneficial behaviors, such as homeownership or retirement savings, they also reduce federal revenues by hundreds of billions of dollars annually. Reforming tax expenditures is a critical step in addressing budgetary challenges and promoting a more equitable and efficient tax system. This essay explores key areas for reform, including the mortgage interest deduction, retirement savings incentives, and corporate tax breaks, while considering the broader economic and social implications of these changes.

The Role and Scope of Tax Expenditures

Tax expenditures are a substantial component of federal fiscal policy, accounting for approximately 8-10% of GDP. These provisions reduce the tax liabilities of individuals and corporations, effectively functioning as government spending through the tax code. While some tax expenditures serve important policy objectives, others disproportionately benefit higher-income households or specific industries, raising questions about their equity and efficiency.

Reforming the Mortgage Interest Deduction

The mortgage interest deduction (MID) is one of the largest and most controversial tax expenditures, costing the federal government over $25 billion annually. Designed to encourage homeownership, the MID primarily benefits higher-income households, as it is limited to taxpayers who itemize deductions.

Capping the Deduction

Capping the MID at a lower level of mortgage debt—such as $500,000 instead of the current $750,000—would reduce its cost while preserving benefits for middle-class homeowners. This reform targets the deduction’s benefits more effectively without discouraging homeownership among lower- and middle-income families.

Converting the Deduction to a Credit

Replacing the deduction with a flat-rate credit would make the subsidy more equitable, providing the same benefit to all eligible taxpayers regardless of their income or tax bracket. A credit could also incentivize homeownership among low- and moderate-income households, aligning with the policy’s original intent.

Addressing Housing Affordability

In addition to reforming the MID, policymakers should consider complementary measures to address housing affordability. For instance, expanding tax credits for renters or investing in affordable housing development would provide broader support for housing security.

Rethinking Retirement Savings Incentives

Tax incentives for retirement savings, such as those for 401(k)s and IRAs, are intended to promote financial security in retirement. However, these incentives disproportionately benefit higher-income individuals, who are more likely to have access to employer-sponsored plans and the financial capacity to save.

Limiting Benefits for High-Income Individuals

Capping the tax benefits for contributions above a certain threshold would ensure that incentives are targeted toward individuals who need them most. For example, reducing the deductibility of contributions for individuals earning over $200,000 annually would align benefits with broader equity goals.

Encouraging Universal Coverage

Expanding access to retirement savings plans through initiatives like automatic enrollment or state-sponsored plans for workers without employer-sponsored options would increase participation rates among lower-income and part-time workers. Providing refundable tax credits for contributions could further incentivize savings in underserved populations.

Balancing Immediate Revenue Needs with Long-Term Goals

While reforms to retirement savings incentives can generate immediate revenue, they must also consider the long-term benefits of reducing reliance on Social Security and other public assistance programs. Policymakers should design reforms that maintain a balance between fiscal responsibility and retirement security.

Reforming Corporate Tax Expenditures

Corporate tax expenditures, including deductions, credits, and preferential rates, reduce the effective tax rate for many businesses. While some of these provisions support innovation and economic growth, others create distortions and inequities within the tax system.

Closing Industry-Specific Loopholes

Many corporate tax expenditures disproportionately benefit certain industries, such as oil and gas or real estate, at the expense of others. Eliminating or reducing these industry-specific breaks would level the playing field and increase federal revenues. For instance, phasing out the deduction for intangible drilling costs in the fossil fuel industry could generate billions in savings annually.

Implementing a Minimum Corporate Tax Rate

A minimum tax rate on corporate profits, such as the global minimum tax agreed upon by OECD countries, would ensure that all corporations contribute a fair share. This measure addresses concerns about profit-shifting and base erosion while promoting international tax cooperation.

Encouraging Research and Development

While reducing corporate tax expenditures overall, maintaining or enhancing incentives for research and development (R&D) is essential for fostering innovation and economic growth. Policymakers should prioritize tax provisions that generate substantial public benefits, such as R&D credits and clean energy incentives.

Addressing Equity and Progressivity

Tax expenditure reforms must address the inequities embedded in the current system. Many tax breaks disproportionately benefit higher-income households, exacerbating income inequality and undermining public confidence in the tax system.

Expanding Support for Low-Income Taxpayers

Reforms should include measures to enhance support for low-income taxpayers, such as expanding the Earned Income Tax Credit (EITC) or Child Tax Credit (CTC). These credits provide direct financial assistance to low-income families, offsetting the impact of other reforms.

Balancing Regressive and Progressive Changes

Policymakers must balance regressive changes, such as reducing universal tax benefits, with progressive measures that increase support for disadvantaged groups. For example, phasing out regressive deductions while expanding refundable credits ensures that reforms promote equity.

Economic and Fiscal Implications

Reforming tax expenditures has significant implications for the economy and federal budget. While these changes can generate substantial revenue, they may also affect taxpayer behavior and economic activity.

Revenue Generation

Reducing or eliminating inefficient tax expenditures can generate hundreds of billions of dollars in additional revenue, helping to reduce budget deficits and fund critical priorities such as infrastructure, education, and healthcare.

Behavioral Responses

Changes to tax expenditures can influence individual and corporate behavior, potentially offsetting some of the intended revenue gains. Policymakers must carefully design reforms to minimize unintended consequences, such as reduced charitable giving or decreased investment in housing and retirement savings.

Economic Growth

Redirecting resources from inefficient tax expenditures to productive investments in infrastructure, education, and technology can boost economic growth. These investments create jobs, enhance productivity, and strengthen long-term competitiveness.

Implementing Reforms

Successful implementation of tax expenditure reforms requires careful planning, stakeholder engagement, and public communication. Policymakers must address political resistance and build broad support for changes.

Phasing in Changes

Gradual implementation of reforms allows taxpayers and businesses to adjust, reducing potential disruptions. For example, phasing out certain deductions over several years provides time for affected industries to adapt.

Enhancing Transparency

Improving transparency around tax expenditures helps build public understanding and support for reforms. Publishing regular reports on the cost and distributional effects of tax expenditures promotes accountability and informed decision-making.

Building Political Consensus

Achieving meaningful reform requires bipartisan cooperation and stakeholder engagement. Policymakers should prioritize areas of common ground, such as closing loopholes and reducing complexity, to build momentum for broader changes.

Conclusion

Reforming tax expenditures is a critical component of addressing the federal government’s fiscal challenges while promoting equity and efficiency within the tax system. By targeting inefficient and regressive provisions, policymakers can generate substantial revenue, reduce income inequality, and support economic growth. Achieving these goals requires thoughtful design, careful implementation, and a commitment to balancing fiscal responsibility with social equity.