Giving tax breaks where credits are due
President Bush’s health care plan underscores the dilemma with tax incentives: They tend to treat the rich rather than the problem.
By David Morris, originally published in the Mineapolis Star Tribune, March 19, 2007
Critics of George Bush’s proposal to expand the number of Americans with health insurance correctly identify its weak link: a reliance on tax deductions.
According to the Kaiser Family Foundation, 43 percent of the 46 million uninsured have no income tax liability. As a result, the White House predicts that its proposal will reduce the ranks of the uninsured by only 7 to 10 percent.
Hopefully, the critical weakness of this health care proposal will open the door to a wider debate about the shortcomings of tax deductions and tax credits overall. The cost of tax breaks — or, as economists now more accurately describe them, “tax expenditures” — is $500 billion to $800 billion a year, or about 5 percent of the gross domestic product.
Most of these tax breaks are inherently unfair. A $1,000 tax deduction might be worth $400 to a wealthy household, $200 to a middle-income household, and not a penny to a poor family. Indeed, 37 percent of all households — home to almost half of all children — have no tax liability.
Why do we skew tax breaks to favor richer people and more profitable businesses? No evidence suggests that they have a higher propensity to engage in socially beneficial behavior. Just ask any waitress or waiter who tips them better — the wealthy or the working class.
There is a way to avoid this inequality. Make the tax incentives refundable tax credits. This is how the earned-income tax credit works. The government will send you a check even if you pay no taxes. As a result, the earned-income tax credit is now our largest and arguably by far the most effective antipoverty initiative.
More typical is our housing tax incentives. For all but the very rich, houses represent the single largest source of lifetime financial savings. The lack of housing, and the resulting lack of savings, is particularly high among blacks and Hispanics. In 2005, government provided $150 billion to homeowners in tax subsidies. But the way the subsidies were structured did little to improve the situation.
Why not replace the housing tax deductions with a level refundable tax credit? It could be revenue-neutral by using the current Treasury loss for housing deductions as the cap.
Economists Richard Green of George Washington University and Kerry Vandell of the University of Wisconsin have examined such a system and predicted that it could increase overall home ownership by 3 to 5 percentage points. Even more impressive, a housing tax credit could increase home ownership by up to 8 percentage points among the lowest-income households.
Economists at the Brookings Institution and the Massachusetts Institute of Technology have proposed that we replace the current tax incentives for contributions to retirement plans with a 30 percent government matching contribution. Under this scenario, worker contributions to 401(k) accounts would no longer be excluded from taxable income. Contributions to IRAs would no longer be tax-deductible. Employer contributions to the plan would be taxable, just as wages are now.
To the Treasury, the change would be revenue-neutral. To the recipient, the tax policy would be a great deal fairer.
As designed now, tax breaks are not only inequitable, they are inefficient. This is particularly striking with federal renewable energy incentives.
Owners of wind turbines qualify for a federal tax credit per kilowatt hour of electricity generated. But farmers and other rural residents very rarely earn sufficient taxable income to take advantage of this incentive. As a result, to enable “locally owned” wind turbines, which produce the same amount of wind energy while generating a far higher amount of local and regional economic activity, a cumbersome corporate structure is created. The locals become partners with Wall Street or corporate investment firms that take the tax incentives and provide the financing.
If the government converted the incentive into a refundable tax credit, the cost to the Treasury would be the same. But 100 percent of the incentive would reach the local owners, and the rural development impact would be far greater.
About ILSR: The Institute for Local Self-Reliance is a nonprofit organization founded in 1974 to advance sustainable, equitable, and community-centered economic development through research and educational activities and technical assistance. More at http://www.ilsr.org