Wednesday, January 12, 2011

Show Me the Money: A Hidden Source of Funding for Federal Deficit Reduction

By Professor Katie Pratt

This op-ed was originally published in the Jan. 12, 2011 edition of the Los Angeles Daily Journal.

If President Barack Obama and Congress ever decide to get serious about

federal deficit reduction, there is a potential $1 trillion deficit reduction funding source that they have ignored. With annual federal budget deficits projected to average $1 trillion for the next decade, they should seriously consider this funding source, instead of assuming - contrary to fact - that radical cuts in federal discretionary spending programs can painlessly and equitably achieve meaningful deficit reduction.

Last week, the new Speaker of the House, John Boehner, citing the "Pledge to America," committed to cut federal spending, reduce federal budget deficits, cut federal taxes and shrink the size of the federal government. Democrats also have acknowledged the serious threat posed by projected

federal budget deficits, and Obama has proposed a freeze on discretionary spending programs. Freezing discretionary spending or cutting wasteful discretionary spending will not achieve meaningful deficit reduction, however, because the total funding for non-defense domestic discretionary spending programs adds up to only about one-sixth of the federal "spending" budget; defense and homeland-security spending, interest on the federal debt and entitlement-benefit spending account for most federal outlays.

Boehner and other prominent Republicans do not acknowledge any connection between tax cuts and federal budget deficits, despite the fact that federal revenue fell during the Bush administration to the lowest levels since the 1950s, and that revenue loss has been a major contributor to federal budget deficits. Instead, they frame tax cuts as "pro-growth" measures and budget deficits as the result of the federal government spending too much money on wasteful and inefficient programs. Many voters also erroneously assume that spending cuts can be achieved painlessly by cutting wasteful, inefficient or overly generous programs.

When House committees and the Government Accountability Office were required in 2003 to identify waste in federal spending programs, they identified potential savings that would total around $7 billion in 2014, a significant amount of money in nominal terms, but a trivial amount compared to the looming budget deficits. Attempting to balance the federal budget entirely through "spending" cuts would require radical, painful cuts in programs that provide real benefits to those in need.

Budget expert Elizabeth Garrett, a member of the Bush Tax Reform Panel, has argued:

"For too long, policymakers have identified the spending side of the fiscal equation with dispensable 'waste, fraud and abuse,' rather than acknowledging the areas where government is the best provider of vital goods and services and working to design and fund those government programs so they operate well. The events surrounding Hurricane Katrina are a dramatic example of the folly of failing to adequately fund expenditures that should be made by government - funding for infrastructure like levees and highways; money to develop and implement adequate disaster management plans; revenues to ensure safety and security for all our citizens.

Although we can cut some discretionary spending, we also can search for wasteful, duplicative or inefficient federal spending in another place most voters would never think of - the federal tax code. Subsidies totaling over $1 trillion, known as "tax expenditures" are woven throughout the federal tax code. These tax expenditures provide federal subsidies that are targeted to specific industries and activities. Some of these tax expenditures (e.g., the home mortgage interest deduction) are well known and considered by most Americans as entitlements. Many tax expenditures are hidden from public view, however, buried in the complex morass of the federal tax code.

Unlike discretionary spending programs, most tax expenditures are not subject to annual budget scrutiny or performance review (such as cost-benefit analysis), and often provide disproportionate subsidies to upper-income Americans.

Tax expenditures also distort economic decision-making, which causes misallocations and reduces growth of the economy. The 2005 Bush Tax Reform Panel report noted that, due to tax subsidies, the effective tax rate on investment in housing is significantly lower than the tax rate on businesses. This tax differential encourages overinvestment in housing and underinvestment in businesses that could provide new jobs for unemployed Americans.

Tax expenditures have proliferated in recent years precisely because they appear to be tax cuts, which just about every voter likes. Who pays the price for the tax subsidies? The answer is unclear, making the costs of many tax expenditures even more hidden than their benefits. The losers may be all taxpayers who pay higher taxes to fund the tax subsidies, or future generations (if the subsidies are deficit financed) or beneficiaries of discretionary programs that are cut (e.g., Hurricane Katrina victims who suffered as a result of cuts in the budget for the New Orleans levee maintenance program). Also, lobbyists and members of Congress know that tax expenditures are not subject to annual budget competition or performance review and typically continue indefinitely. If you were a member of Congress and wanted to create a subsidy program to benefit a constituency, where would you put it? It's no wonder that the House and Senate tax committees receive the highest campaign contributions.

Although politicians are willing to acknowledge the potential problems caused by federal budget deficits, budget experts Alice Rivlin and Isabell Sawhill observe that politicians "have little incentive to do much about deficits because serious deficit reduction is not likely to be a winning political strategy." They note that "Democrats have learned that hair-shirt policies don't win them any friends and may even backfire. The Clinton Administration spent eight years trying to bring the deficits it inherited under control, only to see the surpluses that emerged at the end of their time in office used to finance a large tax cut that primarily benefited a Republican constituency. Republicans, for their part, have gone from being the party of fiscal discipline to the party that sees deficits as a useful tool for constraining federal spending and shrinking the size of government.

The dominant Republican tax-cutting-is-always-good approach is consistent with the theory, referred to as "starve the beast," that the best way to force Congress to cut wasteful and inefficient federal spending is to enact tax cuts that starve the federal government of revenue. Economists William Gale and Peter Orszag argue, however, that recent congressional behavior does not support the starve-the-beast theory; instead it supports a theory that "policymakers jointly go through periods of fiscal restraint and fiscal largess, and the restraint or largess occur simultaneously on both the tax and spending sides." For example, they note that 86 percent of the members of Congress who signed the Republican "No New Taxes" pledge subsequently supported the creation of a multi-trillion-dollar new federal entitlement program, the Medicare prescription drug program. In spite of Republican rhetoric about cutting federal government spending, President George W. Bush's budgets increased the overall size of the federal government, and Obama has continued that trend toward larger government.

Economist Gene Steuerle bemoans the new "Spend It First" budget dynamic: "The name of the game in to spend money before somebody else does. Lawmakers don't limit themselves to the money currently in hand. Whatever economic growth might provide for years or decades to come is now fair game.... Rather than get the budget under control, tax-cutters have joined advocates of program expansion in this dangerous game of pre-spending. Rather than retract untenable promises already made, elected officials compete to make even more unsustainable promises.... [S]pending ahead in this way has become the most glaring economic problem with federal tax, spending and budget policy. And there is no end in sight.

If Boehner and Republicans are concerned about the size of government, they should consider the subsidy programs that are hidden in the federal tax code, not just the discretionary spending programs. Some tax expenditures would survive cost-benefit analysis, but many would not. In addition, some worthwhile subsidies could be kept but improved through reform.

It's no wonder that aggregate tax expenditures have grown enormously; to voters and politicians, tax expenditures look like "free money," but significantly reduce federal revenue without any accountability. To stop the budget hemorrhage that is flowing through the federal tax system, we should seriously consider whether tax expenditures can be capped, cut, or reformed. As an updated version of the old adage goes, "a trillion here, a trillion there, and pretty soon we're talking real money."

Katherine Pratt is a professor of tax law at Loyola Law School, Los Angeles. She will moderate a session during the symposium, "Starving the Hidden Beast: New Approaches to Tax Expenditure Reform," to be held on Friday, Jan. 14 at Loyola's downtown Los Angeles campus and co-presented by the Urban-Brookings Tax Policy Center. A live webstream of the conference will be available, and questions will be accepted online.

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