A Tax Deduction is Not Government Spending

One of the tactics of opponents of the mortgage interest deduction (MID), the charitable expense deduction, and other itemized deductions is to brand these long-standing rules as tax earmarks/loopholes or government-spending-in-disguise.

The argument goes as follows. Suppose a homeowning taxpayer saves $2,000 on their taxes by claiming a deduction for mortgage interest payments. This line of thinking then claims that this tax saving is equivalent in budget terms to the government identifying that homeowner and mailing them a check for $2,000. One policy is a reduction in tax receipts (a tax expenditure) and the other is government spending (an expenditure), but they have the same effect on the deficit; hence, they are the same.

However, there’s a large philosophical difference between the two examples that the accounting arithmetic obscures. Under a government program, the government decides where, when, and how to spend the money. And that money originates as a tax or fee on someone’s income or consumption. On the other hand, under a tax expenditure, the taxpayer decides whether or not to qualify for the tax break. And if the taxpayer qualifies, then the foregone tax revenue is from their own income.

If one accepts that a tax expenditure is in fact government spending in disguise, then that argument, taken to its logical extreme, suggests that the government has first claim on all earned income, and by setting various tax rules via rates, credits, and deductions, it “spends” money by allowing taxpayers to keep it. No one would accept this proposition as valid, and nor should they. And for this reason alone, equating tax expenditures with government spending fails as an economic policy argument.

Indeed, the Supreme Court in April rejected the equivalency of tax expenditures with government spending for similar reasons.

More fundamentally, the definition of what is a tax expenditure is in fact very complex. To properly separate “good” tax adjustments from “bad” ones, you have to specify the ideal income tax first. And doing this objectively is nearly impossible. Even under a “clean” flat tax, you would need some deductions for the cost of investment, business, etc.; otherwise a flat tax would degenerate into a gross receipts tax. Once you introduce some adjustments, others must follow in order to accurately tax net income, as adjusted for family size and other considerations. Separating the “good” adjustments from the “bad” ones quickly becomes a subjective exercise based on one’s notion of what the true measure of taxable income should be.

For example, under the current income tax, while most credits and deductions are classified as tax expenditures, the progressive system of rates is not.  The set of increasing marginal rates means that some people pay a smaller average tax rate than others. Yet, in this case letting some people keep more of their income is not a tax expenditure, as least according to the government scorekeepers. Not even all deductions are treated the same in tax expenditure analysis. While the itemized deductions are tax expenditures, the standard deduction and the personal exemptions are not.

The politics of tax expenditures are more straightforward. In the ongoing debate over the federal deficit and raising the debt ceiling, the central argument is whether to include revenue increases in any agreement. One way to make it easier to accept increases in tax receipts is to label such moves as “cuts in tax expenditures” or “reducing government spending in the tax code.” The end result would be the same however. Taxpayers who made long-term economic decisions, such as buying a home, according to long-standing rules would find that their taxes would be higher and any prices connected to current tax rules would change (such as declines in housing prices).

The other claims against tax expenditures, and the mortgage interest deduction in particular, fail as well.  Branding the mortgage interest deduction (MID) as a tax loophole or earmark is nonsense. Almost 35 million taxpayers a year (representing about 100 million people in such homes) claim the deduction. And most homeowners will claim the MID at some point during their lives, particularly in the early years of a mortgage when they are paying mostly interest and relatively little principal.

So be careful of word games with tax policy. They may call it a government spending cut, but it’s the taxpayer who will end up with a higher tax bill.

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