This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every week we focus on one tax expenditure, explaining what it is, what purpose it’s intended to serve, and whether it’s effective.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project. Please visit this page for all our work on tax expenditures.
Since January, we have been counting down the country’s largest tax expenditures every week. As Tax Day approaches, we pause to review a common theme among many tax expenditures: how their “upside-down” design makes them more costly and undermines their effectiveness.
What is the “upside-down” effect?
Some of our largest government programs are structured as tax exclusions or tax deductions. Because marginal tax rates are higher for people who make more money, exclusions or deductions are more valuable for taxpayers in higher tax brackets. Whether the purpose is to promote homeownership, retirement savings, or investment, these programs tend to provide the largest government subsidies to those who need them the least, while providing little or no benefit to those who could use them the most.
Some tax provisions make sense as exclusions or deductions because they are intended to better measure one’s income and therefore one’s ability to pay taxes. For example, people and companies are generally allowed to deduct business expenses because the tax code aims to tax business income, not gross revenues.
But provisions like the mortgage interest deduction, the retirement and education savings incentives, and the charitable deduction are essentially subsidies for the desired activities. And they are “upside-down” subsidies because they give the biggest rewards to the people who would most likely take the desired action—buy a house, save disposable income—even without the incentive.
How does it work?
Consider the mortgage interest deduction, which is by far the largest government housing program. Its estimated cost of $98.6 billion in the upcoming fiscal year is more than twice as much as the discretionary budget for the Department of Housing and Urban Development. If a family in the 15 percent tax bracket claims the deduction (assuming it itemizes its expenses, which is unlikely), the government essentially matches 15 cents for every dollar in mortgage interest paid. Families in the highest 35 percent tax bracket get the largest benefit: 35 cents for every dollar in mortgage interest.
Of course, taxpayers in higher tax brackets tend to have bigger homes and bigger mortgages, and therefore more deductible interest. And so wealthy taxpayers with larger homes get the greatest benefit from the deduction:[1]
What’s the problem with upside-down tax spending programs?
In addition to fairness concerns, the “upside-down” nature of such deductions raises questions about these programs’ efficacy. If policymakers were designing a new government program to encourage homeownership, they’d probably target incentives toward people who most need them or who are most likely to respond to them. Giving wealthy taxpayers with incomes of more than $250,000 a housing subsidy 10 times as large as families making $40,000 to $75,000 is clearly not the most cost-effective way of encouraging homeownership.[2]
How can we reduce the upside-down effect?
There is a growing consensus among experts engaged in the ongoing budget debate that making tax expenditures more efficient is an important part of reducing the federal deficit. Many experts are therefore focused on reducing the upside-down effect of exclusions and deductions.
The president’s National Commission on Fiscal Responsibility and Reform, for example, proposed to turn itemized deductions into 12 percent tax credits. That is, if you pay $1,000 in mortgage interest, you could reduce your tax bill by $120, regardless of your tax bracket. This would give the same tax benefit to families in the lowest tax bracket as to all other families. Similarly, the Bipartisan Policy Center’s Debt Reduction Task Force would replace itemized deductions with 15 percent refundable tax credits. (A “refundable” credit means it can benefit people with no federal income tax liability.)
To be sure, these are dramatic policy reforms. They could have negative repercussions if implemented too soon. In the case of the mortgage deduction, implementing such significant changes too quickly could hurt housing markets at a time when 23 percent of taxpayers are already “underwater” on their mortgages.
President Barack Obama proposes a more measured approach: capping the value of itemized deductions for wealthy taxpayers at 28 percent. This would give taxpayers in the 33 percent and 35 percent bracket the same subsidies as taxpayers in the 28 percent bracket.
“The tax code is loaded up with spending on things like itemized deductions,” the president said in his deficit-reduction speech this week. “And while I agree with the goals of many of these deductions, from homeownership to charitable giving, we can’t ignore the fact that they provide millionaires an average tax break of $75,000 but do nothing for the typical middle-class family that doesn’t itemize.”
Obama’s proposal on itemized deductions is an important, yet measured step in the right direction that leaves middle-class taxpayers unaffected. It would constitute a $321 billion cut in tax-code spending over 10 years—nearly as much per year as the current-year budget deal struck last week between the White House and Congress was billed as cutting.
When it comes to cutting inefficient spending out of the budget, tax expenditures are a much better place to look than direct spending programs. Addressing the “upside-down” problem by making sure the wealthy don’t benefit more from itemized deductions than middle-class taxpayers is an important first step toward improving the effectiveness of tax-code spending while reducing the deficit.
All tax-code spending programs, especially those that confer special benefits to the wealthiest Americans, should be subject to the same scrutiny.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
“Tax Expenditure of the Week” will return in May, shining light on more hidden tax-code spending. Please visit our new tax expenditure page for all our work on government spending through the tax code.
Endnotes
[1]. James Poterba and Todd Sinai, “Tax-Expenditures for Owner-Occupied Housing: Deductions for Property Taxes and Mortgage Interest and the Exclusion of Imputed Rental Income,” available at http://real.wharton.upenn.edu/~sinai/papers/Poterba-Sinai-2008-ASSA-final.pdf.
[2]. Most homeowners claim the standard deduction rather than the mortgage interest deduction because it is more valuable to them. Nonetheless, the standard deduction is worth much less for taxpayers in lower brackets than the mortgage interest deduction is for top-bracket taxpayers. For a family in the 25 percent bracket, the current standard deduction of $11,600 is worth $2,900.