Congress uses the Tax Code to influence our behavior. Examples include deduction
ID: 2380339 • Letter: C
Question
Congress uses the Tax Code to influence our behavior. Examples include deductions for mortgage interest and property taxes to steer people to home ownership instead of renting. Tax credits for purchasing products that use alternative energy are another incentive. Likewise, deductions for charitable contributions encourage charitable donations. Is this a good (i.e., proper) way for Congress to achieve economic objectives? Can you identify other tax deductions or tax credits that encourage particular behaviors?Explanation / Answer
Just about everyone who has filled out a tax return knows how complicated tax code has become. Part of that complication stems from the fact that the government uses the tax code to encourage certain behaviors, from buying a house to holding a steady job. While the chief goal of the U.S. tax code is to raise money to fund the government, many of the tax credits and tax deductions are designed to reward certain actions, including saving for retirement and giving to charity, on the part of the taxpayers.
1.
Earned Income Tax Credit
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The earned income tax credit is designed to reward people for working and encourage those on public assistance to reenter the work force. This tax credit provides payments to low and moderate income taxpayers who earn income and support their families. The earned income tax credit is a refundable tax credit, meaning that taxpayers can take advantage of the money it provides, even if they do not have any tax liability.
Home Mortgage Interest Deduction
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The government plays a role in encouraging home ownership by providing a tax deduction for the money those homeowners pay in interest on their mortgages. Taxpayers who itemize their deductions can take this deduction and use it to significantly lower their tax bills. Those who itemize can also write off the amount of their real estate taxes, providing yet another incentive for people to own their own homes.
Retirement Plans
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The government also takes an interest in helping people save for a comfortable retirement. The IRS provides a number of retirement savings incentives, including allowing workers to deduct the money they contribute to 401k plans from their Federal taxable wages. The IRS also provides a tax deduction for IRA contributions for wage earners and SEP-IRA and SIMPLE-IRA deductions for small business owners and self-employed individuals.
Health Savings Account
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The IRS provides a tax deduction for individuals who open health savings accounts. This health savings account deduction is intended to encourage people to plan more effectively for the high cost of medical care. The government officials who helped develop the health savings account felt that putting consumers in charge of their health care spending would make smarter decisions, and the HSA deduction is designed to encourage that behavior.
Tax subsidies are the result of selective tax legislation1 that benefits particular groups of people or industries in the economy. In effect, they share the costs of certain actions between the private sector and the government and impact investment decisions by increasing the expected returns associated with a particular pattern of economic activity. Tax subsidies may be applied in a number of ways to any one or a combination of economic variables (land, labor, capital).
While some provisions (e.g., the general investment tax credits) may be available to an entire class of economic activity, such provisions may still be viewed as subsidies because other classes of economic activity are placed at a relative economic disadvantage. In this case, for example, the government has made a decision to favor capital-based productive methods rather than alternatives (such as labor). Similarly, subsidies to new investment favor supply expansions (such as new power plants) over improved efficiency in the use of existing capacity (such as many demand-side management approaches) and constitute a de facto governmental choice of the method by which to meet market demand.
Tax subsidies are generally measured in reference to a normative or baseline tax system, and estimates assume no other changes in the tax code. Each tax expenditure is calculated assuming that there is no interaction with other provisions. As a result, the estimates can't be added directly together without errors. As it is very difficult to estimate the potential interactions from simultaneous removal of multiple subsidies, though, most analyses do add the tax expenditure values together anyway.
Since the government forgoes revenue that would have been collected had there been no special legislation and must make up those revenues through higher taxes on other economic activities, these policies have real costs. These costs are classified as "tax expenditures." Within the United States, we are lucky in that two separate groups (the U.S. Treasury and the Joint Committee on Taxation) both independently estimate tax expenditures associate with current and proposed legislation. Many US states and countries have no information at all about these special tax rulings. As a general rule of thumb, where there is no light the largest mushrooms grow. However, even within the US, the estimates for tax losses for the same provision by the two bodies can differ by hundreds of millions of dollars. The estimation methods or assumptions are not made public, so improving the accuracy of these estimates is not clear-cut.
The stated goal of tax subsidies, according to the U.S. General Accounting Office, is to promote some policy objective such as "economic growth or a desirable expenditure pattern by taxpayers."2 However, there is a great deal of disagreement over whether particular tax benefits typically encourage "socially desirable" economic behavior.3 Further, even if the policies are effective, they are static and may become ineffective or counterproductive as circumstances (be they demographic, technological, or economic) change. For example, percentage depletion allowances were significantly expanded when crucial minerals were needed for war efforts. As these initial conditions changed, the policies did not necessarily evolve with them.
In summary, tax subsidies are neither inherently right or wrong. They are inherently distortionary, however, in that they alter patterns of economic activity to promote particular areas (targeted by Congress) that would not necessarily have received investment or consumer demand in the absence of the government intervention. The subsidies need to be considered as a real cost when evaluating alternative long-term energy options. These costs include the direct cost of increased taxes in other areas to individual taxpayers, and the indirect costs to the economy as a whole through the distortionary effect of the subsidies on R&D, investment, and consumption patterns.
There are a few issues to keep in mind regarding our net tax expenditure estimates. First, special taxes on energy have been treated as negative subsidies if they are used for general revenue purposes. If they are earmarked for specific energy-related uses, such as oil spill cleanup, they are considered user fees and are netted from the total government cost of dealing with the particular energy-related problem. Second, energy-payments such as royalties reflect a return to the resource-owner for selling the oil or minerals in question, and are not a tax. Finally, given the fact that the data regarding Treasury losses from tax provisions are somewhat crude and that interactions between the various tax preferences are not incorporated into these data, our quantification of the tax subsidy magnitude should be viewed as an estimate.
Tax subsidies increase expected returns by decreasing the costs associated with taxation. This is accomplished in four main ways: providing tax credits; altering the statutory tax rate; altering the taxable basis (i.e., the activities and expenses which are or are not included in the calculation of the tax base); and altering the taxable entity (such as by allowing losses from one corporation to off-set profits of another). Each of these methods of subsidizing private activity via the tax code has additional variants as well, which are described in more detail below.
A portion of certain expenditures may be deducted from net taxes owed.
Allowing one type of entity to pay a lower tax than others conveys a financial advantage to the firm with the lower tax rate.4 Three approaches are used to accomplish this end.
Although the actual percentage tax rate may remain constant, government intervention may redefine which activities must be included in the taxable basis to reduce the resultant net profit figure to which that percentage tax is applied. These policies encourage taxpayers to shift spending to the activities that will help them reduce their final tax bill. By altering either the timing or the size of tax deductions, the government creates incentives to engage in particular behavior. The current deduction for intangible drilling costs associated with oil, gas, and mineral exploration is an example of this type of provision.
By allowing taxpayers to consolidate their tax returns in ways generally restricted by the IRS, the government may facilitate the offset of taxable income in one area with losses from another area. In some cases, taxpayers may be able to use consolidation to gain more in reduced taxes than they had actually put into the money-losing enterprise. Redefining the taxable entity gives rise to tax subsidies in at least two ways.
The financial loss to the U.S. Treasury from a particular tax subsidy depends on three factors: the size of the eligible industry or activity, the magnitude of allowable benefit, and the strictness with which eligibility is interpreted by the Tax Court. The important point to remember is that a 10 percent tax credit on oil and gas production can yield revenue losses far greater than a 50 percent solar energy credit, simply because of the relative sizes of the two industries.
The creation of an Alternative Minimum Tax (AMT) in the 1980s reduced the benefits of tax preferences for many in the energy sector. The AMT was developed to ensure that every profit-making venture paid some taxes. Thus, any eligibility for tax benefits below a company's AMT would not be able to be used. Conversely, any relaxation in AMT requirements (such as is provided to independent oil and gas producers in the Energy Policy Act of 1992) would result in higher tax expenditures. The Treasury and Joint Committee on Taxation estimates of tax expenditures used here already incorporate their best-guess on the impact of AMT limits on the size of the subsidies.
The size of the tax expenditure may be measured in two ways: net present value and annual flow. The net present value (NPV) method evaluates the total value of tax losses from a provision going forward. This approach is especially valuable when examining the relative costs of alternative policy options to achieve changes in market behavior. For example, examining the NPV of losses from the oil and gas exceptions to passive loss restrictions would help policy makers determine whether there were more efficient mechanisms to achieve the goal of improved domestic oil security. NPV estimates require assumptions about discount rates, future (potentially long-term) market conditions, the marginal tax rates of taxpayers in each year, and interactions of the tax benefit in question with other tax options. The NPV method has the added advantage that tax expenditure estimates are never negative (i.e., increasing returns to Treasury) as new activity using them declines.8
The annual flow method examines the reductions in tax collections from a tax provision in a single year rather than the for the entire life of the provision. The annual flow method is normally used in Earth Track analysis for a number of reasons. First, data on the magnitude of these losses were available both from the U.S. Treasury and the Joint Committee on Taxation. Second, the flow-through approach provides the "snap-shot" of total support for energy in a particular year that we were trying to obtain. Both methods are useful, and the NPV method should be done during consideration of any new provisions.
Treasury and JCT tax expenditure estimates, therefore, represent multiple years of investment behavior. Many tax subsidies allow items which are normally deducted from taxes over a 20-30 year period to be deducted in 10 years or less. In this example, for each of the first ten years after an investment is made, the Treasury will collect less tax revenue that it would have without the subsidy. Other provisions, such as investment tax credits, can only offset a certain amount of income. As a result, the credits may be "carried forward" and deducted against income in a future year.
Expanding this example to reflect aggregate investment in the economy means that for any single year of tax expenditure estimates (e.g., 1989), the deductions taken in 1989 from all earlier investments which have not yet been fully depreciated are included. To incorporate this multi-year aspect of investment tax credits and accelerated depreciation provisions, it is necessary to examine longer term patterns of investment in the energy sector.
Whether a tax subsidy is available to the producer or consumer of energy, benefits are shared between four parties: the producer (in the form of higher profits), the consumer (in the form of lower prices), the resource owner (in the form of higher royalties or rents), and the worker (in the form of higher wages). The pattern of allocation often changes over time with market conditions, as the relative scarcity of resources changes or the relative market power of these groups shifts.
Increasing expected profits to either producers or resource-owners will increase the supply of a material brought to market. Increasing wage rates will attract more, and perhaps better skilled, workers. Reducing price to the consumer will increase the demand for the energy source. In all four cases, money is transferred from the general taxpayers to the specific entity (often a much smaller group of taxpayers, always a different group from the one making consumption decisions) who owns the energy minerals, develops them, or uses them as fuel. For this reason, we are not concerned with which party ends up with the subsidies, only that the entire amount goes into increasing the attractiveness of a particular energy type.
There are important distinctions among the size of incentives received by various types of taxpayers. For example, whereas corporate expenditures for improved energy efficiency are tax deductible, individuals are governed by a different set of tax rules. As a result, expenditures by individuals for exactly the same purpose must be made with after-tax income.9
One other important point about tax subsidies is that they are estimates, and measure the revenue loss or private benefit of a provision given current estimated levels of growth and the existence of the tax subsidies.10 Although the actual deductions taken from a year could, in theory, be calculated from submitted income tax returns, in practice, such analyses are never publicly available. Therefore, tax expenditure estimates should not be interpreted as estimates of the increase in Federal receipts (or reductions in budget deficit) that would accompany the repeal of the special provisions.11 Such repeal could change economic growth and aggregate income, reducing aggregate demand and therefore overall tax collections. Second, since tax subsidies are enacted to encourage certain economic activity, removal of these subsidies would most likely yield significant changes in the level of activity occurring in the subsidized areas. Finally, tax subsidies may, to some degree, substitute for one another. Therefore, eliminating one or many of the subsidies would yield new tax avoidance behavior by taxpayers, and would affect the expected savings by removing any of the remaining provisions.12