Off the Charts Blog | Center on Budget and Policy Priorities

Congressional Republicans reportedly plan to use the need later this year for the President and Congress to raise the federal debt limit — and the prospect of default if policymakers fail to do so — to force action on an aggressive approach to tax reform.  How they would square their desire for revenue-neutral tax reform with the proposals they’ve offered and the statements they’ve made remains a very open question.

The only tax reform plan that congressional Republicans have produced to date, in the House-passed Ryan budget, would shrink the vast collection of tax credits, deductions, and other preferences, known as “tax expenditures,” to pay for cutting the top rate to as low as 25 percent.  Overall revenues wouldn’t change.

As Jonathan Chait notes, it’s astonishing that Republicans, who in 2011 refused to raise the debt limit until the President agreed to reduce deficits, are now considering using the same leverage to prevent a reduction in the deficit through tax reform that raises revenue.  Moreover, as a recent Politico article highlighted, Republicans still haven’t offered any actual tax expenditure changes to pay for their desired tax cuts.

The Urban-Brookings Tax Policy Center estimated that the Ryan plan’s specified tax-cut goals would dig a ten-year revenue hole of $5.7 trillion, while disproportionately benefiting the highest-income households.  The Ryan plan gives no specifics on how to pay for even one dollar of this amount.

To provide some perspective, the President’s proposal to cap the value of the largest individual tax expenditures at 28 percent would raise $529 billion over ten years.  So the GOP would need to cut tax expenditures by ten times as much as the Obama proposal just to tread water in the nation’s pool of debt.

The Politico story describes a recent House hearing on the mortgage interest deduction, which economists from across the political spectrum recognize is ripe for reform.  The deduction is, however, rather popular, and “top Republicans on the House Ways and Means Committee made clear . . . that they plan to proceed with caution when it comes to deciding [its] fate,” the story reported.

Let’s face it, proceeding with caution won’t raise $5.7 trillion.

Cutting popular tax expenditures is extremely difficult.  Policymakers should pursue modest and politically realistic reforms in tax expenditures and dedicate the savings to long-term deficit reduction.

Obama’s 28 percent cap is not only modest but also equitable.  It’s politically realistic, as well:  during last year’s “fiscal cliff” negotiations, House Speaker John Boehner called for raising $800 billion in revenues through tax expenditure reform, and his staff suggested a type of 28 percent limit on certain tax expenditures as one possible way to do so.  This year, policymakers should enact the proposal into law.

Roughly 27 million working families with low or moderate incomes received the Earned Income Tax Credit (EITC) this tax season to help offset their federal income and payroll taxes.  The EITC encourages work, research has long shown; the EITC expansions of the 1990s did as much to expand work among single mothers as did welfare reform of 1996.  And, exciting new research shows that the EITC’s benefits extend beyond working parents to their children — both when they are young and as adults, as our revised paper explains.

• Healthier infants. Researchers compared changes in birth outcomes for mothers who likely received the largest increases in their EITCs under the 1990s expansions and mothers who likely received the smallest increases.  They found that infants born to mothers who likely received the largest increases had the greatest improvements in a number of areas, such as low-weight births and premature births.

• Better school performance. Researchers who studied nearly two decades of data on mothers and their children concluded that additional income from the EITC leads to significant increases in students’ test scores. Similarly, a credit that’s worth about $3,000 a year during a child’s early years may boost his or her achievement by the equivalent of about two extra months of schooling.

• Higher earnings as adults. Children whose families receive income from refundable tax credits (such as the EITC) are likelier to attend college; they also likely work more and earn more as adults (see graphic). Those same children are also likelier to avoid the early onset of disabilities and other illnesses associated with child poverty, which further enhances their ability to earn more as adults.

In recognition of Tax Day, we’ve collected our top ten charts related to federal taxes.  Together, they provide useful context for ongoing debates about how to reduce deficits and reform the tax code.

Our first chart, below, reminds us what taxes pay for.  National defense, Social Security, and major health programs like Medicare and Medicaid account for roughly three-fifths of federal spending.  Safety net programs and interest on the debt account for 12 percent and 6 percent of federal spending, respectively, while the remaining 20 percent goes to other areas such as roads, education, and health and science research.

Our second chart, below, shows where federal revenues come from.  Individual income taxes make up a little under half of all federal revenues — and have for more than half a century.

Payroll taxes make up a much larger share of federal revenues than in earlier decades, while corporate income taxes make up a much smaller share.  In fact, corporate tax revenues are near record lows when measured as a share of the economy, even though corporate profits are at historic highs.

Many business leaders have called for cutting the top U.S. statutory corporate tax rate of 35 percent, which is high by international standards.  But the average tax rate — that is, the share of their profits that companies actually pay in U.S. taxes — is much lower because of the many deductions, credits, and other write-offs that corporations can take.  Many corporations pay very little tax.

As for taxes on individuals, the country’s overall tax system — counting state and local taxes as well as federal taxes — is modestly progressive, as our third chart, below, shows.  Low-and moderate-income Americans pay significant shares of their income in taxes.

Policymakers considering changes in tax policy must keep in mind the economic context, including the dramatic increase in inequality in recent decades.  Congressional Budget Office data show that incomes grew at much faster rates for high-income people than for everyone else between 1979 and 2009 (the most recent year available).

One way to look at the impact of this unequal growth is to compare the average 2009 income for households in different income groups to what it would have been if the income of every group had grown at the same rate since 1979.

Our fourth chart, below, and the accompanying table give the results.  They show, for example, that the average middle-income family had $8,700 less after-tax income in 2009, and an average household in the top 1 percent had $349,000 more, than if incomes of all groups had grown at the same rate since 1979.

The sharp growth in income inequality suggests that higher-income taxpayers can and should contribute more in taxes to help reduce deficits.

The fifth chart, below, shows that both parties have recognized the need to raise more revenue to help reduce deficits.  During the December 2012 budget negotiations between President Obama and House Speaker John Boehner, both sides called for much larger tax increases than those in the January 2013 “fiscal cliff” deal, the American Taxpayer Relief Act (ATRA), as the fifth chart, below, shows.

Moreover, the bulk of the deficit savings enacted to date — including ATRA and earlier legislation, most notably the 2011 Budget Control Act (BCA) — have come from spending cuts rather than revenues.

An obvious place to turn for more revenue is reforming tax expenditures.  As a group, they cost more than Social Security or Medicare and Medicaid combined, as our sixth chart, below, shows.

Both parties have recognized the need for tax expenditure reform.  For example, Speaker Boehner’s December 3 offer called for raising $800 billion in revenues entirely through tax expenditure reforms.  And Harvard economist Martin Feldstein, former chair of President Reagan’s Council of Economic Advisers, has said that “cutting tax expenditures is really the best way to reduce government spending.”

Tax expenditures are not only costly; many share a design flaw that makes them both economically inefficient and inequitable.  Because their value is based on a person’s tax rate, it rises as income rises, so the biggest subsidies go to higher-income people — even though they least need a subsidy to do what the subsidy is supposed to encourage, like buy a house or donate to charity.

The mortgage interest deduction is a good example, as our seventh chart shows.

The design of the mortgage interest deduction is “upside down.”  For example, an investment banker making $675,000 pays about 65 cents per dollar of mortgage interest, and the taxpayers pick up the remaining 35 cents.   By contrast, a schoolteacher making $45,000 pays 85 cents of every dollar of mortgage interest and taxpayers pick up 15 cents.  Thus the banker’s subsidy represents a greater share of the banker’s mortgage interest expenses than is the case for the schoolteacher.  In addition, the high-income banker is likely to have a more expensive house and thus a larger mortgage than the schoolteacher, further increasing the disparity in the subsidy each receives.

Because it could prove politically difficult to reform tax expenditures on a case-by-case basis, several recent proposals would impose an across-the-board limit on tax expenditures for high-income people.

The soundest of these proposals is President Obama’s proposal to cap the value of certain tax expenditures at 28 percent.  The eighth chart, below, shows that this proposal would raise more than half a trillion dollars over the coming decade.

At the same time, policymakers should close loopholes that allow wealthy people to avoid substantial tax.

One example is the tax break that allows investment fund managers to pay taxes on a large part of their income — their “carried interest,” or the right to a share of the fund’s profits — at the 20 percent capital gains tax rate rather than at normal income tax rates of up to 39.6 percent.

As a result of this tax break, a hedge fund manager earning $10 million or more can pay a smaller share of his income in federal income taxes than a middle-income schoolteacher or policeman.

The House-passed Ryan budget also calls for tax expenditure reforms.  But, whereas the President’s proposal would use the resulting savings to reduce the deficit, the Ryan budget would use them to pay for a new round of tax cuts.

The Ryan budget lays out tax-cut goals that would reduce revenues by $5.7 trillion over ten years, according to the Urban-Brookings Tax Policy Center.  It implies that these tax cuts would be fully offset by tax expenditure savings but doesn’t specify any actual changes in tax expenditures to accomplish this.  And, as our ninth chart, below, shows, the $5.7 trillion revenue hole that the budget’s tax-cut goals would create is even larger than the budget’s $5.2 trillion in program cuts.

In addition to being extremely costly, the Ryan budget’s tax-cut goals are heavily tilted towards people with the highest incomes, as our tenth chart, below, shows.

We estimate that the individual income tax cuts specified in the budget (assuming they met their goals, including a top rate of 25 percent) would raise after-tax incomes by 15.4 percent among households with annual incomes above $1 million but by just 1.8 percent for households with incomes between $50,000 and $75,000.

In dollar terms, the tax cuts would be worth an average of $330,000 apiece to those millionaire households, compared to $1,700 for the middle-class households.

The revenue levels in the Ryan budget imply that the cost of its tax-cut goals will be offset by scaling back tax expenditures.  But Tax Policy Center analyses indicate that if policymakers coupled the Ryan tax-cut goals with sweeping (and likely politically implausible) cuts in tax expenditures for households with incomes above $200,000, these households would still receive a large net tax cut.

As a result, to fully finance the net tax cuts for people with incomes over $200,000, taxes on people below $200,000 would very likely have to rise.  Alternatively, if those with incomes under $200,000 were protected from tax increases, then the Ryan tax changes would add mightily to the deficit.

Federal taxes on middle-income Americans are near historic lows, our updated report explains, and that’s true whether you’re talking about federal income taxes or all federal taxes.

When it comes to income taxes, a family of four in the exact middle of the income spectrum will pay only 5.3 percent of its 2013 income in federal income taxes next year, according to a new analysis by the Urban-Brookings Tax Policy Center.

Average income tax rates for these typical families have been lower during the Bush and Obama Administrations than at any time since the 1950s (see graph).  Taxes were particularly low from 2008 to 2010 because of the Recovery Rebate Credit and the Making Work Pay Tax Credit, which have since expired.

When it comes to overall federal taxes, households in the middle fifth of the income spectrum paid an average of 11.1 percent of their income in taxes in 2009, the latest year for which data are available, according to the Congressional Budget Office (CBO).  This is the lowest on record in data that go back to 1979.

When CBO publishes data for more recent years (such as 2013), overall federal average tax rates on this middle group will likely be higher — though still low historically — because they will reflect the expiration of Making Work Pay and other temporary tax cuts, including the payroll tax cut that expired at the end of last year.

The expiration of the payroll tax cut is the biggest tax change for most people in 2013.  As this table shows, the tax cut helped workers in a wide range of income groups, and its expiration is a key contributor to the slowdown in economic growth that CBO forecasts for 2013.

As recent comments from House Speaker John Boehner make clear, a central issue in debates over sequestration and other budget issues is whether higher revenues — on top of those in January’s “fiscal cliff” deal — will play any role in reducing deficits.

The revenues in that deal came mostly from raising tax rates on high-income households.  Our new report explains why the next stage of deficit reduction should include major reforms to tax deductions, exclusions, and other tax breaks known collectively as “tax expenditures” and examines several specific proposals.

Tax expenditures are ripe for reform.  They are very costly, totaling nearly $1.1 trillion in 2011 — more than Social Security or Medicare and Medicaid combined (see graph.)  And many are “upside down,” meaning they give the biggest benefits to high-income taxpayers, who least need a financial incentive to do whatever the tax break is designed to promote (like buy a home or save for retirement).

Also, there is strong support on both sides of the aisle for reforming them. During the fiscal cliff talks, in fact, Speaker Boehner suggested raising $800 billion over the next decade — considerably more than the fiscal cliff deal will raise — by limiting tax expenditures.

Our report explores two complementary kinds of tax expenditure reforms:

• Setting an across-the-board limit. For example, the President proposes limiting the value of itemized deductions and certain other tax expenditures to 28 cents on the dollar.  This proposal would retain tax incentives for desired activities like charitable giving.  It would also reduce, though not eliminate, the “upside down” nature of some major tax expenditures by shrinking their value for high-income people.

• Closing tax breaks that allow wealthy people to avoid substantial tax. Some tax expenditures are embedded in the tax code in a way that would make it hard to touch them through an across-the-board limit.  Policymakers should address them directly.

One example is the carried interest tax break, which allows investment fund managers to pay taxes on a large part of their income  at the 20 percent capital gains tax rate rather than at normal income tax rates of up to 39.6 percent.  As a result of this tax break, a hedge fund manager earning $10 million or more can pay a smaller share of his income in federal income taxes than a middle-income schoolteacher or policeman.

We’ll look more closely at these kinds of reforms in an upcoming post.

Policymakers should combine a well-designed tax-expenditure limit like the President’s 28-percent cap proposal with reforms of certain tax expenditures that wouldn’t be subject to the limit.  In so doing, they could raise revenue as part of a balanced deficit-reduction package while making the tax code fairer and more efficient.