Off the Charts Blog | Center on Budget and Policy Priorities

The new Congressional Budget Office (CBO) report on tax expenditures (credits, deductions, and other tax preferences) and a recent column by Bruce Bartlett, former adviser to presidents Reagan and George H.W. Bush, add up to three strikes against the tax code’s favorable treatment of capital gains and dividends, which face much lower tax rates than wages and salaries.

Strike 1:  High Cost

CBO estimates that the preferential rates for capital gains and dividends will cost $161 billion this year, making it the second-largest individual tax expenditure.

Moreover, this figure doesn’t include another costly tax break on capital gains:  capital gains tax is forgiven at death.  So, if a taxpayer holds on to an asset until she dies, neither her estate nor her heirs will ever pay tax on any increase in the asset’s value before her death. Nor does it include the plethora of other loopholes (such as “like-kind” exchanges and “inside buildup”) that wealthy people use to defer or avoid paying even these highly discounted capital gains rates.

Strike 2:  Extreme Tilt to the Wealthy

Since capital gains and dividends are heavily concentrated at the top of the income scale, so are the benefits of taxing them at preferential rates.  CBO estimates that fully 68 percent of the benefits go to the top 1 percent of households, while just 7 percent go to the bottom 80 percent of households (see graph).

Their extreme tilt to the top means that these tax breaks make the tax code much less progressive.

Strike 3: Little Economic Benefit

Proponents of preferential rates for capital gains and dividends — and further cuts in those rates, such as those enacted in 2003 — argue that they benefit the country as a whole by stimulating business activity.  But, as Bartlett explains, research by the Federal Reserve and others on the 2003 dividend rate cut shows that it did not produce the promised gains.

Similarly, research on the capital gains preference that we discuss here finds, as leading tax expert Joel Slemrod put it, that “there is no evidence that links aggregate economic performance to capital gains tax rates.”

A new Congressional Budget Office (CBO) report on major individual tax expenditures (the deductions, exclusions, and credits embedded in the tax code) shows why they are ripe for reform — a point that we have made as well.  Tax expenditures are:

1) Costly. Combined, the ten biggest individual tax expenditures cost more in lost federal revenues each year than defense, Medicare, or Social Security, as the first graph shows.

2) Often inefficient. Tax expenditures can distort the allocation of resources.  CBO notes, for example, that the mortgage interest deduction can convince people to “purchase more expensive homes, investing too much in housing and too little elsewhere relative to what they would do if all investments were treated equally.”  In addition, tax expenditures sometimes pay people to do something they would have done anyway.  For example, tax incentives for retirement saving may lead some people to simply “reallocate existing savings from accounts that are not tax-preferred to retirement accounts, rather than add to their savings.”

3) Tilted to high-income people. The value of many tax expenditures is tied to a taxpayer’s tax rate, so it rises as his or her income rises.  These tax expenditures thus are “upside down” — they deliver the biggest subsidies to the people who least need a subsidy to do whatever the tax break is designed to encourage (see second graph).

I’d add a fourth reason why tax expenditures are ripe for reform:  both sides have proposed tax expenditure reform as a core part of a long-term deficit reduction agreement.

President Obama proposes capping the value of large tax expenditures at 28 percent.  House Speaker John Boehner proposed cutting tax expenditures by nearly $1 trillion over ten years at the end of last year.  January’s “fiscal cliff” agreement raised much less revenue than the Boehner proposal ($561 billion over the same period) and didn’t include any tax expenditure limits.

As CBO’s new report highlights, tax expenditure reform remains a key piece of unfinished fiscal business.

Some charities and state and local governments have raised concerns about the President’s proposal to cap, at 28 cents on the dollar, the tax subsidy that affluent Americans receive for tax deductions and some other tax expenditures.  Charities worry that charitable donations would drop substantially (although the Tax Policy Center estimates that the decline would be modest); while states and localities worry they would have to pay higher interest rates on their bonds in order to attract investors.  Several important facts are often missing, however, from the discussion of these issues.

• At 28 percent, the top subsidy rate would be the same as during the Reagan years. Some critics of the Obama proposal have noted that under President Reagan, the top marginal tax rate and the top subsidy rate for deductions were both 28 percent, whereas the Obama proposal would create a gap between the top marginal tax rate (39.6 percent) and the top subsidy rate (28 percent).  That’s true but has no bearing on the issue at hand — namely, the effect on charitable giving.  The subsidy rate is what matters here, because it determines filers’ financial incentive to engage in a subsidized activity such as giving to charity or buying municipal bonds.

• The House-passed Ryan budget and House Ways and Means Chairman Dave Camp’s tax-reform process aim to cut the tax subsidy rate below the Obama level. The Ryan budget and Chairman Camp have set a goal of cutting the top marginal rate to 25 percent.  That would put the top subsidy rate for charitable donations and municipal bond interest three percentage points below the Obama cap.

  Most charities and organizations that have criticized the Obama 28 percent limit have been silent about the Ryan and Camp proposals (in many cases, they also were silent during the Reagan and George H.W. Bush years, when the top marginal tax rate was 28 percent).  Some may mistakenly assume that what counts is the difference between the marginal rate and the subsidy rate — when, in fact, it is the subsidy rate that matters.

• The Obama budget would use the resulting savings primarily to replace the sequestration budget cuts, thereby helping both charities and states and localities. Sequestration is scheduled to impose even deeper cuts next year and to remain in effect through 2021.  Its harsh cuts in a range of programs — including those that alleviate poverty or combat disease at home or abroad as well as programs in education, environmental protection, health research, the arts, and many other areas — will place heavy added burdens on both charities and state and local governments.

  Many nonprofits receive grants or contracts to provide services that are funded in part or in whole through federal programs, especially non-defense discretionary programs that operate through state or local governments.  Meanwhile, most federal grants that state and local governments receive to help them perform various functions come through programs subject to sequestration.

  In fact, sequestration will impose a double burden on nonprofits, raising the demand for their services while slicing their revenues.

  Thus, cancelling sequestration is of considerable importance to the charitable sector and to state and local governments.  While charities and state and local governments would lose some revenue from the proposed 28 percent limitation on tax deductions and exclusions, they would receive substantial revenue gains from repealing sequestration.

  By contrast, under the Ryan and Camp proposals, not only would charities and state and local governments suffer bigger losses from those plans’ reductions in tax subsidy rates, but none of the resulting revenue would go to ease sequestration or other budget cuts.

  Moreover, if all of the revenue from scaling back tax subsidies goes to lowering tax rates, as the Ryan budget and Chairman Camp propose, then further deficit reduction will likely come entirely from the spending side of the budget.  (In addition, it’s very unlikely Congress would be able to pass enough tax-expenditure savings to pay for lowering the top rate to 25 percent; if the resulting tax reform lost revenue, the ensuing budget cuts would likely be bigger still.)

  In short, additional cuts — on top of sequestration — in areas such as education, low-income programs, and state and local aid would almost certainly result from the Ryan-Camp approach, making the job of charities and state and local governments even more difficult.

Some critics of the Obama 28 percent limit say there are other ways to raise revenues for the purposes that the President has proposed.  But in most cases, they haven’t offered specific alternatives or they have suggested alternatives that, despite their merits, have little or no political viability in the current political environment.

The task remains of raising revenues to replace sequestration and to serve as part of a balanced long-term deficit reduction package, and the 28 percent limit remains the most promising proposal that is not significantly beyond the bounds of current political reality.

The paper on tax reform options that the Senate Finance Committee issued yesterday includes CBPP’s proposal for a renters’ tax credit to help the poorest families afford housing.  Such a credit would be a valuable complement to the existing Low-Income Housing Tax Credit (LIHTC).

Here’s why.

A renters’ credit would help rebalance the nation’s housing policy, as well as its housing-related tax subsidies.  The federal government spends more than $200 billion annually to help families pay for housing.  But the bulk of that goes for homeownership tax subsidies (like the mortgage interest deduction) that favor higher-income families, most of whom could readily afford homes without assistance.

Meanwhile, growing numbers of low-income people pay very high shares of their income for rent, as the graph shows.  This forces them to divert resources from other basic needs and places them at risk of housing instability or homelessness, which can cause long-term harm to children’s health and educational outcomes.

Sharp cuts to federal rental assistance under the sequestration budget cuts, together with the 2011 Budget Control Act’s tight caps on annual discretionary funding, will leave even more families struggling to afford housing.  A renters’ credit would address some of these pressing needs.

For two reasons, the renters’ credit should complement — not replace — the LIHTC, which policymakers created in the 1986 tax reform law to support the development and renovation of housing affordable to families with incomes roughly double the poverty line.

First, the LIHTC does not by itself typically make housing affordable to the poorest Americans, such as low-wage workers and the lowest-income elderly people and people with disabilities.  The renters’ credit would help these households afford rents in developments subsidized through the LIHTC and in other buildings.

Second, before creating the LIHTC, policymakers had long struggled to establish efficient, accountable subsidies for construction and renovation of affordable housing, an important need in many areas.  The LIHTC has performed well in this role, though it could be made even more effective.

Policymakers should streamline inefficient housing tax expenditures, such as the mortgage interest deduction, to better achieve their goals and generate revenues to contribute to balanced deficit reduction.  They should also use a portion of the savings (after meeting deficit-reduction needs) to address growing hardship among low-income renters by establishing a renters’ credit to complement the LIHTC.

Here are the analyses and blog posts we’ve issued in the past few days on tax issues.

• Top 10 Federal Tax Charts
• Federal Income Taxes on Middle-Income Families Remain Near Historic Lows
• Where Do Federal Tax Revenues Come From?
• Where Do Our Federal Tax Dollars Go?
• Top Five State Tax Charts
• Where Do Our State Tax Dollars Go?
• Earned Income Tax Credit Promotes Work, Encourages Children’s Success at School, Research Finds
• Tax Foundation Figures Do Not Represent Typical Households’ Tax Burdens