Tax Reform Error #1: Confusing Tax Expenditures with Revenues

House Ways and Means Chairman Dave Camp has released a complex 182-page “discussion draft” called The Tax Reform Act of 2014. Rather get bogged down in details, I will take this opportunity to review several fundamental errors that repeatedly plagued most past and present efforts to reform the federal income tax, including the Camp proposal.

One of the most pernicious errors among would-be tax reformers is to assume that, as the Tax Policy Center asserts, “tax expenditures are revenue losses” attributable to various “loopholes.” On the contrary, the Joint Committee on Taxation (JCT) clearly states that the estimated dollar value of any “tax expenditure … is not the same as a revenue estimate for the repeal of the tax expenditure provision.” As the JCT explains, “unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision…. Taxpayer behavior is assumed to remain unchanged for tax expenditure estimate purposes … to simplify the calculation.”

One glaring difference between revenue estimates and tax expenditure estimates involves taxation of capital gains if those gains are realized by selling assets from a taxable account (unlike IRAs or most home sales). Estimated tax expenditures from not taxing realized capital gains at the top income tax rate of 43.4 percent is listed as a big revenue-losing tax expenditure, even though Treasury, the JCT and the Congressional Budget Office (CBO) revenue estimates would rightly predict that the behavioral response to such a high tax would crush asset sales and thus lose revenue. 

Mainly because the artificially estimated “tax expenditure” from a lower capital gains tax is wrongly equated with estimated revenues, the Simpson-Bowles plan hopes to raise an extra $585 billion over ten years. In reality, investors realize fewer gains when the tax rate goes up, so the higher tax on fewer transactions means revenues fall rather than rise.

The same Simpson-Bowles confusion of tax expenditures with tax revenues recently led Washington Post columnist Robert Samuelson to recommend, “ending preferential rates on capital gains (profits on the sale of stocks and other assets).” Samuelson has a noble goal: to use the expected revenue windfall from “taxing capital gains at full income tax rates” to reduce the top tax rate to 25 percent on salaries and small business profits. But that raises an unresolvable  dilemma: The top capital gains tax was already increased to 23.8 percent in 2014, so raising it to 25 percent wouldn’t matter. The only reason this “tax expenditure” would vanish under Samuelson’s plan is not the trivially higher tax on capital gains but the much lower 25 percent tax rate on income. The tax expenditure would indeed be gone, by definition, but eliminating the tax expenditure would not provide more revenue with which to lower tax rates or the deficit. 

Contrary to hoary tax reform mythology, most of the reduction in estimated tax expenditures after the 1986 Tax Reform was likewise the result of reducing the top marginal tax rate to 28 percent, not from trading fewer itemized deductions for a larger standard deduction. Most of the unexpectly strong revenue gain was also from more taxable income earned and reported at the 28 top tax rate (called the “elasticity of taxable income”). Higher tax rates on capital gains clearly reduced revenue until that rate was lowered in 2007. Higher effective rates on corporate profits also produced much less revenue than projected. There was no “tax preference” when the top tax was 28 percent on both capital gains and income, but that certainly does not mean the higher tax rate on capital gains provided revenue with which to lower the marginal tax rate on income. All that was required to lower the top tax rate was the political courage to do so. 

Suppose the individual tax on realized capital gains was raised to the current top rate of 43.4 percent or the Camp proposal’s top rate of 38.8 percent. In either case, the Treasury Department, JCT, and CBO would rightly estimate that revenues would fall not rise. The “tax expenditure” would again disappear by definition, but so would a lot of tax revenue.

Getting rid of tax expenditures is not at all the same as raising more revenue. Confusing tax expenditures with revenue is the first of many persistent fallacies that hamper effective tax reform.