by Richard Q. Lewis III
“Taxes are what we pay for civilized society….”1 What Supreme Court Justice Oliver Wendell Holmes may have been implying when he wrote those famous words is that nobody enjoys paying taxes, but we do enjoy an elevated standard of living. However, in light of the so-called “fiscal cliff,” there is endless debate about whether some taxes are necessary and whether the money assessed is actually used for the purpose for which it was received.
It is indisputable that the federal government uses tax expenditures to promote certain activity among targeted groups of people. The ideological goal of tax expenditures is to create a more financially stable taxpayer and prosperous society, which will translate into a steady stream of tax revenue for the government. The government attempts to achieve this goal by providing many individual tax expenditures to middle- and low-income taxpayers to encourage spending. However, many of the tax expenditures fail to meet their goals and create an unintended economic reality of a small tax base and decreased revenues.
Notwithstanding, over the past few decades, tax expenditures have become the tool of choice by the government to stimulate the economy.2 They are politically favorable because they are economically equivalent to direct spending, but are disguised as tax breaks.3 This article will examine two primary areas of expenditures that affect the broadest range of taxpayers and explore whether those expenditures actually accomplish the desired results: expenditures for real estate and education.
What Are Tax Expenditures?
Tax expenditures are defined as “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption or deduction from gross income or which provide a special credit, a preferential tax rate or a deferral of liability.”4 They operate to reduce the income tax liabilities of individuals and businesses that undertake certain types of activities.5 They are not neutral, but targeted to specific taxpayers to promote a particular behavior or response.
Tax expenditures are sometimes referred to as “backdoor spending” through the tax code because the same result might otherwise be accomplished through a direct outlay.6 They benefit hundreds of different types of activities and individuals and currently account for one-fourth to one-third of all benefits and subsidies granted to the public.7 Unlike direct outlays or entitlement programs on the spending side of the budget, most tax expenditures do not go through a direct appropriations process each year.8 Consequently, they continue and often expand with no congressional vote or oversight.9 In 2008, the Office of Management and Budget (OMB) estimated the tax expenditure budget to total $878 billion.10
In 2012, the tax expenditure budget is estimated to reach $1.1 trillion in revenue losses. This accounts for approximately 6.7 percent of the projected gross domestic product (GDP) for that year.11 Of these estimated expenditures, about $900 billion (5.8 percent) of the GDP goes to support social services program activities, which include, among other items, housing and education.12
By their very nature and design, tax expenditures violate the three goals of any balanced tax regime: neutrality, equity, and simplicity. An ideal tax regime should be neutral in its application, equitable in its effects, and simple to administer. One would assume, with almost six percent of the federal budget going to fund these tax expenditures, the significant motivation to the taxpayers to take advantage of these incentives would justify this unbalanced tax structure. However, the two large tax expenditures, housing and education, do little more than widen the gap between low- and high-income taxpayers.
Real Property Tax Expenditures
The federal government provides about $180 billion in tax expenditures to homeowners in the form of tax incentives as the mortgage interest or real estate tax deduction, and the exclusion of capital gains from home sales.13 In 2008, the mortgage interest deduction accounted for $88.5 billion dollars of the federal tax expenditure budget.14
Through the use of the tax code, the federal government allows mortgage interest payments to be deducted for itemizing taxpayers15 for interest allocable to a primary or secondary residence for mortgage principal amounts up to $1 million.16 Interest allocable to home equity loans of up to $100,000 may also be deducted on an annual income tax return.17 Only itemizing taxpayers may deduct qualified mortgage interest or real estate taxes.18 As with other itemized deductions, complications with the alternative minimum tax (AMT) are possible.19 In general, interest allocable to a home equity loan and property tax payments may not be deducted against AMT taxable income, although mortgage interest classified as acquisition indebtedness, including debt to finance home repair and improvement, may be deducted.20
The capital gains exclusion on home sales is the second largest of the real estate tax expenditures. In 2008, it accounted for $30 billion of the federal tax expenditure budget.21 Under the exclusion, single taxpayers may exclude up to $250,000 in profit, and married joint filers may exclude up to $500,000 in profit from the sale of their primary residence from capital gains treatment. In other words, the taxpayers would not pay any capital gains taxes on that profit.22 This tax expenditure does not apply to any real estate owned and sold for investment purposes.23
For most middle income Americans, housing wealth is the single largest source of savings.24 Home ownership serves as a financial solidifier and a hedge against economic uncertainty and inflation.25 There is a direct correlation between home ownership, greater educational attainment, likelihood of being married, better family outcomes, higher salaries, greater wealth, and increased ownership of other assets.26 With the positive consequences of home ownership, it is clear why the federal government provides these incentives through tax expenditures to create more homeowners. However, the incentives violate the concepts of neutrality, equality, and simplicity in the tax code. They are specifically directed toward low- and middle-income taxpayers, provide inequality among the tax bases, and are too complicated and expensive to provide any significant savings to the taxpayers they were designed to benefit.
In 2004, homeownership reached an all-time high of 69 percent.27 While tax expenditures may have played a part in raising home ownership among the tax bases, they often do little more than increase the wealth of the highest tax bracket and keep lower income taxpayers in their current economic position. As an example of this phenomenon, consider that the largest outlays for discretionary housing assistance include public housing and the §8 rental voucher program.28 While the government might subsidize a very low-income renter household at about $4,800, a high-income homeowner (home value at $500,000) could realize twice that, at $9,900, through the exclusion from tax of the gross rental value of the home (which equals deductions on mortgage interest and real estate taxes, plus the net rental value after such deductions are taken).29 Families in the middle-income brackets do not qualify for rental subsidies and may lack the means to buy a home; or having bought one, lack the federal tax liability to itemize their real estate taxes and mortgage interest. Low-income families receive the bulk of the benefits from direct spending, while the high-income taxpayers benefit from the housing tax expenditures.30
The chart in Figure 1 illustrates how the federal housing expenditures are distributed across income classes.
There are two things that are clear from review of real estate tax expenditures: 1) They are not accomplishing the goals of increased home ownership; and 2) the expenditures benefit high-income taxpayers. The reason low-income taxpayers are not reaping the benefits of these expenditures is because most require an itemization of deductions and are nonrefundable. Since low-income taxpayers have zero or no tax liability, they do not get the benefit of the expenditures. Therefore, in order to reach the goal of increased ownership, the government should provide a refundable tax credit for mortgage interest and real property taxes. This would minimize distortional taxpayer behaviors, produce larger tax benefits for low-income families, and increase overall home ownership rates.31 Since the credit would reward home ownership and not the amount one borrows, it would not provide an incentive to finance the purchase of a larger home.32
Education Tax Expenditures
Between 1997 and 2006, federal tax expenditures for education grew from $0 to approximately $6 billion.33 This was largely due to Congress’ enactment of several higher education tax benefits in response to the constraint on college enrollment due to rapidly rising educational costs. The expenditures included the Lifetime Learning Credit, the Hope Credit, and deductions for tuition and fees.34
In 2005, the Lifetime Learning Credit provided approximately $2.2 billion in tax relief to students and their families.35 The expenditure provides up to $2,000 in tax credits for training and coursework for students, regardless of their year in college or whether they are in a degree credit program.36 To receive the full credit, students or their parents must pay at least $10,000 in tuition and required fees.37
Students and their families received at least $3.5 billion in tax relief pursuant to the Hope Credit.38 In 2006, the Hope Credit provided a tax benefit of up to $1,650 for first- and second-year students enrolled at least half-time in degree credit programs.39 To qualify for the maximum tax credit, a student’s tuition and fees must be at least $2,200.40
In 2005, the tuition and fees deduction provide families $1.9 billion in tax relief.41 The deduction allows parents or students who pay tuition and fees to reduce their taxable income by up to $4,000.42 These limits apply to all students in the family.43
Despite this recent legislation to curb the cost of higher education in the United States, obvious inequalities among the income classes continue to persist.44 Only 54 percent of high school graduates from the lowest income quartile (<$30,000) enter college compared with 80 percent of the graduates from the highest quartile (>$100,000).45
For example, both the Hope and Lifetime Learning Credits are nonrefundable, so the resulting benefits cannot exceed taxes owed.46 Moreover, the credits are no benefit to taxpayers who do not make itemized deductions. In addition, both credits phase out between adjusted gross incomes of $45,000 and $55,000 ($90,000 and $110,000 for married couples).47
Furthermore, the Hope Credit is available per student while the Lifetime Learning Credit is per return.48 Each student may receive only one credit, either the Hope or the Lifetime Learning Credit; however, a family with more than one student may receive both credits.49 The student or family, who otherwise qualifies for the credits, must make a mathematical calculation to determine which credit reaps a more favorable tax position. Additionally, the credits cannot be used if the taxpayer takes a deduction for qualified tuition and related expenses.50
The deduction for tuition and expenses is also complex and not neutral. It is targeted to specific high-income taxpayers. In addition, it cannot be combined with the Hope Credit or Lifetime Learning Credit. Notwithstanding, unlike most other deductions and educational credits, this deduction is “above the line” so the taxpayer does not need to itemize deductions to receive this tax benefit.51 The value of the tuition and expenses deduction depends on a person’s marginal tax rate.52 The maximum value for a person in the lowest tax bracket is $200. Families in higher tax brackets pay higher marginal rates and, therefore, receive a larger benefit from the tuition and expenses deduction.53 Given the current tax rates, unless a taxpayer’s marginal tax rate was above 50 percent, the Hope and Lifetime Learning Credits are more beneficial than the maximum deduction for tuition and related expenses.54
The purpose of the educational tax incentives is to increase college attendance for low- and middle-income taxpayers. However, the expenditures provide the greatest benefit to the high-income taxpayers; those who are most likely to attend college without a subsidy.55 The structure of the tax expenditures is such that there is no response to the subsidies and it is unlikely that these programs significantly increase college attendance for any income class.56 Low-income taxpayers cannot use the incentives because they are nonrefundable and mutually exclusive; middle-income taxpayers will not use the incentives because they must be itemized or provide little or no benefit; and high-income taxpayers will reap the benefits of the incentive in the form of increased consumption.57
The chart in Figure 2 shows the disparate effects of the educational expenditures on the separate income taxes.
As you can see from the chart, high-income taxpayers benefit the most from the deductions, while middle-income taxpayers receive the greatest tax benefit from the credits. Low-income taxpayers, the ones who the expenditure is designed to benefit the most, receive little or no benefit.
One proposal for improving the effectiveness of the tax expenditure is not unlike the proposal to improve the other ineffective expenditures: Make it refundable. This would directly benefit more low-income students.58 Many more families would be eligible to receive the credit and some families would get an increased credit.59 Consequently, families with income less than $30,000 per year would qualify for almost half of the benefits.60 In addition, combining the credits and making them available to all students in a degree-seeking program would promote simplicity and neutrality in the tax system.61
It has long been recognized that if you want to discourage behavior, you tax it. This is evident in the use of “sin” taxes on items like alcohol and cigarettes. The converse is also true: If you want to encourage behavior, you give a financial incentive. One of the largest and systematic ways the government seeks to influence the behavior of its people is through the use of tax expenditures.
Using the tax code as a policy tool, the government has sought, among other aspirations, to increase home ownership and college enrollment among low- and middle-class taxpayers. The ultimate goal of these expenditures is simply to create a more stable and better-educated society, which will make higher salaries that will result in increased tax revenue. The government has used tax expenditures to change people’s behavior and motivate them to reach for these ideals pursuant to the reward of a tax credit or deduction. However, many of the expenditures fail to reach their goals and result in wasteful spending and windfalls for the most affluent taxpayers.
Tax expenditures should only be used when it can be conclusively demonstrated that the effect of the expenditure justifies higher taxes for all taxpayers.62 It is clear that some tax expenditures do not meet the aspirational goals for which they were genuinely proposed. Consequently, the government should reevaluate their widespread use and effectiveness. While Americans pay taxes to live in a more civilized society, they do not appreciate their money being spent on an ineffective tax policy.
1 Compania General de Tabacos de Filipinas vs. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (quote by Justice Oliver Wendell Holmes).
2 C. Eugene Steurele, The New Old Tax Expenditure Debate, Part 2, Economic Perspective, Tax Policy Center (June 10, 2002).
3 See Eric Toder, Tax Expenditures and Tax Reform: Issues and Analysis, National Tax Association, Proceedings of the 98th Annual Conference, Miami (Nov. 2005).
5 C. Eugene Steuerle & Gillian Reynolds, Tax Expenditures: What is the Tax Expenditure Budget, The Tax Policy Briefing Book (July 17, 2009).
6 Toder, Tax Expenditures and Tax Reform: Issues and Analysis at 2.
13 Gillian Reynolds & C. Eugene Steuerle, Tax Expenditures: What Are the Largest Tax Expenditures? The Tax Policy Briefing Book (July 20, 2009); see also Adam Carasso, C. Eugene Steuerle & Elizabeth Bell, Making Tax Incentives for Home Ownership More Equitable and Efficient, Discussion Paper No. 21, Tax Policy Center (June 2005).
15 Many itemized deductions are subject to adjusted gross income limitations. In addition, if the standard deduction exceeds itemized deductions, the taxpayer will benefit from taking the standard deduction. The standard deduction for a single filer is $5,350, and $10,700 for married joint filers.
16 Robert D. Dietz, Housing Tax Expenditures Analysis (May 27, 2008).
19 Id.; Kaye A. Thomas, Alternative Minimum Tax 101, Tax Guide for Investors (1997). The AMT provides an alternative set of rules for calculating your income tax. In theory, these rules determine minimum amount of tax that someone with your income should be required to pay. If you’re already paying at least that much because of the “regular” income tax, you do not have to pay AMT. But if your regular tax falls below this minimum, you have to make up the difference by paying alternative minimum tax.
21 Reynolds, Largest Tax Expenditures.
22 I.R.S. Publication 523.
24 Carasso et al., Making Tax Incentives for Home Ownership More Equitable and Efficient.
27 Id. at 2.
28 Id. at 3.
31 Id. at 6-7.
32 Id. at 7.
33 Elaine Maag, David Mundel, Lois Rice & Kim Rueben, Subsidizing Higher Education Through Tax and Spending Programs, Tax Policy Issues and Options (May 2007).
34 Id. at 2.
50 26 U.S.C. §25A(g)(5) (2009).
51 Maag, Subsidizing Higher Education Through Tax and Spending Programs at 2; see also 26 U.S.C. §62(a)(18) (2009).
54 Deborah Schenk & Andrew L. Grossman, The Failure of Education Tax Incentives, NYU L. and Economics Research Paper 07-28 (August 10, 2007).
55 Elain Maag, Education: What Tax Incentives Exist to Help Families Save for College, The Tax Policy Briefing Book (February 16, 2008).
56 Id.; see also Maag, Subsidizing Higher Education Through Tax and Spending Programs.
58 Id. at 6.
61 See id. at 5.
62 See id.
Richard Q. Lewis III is an attorney in the tax, estate planning, and corporate practice groups in the Sarasota office of Shumaker, Loop & Kendrick, LLP. His principal areas of practice are tax law, estate planning, and corporate law. He also represents business owners and their respective entities in corporate formation, governance, and transactions in addition to advising clients on federal, state, and local tax issues.
This column is submitted on behalf of the Tax Law Section, Michael Allen Lampert, chair, and Michael D. Miller and Benjamin Jablow, editors.