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Tax definitions matter

Balancing a government budget, in principle, is easy — government expenditures must equal tax revenues. If spending exceeds revenues, then either spending must be reduced or revenues increased or some combination of the two must occur.

However, when raising revenue, there are two options, not one: either tax rates could be increased or "tax expenditures" could be reduced. In the current debate over raising the debt ceiling, the arcane world of government tax expenditures is being discussed more than ever, calling for an explanation of just what in the world these are.

The tax expenditure is a tool used by the government to promote private sector spending that the government favors. It is a combination of a reduction in taxes paid together with an increase in taxpayer spending in ways that the government deems in the public interest. The most familiar example is the deduction for home mortgage interest expense. To encourage home ownership and stable neighborhoods, the government allows for the deduction of this expense when homeowners compute their taxable income.

Similarly, to encourage research spending on fuel-efficient airplane engines, aircraft engine manufacturers are permitted to deduct some of their research expenses when determining the company's tax liability. In both cases, the idea is to promote a greater amount of a favored economic activity than would result without the subsidy.

Notice that the government does not spend the money directly. It does not open up a government lab or hire the scientists and engineers needed to produce the new airplane engine designs. With tax expenditures, those key functions remain in the private sector. Similarly, the homeowner subsidy encourages private individuals to purchase homes that they otherwise would not buy. The responsibility for the favored activity rests with the actor best able to bear that responsibility: presumably the homeowner can best choose which house to buy and the manufacturer can better harness its expertise to innovate jet engines. The tax expenditure serves an important government objective without direct government spending.

Naturally, tax expenditures are highly prized and have become the object of much corporate lobbying. Unfortunately, some of these tax expenditures are of doubtful national interest. For example, the ethanol tax expenditure provides a tax break to enhance an industry that produces a gasoline additive that reduces air pollution somewhat, but it also gums up engines, uses enormous amounts of water and corn, contributes to water scarcity and drives up the price of basic corn-based foods. Still, because of the enormous political clout of Midwest corn growers, ethanol tax expenditures continue.

Once the function of tax expenditures is understood, it is easy to see that they are simply another form of government spending. In ordinary language, tax expenditures are a subsidy tied to a desired result. They are the equivalent of a grant, except that the money is never collected as tax revenue to be later paid out as a grant: It is simply a tax revenue reduction in exchange for the favored private spending.

What is critical for the current debate is that both direct spending and tax expenditures are two versions of the same thing: government spending. It is clearly wrong to argue, as the tea party is wont to do, that a reduction in tax expenditures is a tax increase. It is a spending decrease.

Back to ethanol: If a reduction in the ethanol subsidy is called a tax increase, then a reduction in the Medicare program must also be called a tax increase; or they must both be called a subsidy reduction. What is not logical is to call one a tax increase because it involves a firm and the other a subsidy reduction because it involves a person.

Grover Norquist, founder of the Americans for Tax Reform, is a master at spreading this type of confusion. His organization insists that members of Congress sign a no-tax increase pledge or face an opponent sponsored by his group in the next election. Norquist not only opposes all tax increases; he also includes in his definition of a tax increase any reduction in tax expenditures. In the case of the ethanol industry, his actions deny Congress a chance to raise some revenue towards a solution to the debt crisis, and a chance to correct a huge mistake.

Indirect government spending through tax expenditures and direct government spending are exactly the same thing. Putting tax expenditures on the table enables the president and Congress to raise revenue without raising tax rates.

Charles O. Kroncke is associate dean in the University of South Florida College of Business. William L. Holahan chairs the department of economics at the University of Wisconsin-Milwaukee.

Tax definitions matter 07/16/11 [Last modified: Saturday, July 16, 2011 4:30am]
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