Tax Reformers Must Kill Subsidies for the Rich

(Originally published here.)

The nonpartisan Congressional Budget Office has released a new report making clear what many have long suspected: The U.S. tax code is rigged in ways that end up rewarding the rich at the expense of the middle class.

Source: Congressional Budget Office

Source: Congressional Budget Office

These “tax expenditures” — deductions for charitable giving and mortgage interest, as well as the lower tax rates assessed on investment income — disproportionately go to those at the top of the income distribution. (A few tax subsidies, such as the earned income tax credit and the child tax credit, benefit the poorest, although these are much smaller in dollar terms.) More than half of all tax subsidies go to the top fifth of earners. About 30 percent of tax subsidies are claimed by just 5 percent of the population.

This has a big effect on the welfare of the well-to-do. One way to see this is by looking at the value of the tax subsidies as a share of total after-tax earnings. For most income groups, the subsidies are worth about 7.5 percent to 8 percent of after-tax incomes. Those at the very top, however, benefit much more. Those in the top 1 percent actually get a bigger boost to their income from subsidies than those in the bottom quintile.

Source: Congressional Budget Office

Source: Congressional Budget Office

The CBO helpfully explains why this is by showing the dollar value of each tax subsidy and the extent to which each subsidy benefits each income group.

Source: Congressional Budget Office

Source: Congressional Budget Office

For example, the preferential treatment of income from financial assets is worth about $85 billion, of which about $70 billion goes to the highest-earning 5 percent. That’s not chump change. Eliminating this subsidy would reduce the after-tax incomes of those in the top 1 percent by more than 5 percent.

Other tax subsidies are just as unfair but also distort economic activity in unhealthy ways. We’ve written extensively about the problems with the ways the U.S. government uses the tax code to subsidize leveraged purchases of houses. Deductions that offset the burden of state and local taxes redistribute resources from low-tax regions to high-tax ones. The charitable deduction may sound like a noble concept, but in practice it frequently diverts resources away from projects that help the genuinely needy.

The CBO report is meant to inform rather than argue for a particular point of view. In practice, widespread tax reform will take a long time, if it happens at all. Households and businesses have spent a long time getting accustomed to the current system, so it’s expected that they will resist alterations. Sudden changes could create severe dislocations, even if they appear to be “revenue neutral” in the aggregate. That’s why we have recommended gradual adjustments that give people time to adapt to a simpler and fairer code.

This healthy caution shouldn’t dissuade us, however, from doing what needs to be done to fix the U.S. tax system. Hopefully the latest CBO paper will remind Congress of that.

(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)

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About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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