The Bizarre Economics of ‘Tax Expenditures’

By David R. Henderson, Hoover Institution at Stanford University

If you follow discussions about tax policy that academics and politicians engage in, sooner or later you’ll come across the concept of a “tax expenditure.” The term seems internally contradictory. How could something be both a tax and an expenditure?
 
It can’t.  The term is contradictory. And thinking in terms of tax expenditures can lead you to some strange conclusions.
 
Here’s an example to show what the term means. Imagine that John Smith is in the top federal tax bracket, paying a marginal tax rate of 37 percent, and he switches from being a renter to a homeowner, financing his new home with a $500,000 mortgage. Assume that John’s mortgage interest rate is the current average of about 7.2 percent. Therefore, he pays approximately $36,000 in annual mortgage interest, which he can deduct. If he already itemized his deductions before buying the home, he will certainly itemize now. John can deduct the $36,000 in interest, saving himself 37 percent of $36,000, in taxes. That’s $13,320 in reduced taxes. Many tax policy people will say that he got a “tax expenditure” of $13,320 for having that mortgage. All they mean is that his taxes would have been $13,320 higher if he hadn’t got the mortgage.
 
Why do they call it a tax expenditure? Because their implicit assumption is that there shouldn’t be a deduction for home mortgages.
 
It’s true that deductions for home mortgages cause some people to buy instead of rent and also cause many people to buy a more expensive home than otherwise. So one can make the case that because this deduction distorts people’s decisions, there shouldn’t be a deduction for a home mortgage. But then they should simply say that a home mortgage deduction is bad policy, not that it’s a tax expenditure.
 
Moreover, notice something strange. What if Congress passed and the president signed a bill that reduced the top tax rate from 37 percent to 30 percent? Then the person’s tax break from the mortgage would fall from $13,320 to 30 percent of $36,000, which is $10,800. So cutting his marginal tax rate would actually reduce the tax expenditure.
 
Similarly, raising his tax rate would increase the tax expenditure. And then tax policy wonks would say that he benefited hugely from the tax expenditure even though the higher tax rate made him worse off.
 
Thinking in terms of tax expenditures, and using tax policy to reduce them, can lead someone to advocate some strongly anti-growth policies. More on that in my next TaxBytes.

Today's TaxByte was written by David R. Henderson, a research fellow with the Hoover Institution at Stanford University.