When government monetarily encourages some activity, is it better to write checks to those we wish to motivate or should they get special tax treatment?
Gov. Tim Pawlenty recently proposed assorted benefits for members of the Minnesota National Guard. These include state-paid re-enlistment bonuses, higher college tuition reimbursements, excluding military pay from state income taxation, and allowing deduction of service-related travel and other miscellaneous expenses from taxable income.
The governor’s proposals highlight how both direct payments (bonuses and tuition reimbursement checks) and special tax treatment (exclusion of certain income or deduction of certain expenses) can be used to achieve the same general end: higher effective compensation for a specific set of public employees.
When or why should government use direct payments versus tax breaks? The answers are more political than economic. One skeptic has argued, “Politicians and economists have a love-hate relationship with tax breaks. Politicians love them and economists hate them.”
In general, economists dislike subsidies delivered via special tax provisions because they are not as transparent as direct payments. It is harder for the average person to see that a subsidy is being paid. Politicians, many argue, love them for precisely the same reason. It is politically easier to implement a program that transfers public funds to some specific group when those transfers are disguised.
The accepted doctrine in economics is that governments should make payments only when there is a clear public purpose and society as a whole is better off with the payments than without. In any case, the whole process should be as transparent as possible.
This accepted doctrine among economists carries little weight in Congress or in state legislatures, where special tax breaks remain the first choice when a subsidy or payment decision is made. Candid legislators freely acknowledge that the disguised nature of such “tax payments” usually is a political asset.
It is rare when there is no dispute about what explicit spending should be included in public budgets. Implicit spending via special tax provisions benefiting one group never gets the same level of attention. Experienced legislators know it is easier to get majority support for tax breaks than for overt payments with the same cost to the Treasury.
They would add, however, that there are times when it is simpler to piggyback some subsidy on an existing income tax system — which already involves most households — rather than to create a new bureaucracy to achieve the same end by sending government checks.
Informing potential recipients of their eligibility for a new program is always harder than one might think. Households are used to the income tax and the idea that certain categories of income or expense may be subject to preferential treatment.
Adding to the list of tax-preferred items also is easier to implement and communicate than starting a stand-alone subsidy program from scratch, proponents of tax breaks argue.
Economists counter with the drawbacks of most tax breaks. They can only be used to transfer resources to households with enough income to file returns. They add to the complexity and hence the economic burden of preparing tax returns. They are used more frequently by highly educated people, who are more alert to potential government largess via tax refund checks.
Moreover, if tax breaks involve special income exclusions or expense deductions, they inevitably confer greater benefit to those in higher tax rate brackets.
Take, for example, different Guard members with $500 in expenses eligible under the Pawlenty proposals. An officer in the 7.85 percent state income tax bracket would get a benefit of $39.25. A junior NCO in a lower tax bracket, 5.35 percent, would be ahead by $26.75, a third less than her higher-income superior. Meanwhile, a private who is a full-time student not earning enough to pay any tax would get no benefit at all.
Tax policy wonks prefer “funded tax credits,” where everyone incurring the eligible expense would be given a credit against taxes owed. For example, a Guard tax credit of 8 percent of eligible expenses would be worth $40 to all three soldiers. Those owing taxes would see them reduced by this amount and those with low incomes could get a refund check even if they had no taxes withheld that year.
Economists have made this argument for decades, but it has had little effect on tax policy, especially at the national level. Some states with income taxes have gone further in replacing deductions with credits, but less has happened at the federal level. Thus, special tax breaks proliferate apace, with “yea” votes by Congress members who all the while decry the complexity of the federal income tax system.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.