Is a “Tax Expenditure” Necessarily Bad Policy?

David Henderson has written for the for Policy Innovation an interesting commentary addressing “The Bizarre Economics of 'Tax Expenditures'” He points out that tax policy discussions almost always include reference to the term “tax expenditure.” He classifies that term as “internally contradictory.” He bases his conclusion on the premise that something cannot be both a tax and an expenditure.

Henderson gives an example of a tax expenditure. He describes a person who deducts mortgage interest, and in doing so causes his federal income tax to be less than what it would be without the deduction. The reduction in tax liability due to the deduction is a tax expenditure. In that, he is correct.

Henderson then asks, “Why do they call it a tax expenditure?” His answer is wrong. He claims that the term “tax expenditure” rests on the “implicit assumption . . . that there shouldn’t be a deduction for home mortgages.”

Why is he wrong? Let’s step back. There are two ways that the federal government can move money into the private sector. One is a direct expenditure. A direct expenditure is the delivery of a check, an electronic fund transfer, or the delivery of some sort of prepaid card. The other way is to shift money by providing an income tax exclusion, a deduction, or a credit to a taxpayer. A technically precise term for that sort of expenditure would be “expenditure accomplished through the tax system.” Another technically precise term would be “expenditure accomplished through providing an income tax exclusion, deduction, or credit.” Both of those technically precise terms are mouthfuls and make it difficult to speak, to understand when listening, to write, or to read because they clutter sentences and paragraphs. So as shorthand for those technically precise, but verbose, terms people speaking about tax policy and government spending shortened the term to its two most important words, tax and expenditure.

Henderson, proceeding on his claim that the term “tax expenditure” is used to describe exclusions, deductions, and credits that should not exist, says that instead of using the term policymakers and those discussing policy should simply state that “the deduction is bad policy.” But this demonstrates the flaw in Henderson’s position. At present, EVERY exclusion, deduction, and credit is classified as a tax expenditure because EVERY exclusion, deduction, and credit has the same effect of reducing tax liability. According to Henderson’s method of reasoning, because anything termed a “tax expenditure” is something that policymakers and those discussing policy should simply describe as “bad policy,” logic mandates that every tax expenditure, that is, every exclusion, deduction, and credit is “bad policy.” That surely is not the case.

A tax expenditure is nothing more than an equivalent of a direct expenditure. For example, instead of providing a deduction for mortgage interest, the federal government could provide a direct cash subsidy to the homeowner. Currently, the amount of that subsidy would be measured by the homeowner’s tax status. Whether there should be subsidy, however paid or measured, is a different issue than the terminology used to describe one way of providing that subsidy. Tax has a language all its own. Tax expenditure is a term that is part of that language. Calling something a tax expenditure is not, in and of itself, an evaluation of the wisdom of the tax provision causing the tax expenditure.

How to Pay for Street Reconstruction

Apparently, streets in St. Paul, Minnesota, are crumbling. According to this report, the amount of funding available for street maintenance has been holding steady while the cost of repairs and reconstruction has nearly doubled. It’s at the point where the city is reconstructing only one-third as many miles of streets as it did 20 years ago.

So the mayor of the city wants to increase the city sales tax. It would raise $1 billion over the next 20 years, and most of it would be used to rebuild 44 miles of certain streets. The rest would be used to improve city parks, trails, athletic and recreation facilities, and similar projects. To put this in perspective, in the early 2000s, the city annually reconstructed 10 to 15 miles of streets, and now does only 5 miles. So the tax would permit rebuilding 44 miles of streets over 20 years, which comes out to 2.2 miles per year. One billion dollars is an interesting price tag for that sort of marginal improvement.

What strikes me is the disconnect between sales taxes and street use. The streets need reconstruction because streets wear out. They wear out primarily through use, though weather also plays a role. There’s not much of a correlation between retail transactions and street use. Though consumers use streets to get to stores and stores use streets when shipping or receiving merchandise, it is likely that most retail consumers in St. Paul do not use the streets slated for reconstruction. Why not a tax or funding method tied more closely to the use of the streets in question? Another problem is that the proposed sales tax revenue would be used for a handful of streets, leaving the overwhelming number of other streets bereft of funding for maintenance and repairs.

Other proposals offered by St. Paul citizens and officials are likewise disconnected. Raising property taxes presumes a direct connection between property ownership and street use. Though there is a much higher correlation, it isn’t sufficient direct. Cutting funds for libraries and schools makes no sense. Asking non-profit institutions to bear the cost suggests that somehow only non-profit institution, and their members or clients, benefit from street use.

What would work? Readers of MauledAgain will not be surprised by this question from me: why not a mileage-based road fee? I’ve discussed this fee in posts such as Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, Liquid Fuels Tax Increases on the Table, Searching For What Already Has Been Found, Tax Style, Highways Are Not Free, Mileage-Based Road Fees: Privatization and Privacy, Is the Mileage-Based Road Fee a Threat to Privacy?, So Who Should Pay for Roads?, Between Theory and Reality is the (Tax) Test, Mileage-Based Road Fee Inching Ahead, Rebutting Arguments Against Mileage-Based Road Fees, On the Mileage-Based Road Fee Highway: Young at (Tax) Heart?, To Test The Mileage-Based Road Fee, There Needs to Be a Test, What Sort of Tax or Fee Will Hawaii Use to Fix Its Highways?, And Now It’s California Facing the Road Funding Tax Issues, If Users Don’t Pay, Who Should?, Taking Responsibility for Funding Highways, Should Tax Increases Reflect Populist Sentiment?, When It Comes to the Mileage-Based Road Fee, Try It, You’ll Like It, Mileage-Based Road Fees: A Positive Trend?, Understanding the Mileage-Based Road Fee, Tax Opposition: A Costly Road to Follow, Progress on the Mileage-Based Road Fee Front?, Mileage-Based Road Fee Enters Illinois Gubernatorial Campaign, Is a User-Fee-Based System Incompatible With Progressive Income Taxation?. Will Private Ownership of Public Necessities Work?, Revenue Problems With A User Fee Solution Crying for Attention, Plans for Mileage-Based Road Fees Continue to Grow, Getting Technical With the Mileage-Based Road Fee, Once Again, Rebutting Arguments Against Mileage-Based Road Fees, Getting to the Mileage-Based Road Fee in Tiny Steps, Proposal for a Tyre Tax to Replace Fuel Taxes Needs to be Deflated, A Much Bigger Forward-Moving Step for the Mileage-Based Road Fee, Another Example of a Problem That the Mileage-Based Road Fee Can Solve, Some Observations on Recent Articles Addressing the Mileage-Based Road Fee, Mileage-Based Road Fee Meets Interstate Travel, If Not a Gasoline Tax, and Not a Mileage-Based Road Fee, Then What?>, Try It, You Might Like It (The Mileage-Based Road Fee, That Is) , The Mileage-Based Road Fee Is Superior to This Proposed “Commercial Activity Surcharge”, The Mileage-Based Road Fee Is Also Superior to This Proposed “Package Tax” or “Package Fee”, Why Delay A Mileage-Based Road Fee Until Existing Fuel Tax Amounts Are Posted at Fuel Pumps?, Using General Funds to Finance Transportation Infrastructure Not a Viable Solution, In Praise of the Mileage-Base Road Fee, What Appears to Be Criticism of the Mileage-Based Road Fee Isn’t, Though It Is a Criticism of How Congress Functions, Ignorance and Propaganda, A New Twist to the Mileage-Based Road Fee, The Mileage-Based Road Fee: Simpler, Fairer, and More Efficient Than the Alternatives, and Some Updates on the Mileage-Based Road Fee.

In all fairness, that question cannot be answered until another question is resolved. Does St. Paul have the authority to enact a mileage-based road fee? I don’t know. Perhaps someone who is expert on Minnesota legislative delegation law has an answer. The same question would need to be answered before a different but similar approach were taken. Why not revenue from a system similar to what is used in cities that impose congestion fees? Congestion fees are nothing more than tolls imposed during high volume periods, and there is no reason the systems in place to collect those fees cannot operate all the time. But I doubt St. Paul has authority to impose a congestion fee or toll on its downtown streets without state authorization. Perhaps I am wrong. Again, a Minnesota legislative delegation law expert might have an answer.

Public officials and citizens should find it helpful to consider use fees, and to think about the connection between public expenditures and revenue sources. Simply grabbing any sort of tax to fund any sort of expenditure is not a pathway to good government.

Complaining About Taxes When Not Understanding Arithmetic and the Time Value of Money

The recent excitement about a lottery prize topping one billion dollars has generated a blizzard of posts, such as this one, claiming that the "government" or "the IRS" will "take" more than half of the winnings. Whether this claim has arisen independently among many writers or is simply the repetition of a computation worked out by one person is a question I don't have the time or inclination to research. What I do know is that whoever makes this claim is wrong, and whoever repeats it has failed to do independent research.

So let's work with a $1 billion lottery prize. The winner can take an annuity, that is, payments over a period of time, or a lump-sum, which is what almost every winner chooses the lump-sum, either because of the attraction of a huge amount of money instantly in hand or because the lump-sum can be invested at rates of return that are better than what is built into the annuity payments.

In recent months, the lump-sum amount for a $1 billion prize has been roughly $516.8 million. What is the federal income tax on a $516 million lottery prize? It depends on how much other income the winner already has. Let's assume the winner is unmarried, has $70,000 in other income, and $20,000 in deductions. The winner's taxable income would be $516,850,000. The federal income tax on that amount of taxable income is $191,197,455 (which is 38.99 percent of the taxable income). The state income tax could range from zero, in states with no income tax, to as much as 13.3 percent, in California. Rather than analyzing dozens of states, let's assume a state income tax of 8 percent, or $41,348,000 in state income tax. The total income tax for the winner would be $232,545,455.

Of the $516,800,000 lottery prize and the $70,000 of other income, the winner keeps $284,324,545. That's 55 percent of the cash prize.

The problem with the "government takes more than half" claim is that people do the following erroneous computation. They consider the winner as having won $1 billion and keeping $284,324,545. That is 28.4 percent of the "prize," and thus, according to the reasoning of whoever makes this claim, the other 71.6 percent must be going to "the government" or "the IRS." The flaw in this reasoning is that the winner does not win $1 billion. The winner chose to waive the $1 billion payable over a period of years in order to get an immediate $516.8 million. Put another way, of the $1 billion, the winner goes home, after taxes, with $284,324,545. That is $715,675,455 less that $1 billion. But only $232,545,455 of the $1 billion is "lost" to taxes. The other $483,130,000 that is "lost" is lost because of the time value of money, which is what converts a $1 billion annuity into a present value lump sum of $516.8 million.

The flaw in the reasoning of the "government takes more than half" alarm bell ringers is a combination of bad arithmetic, bad logic, and bad understanding of the time value of money. In some instances, I suspect that those making the claim fully understand the arithmetic and the logic but are trying to drum up outrage among those with less understanding in order to rally support for their anti-tax, anti-government programs. Whether it is the product of ignorance, a not-so-subtle tactic, or some combination, the claim has gone viral. It shows up on social media posts, mostly by people who also post similar unfounded claims about a variety of topics, as well as popping up in more than a few mainstream media publications.

The price that this country is paying for deficiencies in K-12 education continues to grow much more quickly than the benefits that are being reaped by the "reforms" that are crippling the nation's education systems. Something needs to be fixed, and yesterday isn't soon enough.

I'm Still Here

Reader Morris asked me if my July 11 post was my final post. I assured him, no, it was not. Nor is this post intended to be a final post. My expectation is that I will not know when I have posted my final post. There hasn't been a post for the past three weeks because of several reasons. I've been away. I've been dealing with a variety of things that come with owning a home, and a bunch of them demanded attention at about the same time. The front door lock needed repairs, the trees need attention, the property needed to be powerwashed, most of the cast iron drain pipes needed to be replaced because they cracked and were leaking, the generator needed its annual check-up, the bathtub faucets needed replacement, and on and on it goes. There may be an interesting tax issue in there somewhere but I doubt it. Do any of the expenditures increase adjusted basis in the property? I'll leave that as an exam question if someone teaching the tax course needs an idea. It also is a slow time for tax developments that motivate me to write. That usually happens during the summer, particularly in July and August. Not much happens on the legislative front. The cases that have been decided aren't remarkable. The proposals that have been floated are repeats. When I have something to say, or write, I speak and my fingers dance on the keyboard. In the meantime, enjoy these brief moments of quiet.* * This expression of the moment reflects a story told to me several times by my mother. Apparently I began talking at a very young age, perhaps 6 or 7 months. A few months later, I stopped talking. Completely. Worried, my mother asked around, to friends and family and neighbors who had children, to learn if this was normal. Her father said to her, almost in these words, don't worry, soon he talks again and you will wish he was again quiet. Somehow he knew.