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The Economic Impact of
Tax Exemptions and Credits on Taxpayer Behavior
Source: Mercatus Center

Like it or not the taxing policies of our government directly impact our behavior. The purpose of collecting taxes should be limited to paying for those programs and services that are allowed under the Constitution. It would seen that in recent times this process has turned more into a "social engineering" exercise!

Tax expenditures (e.g., exemptions and credits) are provisions in the U.S. tax code through which individuals and corporations can lower their tax burden by behaving certain ways, reflected at both the individual and corporate levels. The current total tax expenditures in the United States hover around $1 trillion, with over 80 percent accruing to individuals and the remainder to corporations. These provisions of the tax code alter behaviors. Jeremy Horpedahl and Brandon Pizzola of the Mercatus Center at George Mason University in northern Virginia noted that in some cases, these actions can manifest distortive incentive structures; at the holistic level, this damages the economy.
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The tax expenditure framework benefits the wrong people and encourages "gaming" by those in a position to take advantage. The entire economic system is distorted in terms of where resources are spent, how capital is allocated, how income is distributed, and how lobbying wastes resources and affects the structure of the tax code. These issues impact all the top tax expenditure scenarios.

Some of the largest individual tax expenditures are:

  • Exclusion of employer contribution for medical insurance premiums and medical care.
  • Retirement and pension contribution -- employer contribution into these programs are not included in the employee's deductible income.
  • Deductibility of mortgage interest on owner-occupier homes.
  • State and local taxes -- these reduce an individual's income and ability to pay federal taxes.
  • Lower tax rates for certain capital gains and dividends -- lower rates encourage investment and economic growth.

Some of the largest corporate tax expenditures are:

  • Accelerated depreciation of machinery and equipment.
  • Deferral of income from controlled foreign corporations. [See related story]
  • Deduction for U.S. production activities.
  • Credit for increasing research activities.
  • Exclusion of interest on public-purpose state and local bonds.

There are several benefits to revamping and simplifying the tax code.

  • Lowering tax rates leads to more robust economic growth.
  • Dismantling the tax expenditure system includes less distortion, a simpler tax code, and less money spent on lobbying and rent-seeking.
  • The cumulative benefits would aid the economy at large.

An Alternative Approach:

An even better approach would be consider replacing the current federal income tax structure and completely replacing it with a national sales tax. This idea is based upon the premise that if everyone benefits from federal government services (e.g., we all benefit from having a national defense, etc.) then everbody ought to pay something. Under a national sales tax (sometimes called the fair tax) taxpayers would have the freedom to control how much they pay in taxes based upon the choices they make about what to purchase. The less a person purchases the less their tax burden. One thing that could be considered is to exempt the sale of food from this tax.

Of course, all this assumes that the Federal Income Tax system we now have will be disassembled and phased out. Increasing taxes is not the answer to our economic problems. So, for this to work, the current system would need to be phased out and replaced with a Federal sales tax. There must also be a limit placed on the Federal sales tax rate imposed. Any move to increase it above that level should require voter approval. This is what we currently do in our local communities and the same process should be mandated at the national level. [More on the Fair Tax Alternative]