A ‘Tax-and-Credit’ Budget Shortchanges the Public

Democrats have long been tarred with the “tax-and-spend” label. Yet, as President Bill Clinton’s recently released budget demonstrates, they might be better described as the “tax-and-credit” party. Still chastened by policy defeats in the mid-1990s, the president and congressional Democrats have shied away from new spending programs and instead proposed targeted tax breaks for health care, child care, education and other social aims.

This new strategy was vividly displayed in Clinton’s State of the Union address. Of the hundreds of billions of dollars in new initiatives that Democrats gleefully applauded, virtually all are administered through the tax code. They include an expanded tax break for college tuition, new tax subsidies for retirement savings, a package of tax proposals to encourage charitable giving, an expanded tax credit for long-term health care and a bevy of tax breaks for health insurance. Perhaps the reductio ad absurdum of the strategy is a school-construction plan that, instead of simply allocating new federal dollars, gives tax credits to those who buy bonds from local school systems.

In the current political context, the Democrats’ new approach seems an unqualified triumph. It responds to Republican calls for big tax cuts while upholding the traditional Democratic preference for initiatives aimed at working Americans and earmarked for specific purposes.

Yet, over the long term, the tax-and-credit approach may not be so wise. Far from representing a new “third way,” targeted tax breaks are among the oldest and largest components of U.S. social spending. They are also among the most wasteful and inequitable. Before embracing them, advocates of expanded social assistance should think about whether they wish to add to the scores of hidden entitlements lurking in the tax code rather than reexamine them.

For all their allure, tax breaks are fundamentally the same as direct spending. As Stanley S. Surrey, a former Treasury official, first emphasized, special tax breaks or “tax expenditures” do just what spending programs do: subsidize a group of taxpayers or a favored activity. The only difference is that tax breaks reduce the amount that recipients pay in taxes rather than provide a cash grant. In fact, tax expenditures are not just equivalent to spending. Most are equivalent to that much-maligned spending known as “entitlements,” because any taxpayer who meets the criteria for receiving a tax break automatically gets it.

This has not, of course, dulled politicians’ enthusiasm for tax breaks. In 1995, according to political scientist Christopher Howard, tax expenditures with social-welfare aims cost roughly a third as much as all federal spending on social programs. International evidence indicates that the United States spends considerably more on social policy through the tax code than do other nations. Indeed, if social-spending statistics accurately reflected tax subsidies and burdens and included all the private-welfare activities tax breaks subsidize, the United States would have a social-welfare system comparable to Sweden’s and larger than Denmark’s.

This alone may not cause concern. After all, many Democrats want the federal government to do more to deliver services and protect citizens against market risks. But two other features of tax expenditures should cause worry: their relative lack of public visibility and their generally regressive distributional effect.

Though tax expenditures appear in the federal budget, they do not feature as prominently as direct spending in public debate. This is, no doubt, a key reason for their political appeal: Lawmakers can smuggle into law programs that might not survive the glare of the public spotlight.

Yet, the hidden character of tax breaks is a double-edged sword. It means the complex assortment of spending programs embodied in the tax code is never subject to public review, never weighed against competing priorities, never given the scrutiny necessary to integrate multiple objectives. As the tax code grows cluttered with spending initiatives, it becomes more complex and less capable of achieving its basic goal of raising revenue.

The lack of visibility of tax breaks also prevents them from gaining the popular appreciation that the most celebrated social programs have. Millions of Americans are grateful to the government every time they get a Social Security check. How many even know about the multibillion-dollar tax break for employer-sponsored pensions?

Perhaps most important, the hidden character of tax breaks allows gross inequities in distributing social benefits. Imagine a politician proposing a new health-insurance program that would provide $1,700 a year to families with annual incomes between $100,000 and $200,000, and just $153 a year to families with incomes between $10,000 and $20,000. Yet, that is the approximate distribution of benefits provided by the special tax treatment of employer-provided health insurance.

Because most tax expenditures lower taxable income, their value is greater for individuals in higher tax brackets. Unless tax breaks are refundable (as is the earned-income tax credit), poor Americans who pay no taxes do not benefit at all. Many tax expenditures also require the itemization of deductions, which only a third of taxpayers, usually the wealthiest, do.

Tax breaks are typically regressive for another reason: They are worth more to those who receive generous workplace benefits or have the means to engage in tax-subsidized activities, such as buying a home. Many tax expenditures are designed to subsidize fringe benefits provided by employers, such as health insurance and pensions. Yet, coverage under employer programs is highly skewed, with low-wage workers covered less often and less generously than their better-paid counterparts. To make matters worse, the provision of fringe benefits is declining rapidly among lower-income groups. In fact, inequality in the distribution of fringe benefits has outpaced the growth of wage inequality for more than a decade.

The tax code will never be a political demilitarized zone. Even if it were possible to eliminate all the hidden subsidies for social benefits, few Americans would want to. Indeed, tax breaks have occasional advantages over direct spending. They carry little stigma, and most are administered by a single agency that, whatever else might be said about it, is eminently capable of assessing eligibility.

But the reality that tax expenditures will always be part of U.S. social policy does not condemn us to the current unsatisfactory structure of tax benefits or to the present blinkered political debate. Tax expenditures with social-policy goals--and the “private welfare state” of employer-provided benefits that they underwrite--should be openly debated, and explicit comparisons made between direct-spending programs and tax expenditures designed to fulfill similar purposes. Without this scrutiny, politicians will continue to consider cutting programs that disproportionately benefit citizens in the lower half of the income distribution while maintaining or expanding tax breaks that benefit those in the upper half.

Even modest reforms would help. To make tax expenditures less regressive, tax deductions (which lower income and are thus worth more to taxpayers in higher brackets) could be replaced with tax credits (which lower taxes by a fixed amount). Tax credits could, in turn, be made refundable, allowing those whose tax burdens fall below the amount of the credit, or who pay no taxes, to claim benefits. Eligibility for some benefits could be phased out at higher incomes, for example, by making subsidies for social services available only to those who spend a high percentage of income on them. And the value of tax benefits could be capped at reasonable levels, preventing wealthy Americans from buying, say, million-dollar homes with tax-subsidized dollars.

Surely the political barriers to new spending programs are daunting. Surely, too, Clinton should be commended for trying to assist lower-income Americans who continue to struggle to pay for education, child care, medical costs and saving for retirement. Yet, despite efforts to overcome the inherent limits of tax-based social programs, the president’s proposals threaten to weigh down an already burdened revenue code with a mess of loosely connected programs that promise little to the most disadvantaged and fail to elicit much public enthusiasm.

It may well be that the new social-policy strategy of Clinton and congressional Democrats is all that is possible. But if Americans and their leaders had a true debate about the uses and limits of tax policy as an instrument of social protection, perhaps they would recognize that the hidden spending submerged in our tax code is just as real, and far less fair, than the public social programs that are the cause of so much dispute.