Lawmakers could pay for reconciliation while improving the tax code
With price increases for businesses and individuals potentially released of the Build Back Better (BBB) reconciliation package, lawmakers are weighing alternative options to boost revenue. Rather than offering complicated changes to the tax base or untested proposals such as mark-to-market valuation for billionaires, they should prioritize options that increase revenue while improving the structure of the tax code. .
When seeking new tax revenue, legislators often immediately think of raising tax rates. But raising tax rates can have the most adverse economic effects because it changes the incentives to work, save or invest. Broadening the tax base can improve the structure of the tax code, often with much less adverse economic effects.
For example, the tax code is full of so-called tax expenditures, or expenditures via the tax code. While some expenses are important structural elements of the tax code, many are complicated and disproportionately benefit specific industries or households. Eliminating these provisions would be one of the least economically damaging ways to generate revenue.
On the business side, lawmakers could target spending that creates unequal conditions of competition between industries or sectors, such as exemptions for credit union income and interest on municipal bonds, and tax benefits for Blue Cross and Blue Shield companies. the Treasury Department estimates the cost of the three expenditures at a combined total of $77.7 billion over 10 years. Note that the Treasury Department’s tax expenditure estimates are not revenue estimates, because the revenue generated by repeal may be different after accounting for behavioral responses.
One of BBB’s goals is to fight climate change. To achieve this and raise revenue, lawmakers could replace the slew of mostly temporary and ineffective tech-specific tax credits with a carbon tax. From 2021 to 2030, energy production and energy investment credits are estimated at cost $115 billion, while a carbon tax starting at $25 per metric ton of carbon could generate nearly $1 trillion over 10 years. Such an exchange would generate significant revenue and more effectively tackle carbon emissions in a technology-neutral manner.
In Options for Reforming the US Tax Code 2.0, we estimated that eliminating all business tax expenditures unrelated to structurally important items such as deferral, cost recovery, and foreign revenue would generate nearly $960 billion over 10 years while reducing production economy of 0.2%. The economic impact is limited because some expenditures, such as technology-specific tax credits, incentivize switching from one activity to another rather than increasing overall activity, and others are temporary.
Lawmakers could also reevaluate the tax-exempt status of government-sponsored enterprises (GSEs) and some businesses still classified as nonprofits. Research suggests, for example, that non-profit hospitals do not appear to engage in more charitable activities than for-profit hospitals, which calls into question their tax-exempt status. Apply the Corporation tax to nonprofit hospitals could raise nearly $40 billion over 10 years, while applying it to Fannie Mae and Freddie Mac, the Farm Credit System and the Tennessee Valley Authority could raise nearly $87 billion.
On the individual side, instead of expanding deductions that narrow the income tax base and disproportionately benefit high-income earners, lawmakers could further limit them. For example, eliminating the deduction for state and local taxes would yield $1.6 trillion over 10 years on a conventional basis and eliminating the mortgage interest deduction would yield nearly $1.1 trillion. A more modest move to lower the mortgage interest deduction cap to $500,000 in principal could bring in nearly $150 billion over 10 years.
A number of other exclusions narrow the income tax base and lead to significant distortions, such as the exclusion of interest on municipal bonds, which the Treasury estimates cost nearly $284 billion. for individuals over 10 years.
By far the largest tax expenditure is the exclusion of employer-provided health insurance, which the Treasury Department estimates at $2.8 trillion over 10 years. Under current legislation, health insurance provided by employers is not included in taxable income, leading employees to favor health insurance over regular wages as compensation. This distortion results in more spending on overly comprehensive insurance schemes than would otherwise occur, and reduces tax revenue.
The most ambitious option to fill the biggest hole in the income tax base would be to revoke the exclusion from employer-provided health insurance entirely. An alternative, however, would be to cap the amount that could be excluded, counting and taxing anything above the cap as ordinary income. This change would increase revenue while helping to contain health care costs.
As legislators weigh alternative options to increase revenue, broaden the tax base, and eliminate non-cost recovery tax expenditures, international taxes and deferral are good starting points. Rather than offering untested and complicated ways to generate revenue, changes that improve the structure of the tax code by making it simpler and more neutral for industries and households should be prioritized. Above all, legislators should avoid economically damaging increases in marginal tax rates.
Kickoff Resource Center: President Biden’s Tax Proposals