Donald Trump entered office promising to cut taxes, indeed to reform the American tax system. The last major reform happened over 30 years ago, in 1986, and both major parties largely agree today that the tax system is unnecessarily complex, even byzantine. With Republicans controlling both houses of Congress, a major rewrite to the tax code is possible.
In September, the White House and Republican Congressional leaders issued a joint framework for tax reform that focuses on lowering tax rates, paying for them by “closing special interest tax breaks and loopholes.” Such “tax expenditures,” as they’re called in government, were worth well over $1.5 trillion in 2016, according to Congress’s Joint Committee on Taxation – in other words, they cost the federal government over $1.5 trillion in lost revenue.
A detailed tax plan is not yet available, but many journalists are focusing on these breaks, each of which has a constituency. Some benefit middle class homeowners, others oil companies. Powerful lobby groups help such groups navigate Washington, stymieing change. As part of our occasional series on tax policy, this explainer looks at tax breaks, how they work, and the tension between the government’s need to raise revenue and what individuals and corporations have come to expect.
Mechanics of tax legislation: The government needs money
For a permanent tax cut to become law, it must pass the Senate with 60 votes (or at least 60 senators must vote on closing the arguments about the bill, “cloture”).
Republican leaders do not have that many votes. So they are using a legislative mechanism called “budget reconciliation” that requires only 51 votes. Under the terms of this rule, however, Congress cannot increase the deficit. Translation: Any change to tax revenues (what the government takes in) must be offset by savings.
How does the government save? One option is to cut spending. But the biggest line items in the federal budget all have significant constituents. It’s politically delicate – if not potentially dangerous — to cut welfare programs or defense spending or subsidies for pension plans.
“There just aren’t that many revenue raisers,” Harvard Business School’s Mihir Desai explained recently. “Tax expenditures, which are also sometimes labeled loopholes, have become highly concentrated in certain areas, namely, employer-provided health insurance, the state and local tax deduction, the mortgage interest deduction, all of which are sometimes called loopholes but are in fact very serious consequential policy choices. That makes reform really, really hard.”
What are deductions, credits and loopholes? A glossary
When you, or a company, pay taxes, you tell the government how much salary or profit you earned and then you pay a percentage of that sum in taxes. A deduction is an amount you can subtract from your taxable income, reducing your tax liability. Examples: the mortgage interest deduction, contributions to some retirement accounts, and charitable contributions.
These itemized deductions are regressive, benefiting the wealthy most because they pay a higher marginal rate (the amount one pays on another dollar of income). Under the current tax brackets, where the highest earners pay 39.6 percent on every dollar of income above $415,051 and the lowest pay 10 percent on their income, a high earner saves 39.6 cents for every dollar of deductions; a low earner saves 10 cents per dollar (or, because of credits, often nothing at all).
Unlike a deduction, a credit is subtracted from the taxes you owe. If your tax liability is $100 and you have a $50 credit, you pay $50 in taxes. Therefore, credits are worth the same to everyone who can use them. Some credits are nonrefundable. Perhaps your tax liability is so low you cannot take full advantage of the credit. If it’s a nonrefundable credit – like a credit on an electric vehicle – you don’t get the difference back; you cannot reduce your tax burden below zero. But other credits, like the Earned Income Tax Credit (EITC), are refundable – if this credit is worth more than you owe in taxes, you will receive the difference from the government. This one is intended to help low-income families.
The EITC is the most expensive tax credit, costing the federal government $68 billion in 2015 – the vast majority of that (85 percent) was paid out as a refund, according to statistics from the Internal Revenue Service (IRS). It is also the most popular credit, claimed by over 17 percent of tax-filing households that year.
Credits and deductions are types of tax expenditures, or tax revenue lost to the government.
A loophole is just another way to describe a deduction or other legal method for reducing your tax liability, though the word often carries negative connotations.
Deductions and credits are essentially subsidies – that is, they are like a transfer of money (in this case, money that otherwise would have gone to the government) to you or an organization such as a charity or a local government. And they incentivize certain behaviors, such as saving for retirement, buying an electric vehicle or giving to your church.
Some deductions and expenditures often discussed in the press
- Deduction for state and local taxes (SALT): Republicans in Congress have also proposed to end or at least cap the federal deduction for state and local taxes (SALT), which helps subsidize state and local governments. Under this provision, a California taxpayer, say, deducts her property tax and state income tax from the income she declares to the federal government. This disproportionately affects residents of Democratic-leaning states, since these states tend to have higher taxes, Quartz points out. Eliminating SALT could raise between $1.3 trillion and $1.8 trillion over a decade, argue left- and right-leaning think tanks, respectively. The Congressional Budget Office estimates that capping this deduction at 2 percent of one’s gross salary would increase federal revenues by almost $1 trillion over the next 10 years.
- Employer-sponsored health insurance: The largest individual tax break covers health insurance premiums, by excluding employer and employee contributions as taxable income. This provision was worth $155 billion in 2016, according to the JCT. Other health-related exclusions totaled over $75 billion. These are not itemized deductions. They are benefits employees receive tax-free.
- The mortgage interest deduction is a popular subsidy benefiting homeowners who subtract from their taxable income the interest they pay on their mortgages. The Joint Committee on Taxation (JCT) estimates this deduction is worth about $65 billion a year. The Republican framework says it is not on the chopping block, though it has long been in the sights of reformers and a cap is possible. Any change could have major implications for the housing market.
- Retirement plans: Individual Retirement Arrangements (IRAs) and some other investment withholdings such as 401(k) plans have tax-preferred status. Trump has promised that reforms will not affect these programs, though some House Republicans have said they are still weighing changes. According to the Labor Department, over 62 million Americans have 401(k) plans, which allow them to set aside up to $18,500 (in 2018) for retirement before taxes are withheld. They must pay taxes when they withdraw money from the 401(k) during retirement; technically, this is not a deduction, but a deferral.
- Charitable contributions: The Republican framework promises not to touch this deduction, which amounted to $54 billion in lost revenues to the federal government in 2016, according to the Office of Management and Budget. As with other itemized deductions, high earners benefit more from charitable giving because they pay a higher marginal tax rate. A provision in the IRS code allows for donations to Israeli charities to be deducted in some cases, but not to charities in other countries.
- Tax breaks for oil producers: Pundits on the left frequently float the idea of cutting tax breaks for oil producers, which enable oil and gas companies to deduct drilling costs from their taxable income and cost the federal government about $4 billion a year, according to a 2016 study by the National Bureau of Economic Research.
- Deduction of debt interest: This allows companies to deduct the interest they pay on loans from their profits before paying corporate tax. But, explains the Financial Times, “that benefit is especially important to private equity groups whose modus operandi is to leverage up on debt to buy other companies.” Axing this deduction could add significant revenues to government coffers, but it would likely be offset by another mooted tax reform: cutting the corporate tax rate from 35 percent to 20 percent.
Other deductions include union or professional association dues, gambling losses and some moving expenses. For a full list of deductions and credits, with definitions and terms, see this page from the IRS.
Itemized deductions and the standard deduction
The Republican tax framework proposes to double the standard deduction most taxpayers take. This is an amount – $6,350 in 2017 for an individual filing alone – that one can deduct from their salary instead of itemizing deductions for SALT, mortgage interest, charitable giving, etc. The higher amount will simplify taxes for many Americans, while also reducing the incentive to act in particular ways (to donate to your church or alma mater, to buy the house with the bigger mortgage, etc.). The standard deduction rarely impacts the super wealthy.
Proponents of the Republican framework argue that tax cuts help drive growth, that leaving money in consumers’ hands will encourage them, for example, to buy cars, in turn creating jobs for people to build cars, who will then pay taxes and fill government coffers. The question is, of course, how much the cuts will jumpstart the economy. A 2012 report from the Federal Reserve Bank of St. Louis challenges assumptions that consumer spending can continue to drive growth.
Relatedly, expecting growth by entrusting corporations to invest is sometimes known as “trickle-down” or “supply-side” economics. A 2014 report by the Congressional Research Service concludes these policies have a relatively small effect on growth.
Taking into account these larger macroeconomic trends is called “dynamic scoring.” A popular model developed at the University of Pennsylvania and known as the Penn-Wharton Budget Model has found President Trump’s plan would add significantly to the deficit and slow growth.
Looking for the latest?
Check out the Senate Finance Committee and the House Ways and Means Committee, the two committees responsible for drafting legislation. The Treasury Department compiles annual statistics on what expenditures cost. Treasury also explains how tax legislation winds its way through government. The IRS has statistics galore. The JCT has a page of links to other resources.
Related explainers from Journalist’s Resource
- We’ve also written about who benefits when sales taxes are cut.
- The Congressional Budget Office issues regular reports focusing specifically on federal spending and the debt, including a 2017 paper on the economy and budget in the decade ahead and a 2016 paper on options to reduce the annual deficit.
- The Congressional Research Service – Congress’s nonpartisan research arm – also publishes regular reports, including on topics such as the debt limit (2015), foreign holdings of federal debt (2016), deficits (2016), and how Treasury manages debt (2016).
- The Bureau of Economic Analysis performs cost-benefit analyses of various programs affecting the U.S. economy.
- The Tax Policy Center, a nonpartisan think tank, has a free briefing book on how the budget works as well as regular cost-benefit analyses on government initiatives. The National Conference on State Legislatures is also a good resource.
- Other think tanks and campaigners monitoring the budget, some of whom have agendas, include The Center for Budget and Policy Priorities, the National Priorities Project and The Committee for a Responsible Federal Budget.
- Bergman, Peter; Denning, Jeffrey T.; Manoli, Day. “Broken Tax Breaks? Evidence from a Tax Credit Information Experiment with 1,000,000 Students.” IZA Discussion Paper No. 10997, 2017.
- Brewer, Ben; Conway, Karen Smith; Rork, Jonathan C. “Protecting the Vulnerable or Ripe for Reform? State Income Tax Breaks for the Elderly–Then and Now.” Public Finance Review, 2016. DOI: 10.1177/1091142116665903.