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Curb deficits by reining in spending hidden in tax code

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Federal spending is rising faster than the budget numbers imply. That’s because some increases are disguised as tax cuts.

When the government gives a tax credit to homeowners who buy solar energy panels, it’s just like giving them a cash subsidy to buy those panels. But it’s recorded as a reduction in taxes rather than as an increase in outlays.

And when the president calls for an increase in the child care credit, that’s also treated as a tax cut instead of the rise in spending that it actually is.

According to calculations of the Treasury Department that are hidden deep in the government’s annual budget, there are hundreds of billions of dollars of spending every year that are recorded as tax reductions. They are called “tax expenditures.”

The biggest tax expenditure is the exclusion of employer health insurance premiums from the taxable income of employees. That exclusion resulted in a tax reduction of $160 billion in 2010 and is projected to be $1.4 trillion between 2010 and 2016. That’s a $1.4 trillion subsidy to health insurance that is disguised as a tax reduction.

Limiting tax expenditures could produce enough revenue to achieve very substantial cuts in future budget deficits while also lowering personal tax rates. Indeed, if tax expenditures are not reduced, Congress will  be forced to raise tax rates or to introduce new taxes.

There is no way to achieve the needed reductions in future deficits just by cutting traditional government outlays, even if there are further cuts in defense spending. And slowing the growth of Social Security and Medicare is needed just to avoid an explosion of future spending on those programs.

Limiting tax expenditures should have bipartisan appeal. Republicans should welcome limits on tax expenditures as a way to cut hidden government spending. Democrats should accept it as a way to raise the revenue that they insist must be part of any deficit reduction plan.

This is really a reduction in government spending, not a tax increase. And deep enough cuts in tax expenditures would actually allow reductions in personal tax rates as well as in budget deficits.

I favor putting a cap on the total value of tax reductions that each individual can achieve through tax expenditures. Specifically, I favor limiting the tax reduction that individuals can achieve through itemized deductions and the exclusion of employer health insurance payments to 2 percent of each taxpayer’s adjusted gross income. Such a cap would allow each taxpayer to benefit from all of the current tax rules but would limit the total  tax reduction to no more than 2 percent of that taxpayer’s total income.

I am surprised that some conservatives who favor cutting government nondefense spending oppose limiting tax expenditures because they regard the resulting increase in tax revenue as a tax increase.

Although government accounting rules treat the end of a tax credit or the limit of a tax deduction as a revenue increase, the economic effect is the same as a cut in spending. Anyone who favors less government spending should also favor cutting tax expenditures.

Martin Feldstein is a professor of economics at Harvard. He was chairman of the Council of Economic Advisers from 1982-84. This article is adapted from The Weekly Standard.