Friday, May 31, 2013

Three charts one story

The Congressional Budget Office released a report on "tax expenditures" which purports to show one thing (the skewing of benefits to the highest quintiles in income) but actually shows something quite different.  This is not to say that the data is wrong - merely that it fails to account for a key fact.
The WP immediately seized on the story.  (Gee what a surprise.)

You may remember that Tax Expenditure theory is one of those delightful Washington creations which purports to measure the loss in tax revenue that is created by allowing taxpayers to exclude certain parts of income from their tax returns through deductions and credits and income exclusions.   For example, a large one (originally created when WWII wage and price limits were cutting into employment) is the exclusion from income of health benefits.   Many have distortive effects.   The health care system would probably be much better if we did not have that exclusion.  Tax Expenditure Theory was invented in large part by a former Assistant Secretary for Tax Policy who thought that rich folks did not pay enough tax.  It was one of those insider debates that is deceptively simple, but ultimately not very accurate.   The arithmetic is correct, but the thinking is distorted.

 The problem with these types of concepts was first pointed out by Adam Smith in the Theory of Moral Sentiments.  (Emphasis added)

"The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it."

Ultimately, while we may think we can calculate the effects of structural elements of the tax code - those calculations may have no ultimate relation to actual human behavior.  So here are the charts - the first two from the CBO report.   The first, with seeming great precision, seems to show that the highest 20% of taxpayers reap enormous benefits from the tax expenditures.

 The second attempts to show the distribution of benefits by type of of preference - exclusions from income, preferential treatment of income (for example capital gains) or tax credits.

The problem with all this seeming precision is that it fails to account for the ultimate structure of the how the income tax ultimately works.   In spite of these preferences the American tax system has two characteristics that are key.   First, it is highly progressive.  The distribution of tax payments skews significantly to higher income taxpayers.   The Tax Foundation has the most reliable data on who actually pays income tax.  Here is a chart divided by income.
Note the top 1% of taxpayers have a bit more than 18% of the adjusted gross income but pay 37% of the tax burden - so even if the CBO numbers are correct, they may not be important. The bottom 50% have just under 12% of the income and pay 2.4% of the tax.   By any measure that is a progressive system.

But wait, there is more.  According to the latest IRS data about 70% of the taxpayers do not itemize.   While it can be argued that some exclusions (like the one for health insurance) are accounted for in this data you will notice that those are skewed relatively evenly.   But the rest of the provisions in the code are supposed to be bundled up in the Standard Deduction for those who choose not to itemize.   But the CBO report does not seem to take that into account.  One final comment, about half the taxpayers pay no income tax - so the distribution of tax expenditures has no effect. But again the report ignores that detail.

After reading the report one is left with the question - so what?   Should the tax system be simplified?  Absolutely!   But do tax expenditures materially distort the fundamental progressive nature of the tax system?  Probably not.

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