Monday, April 06, 2009

Why Tax Deductions make our Economy Less Stable

Yair Listokin

Stabilizing the business cycle through fiscal policy is very much in vogue. President Obama’s stimulus package and budget proposal prescribe historic budget deficits in an effort to mitigate the impacts of the economic crisis. The goal is that government spending will replace the demand that vanished with the bursting of the credit and housing bubbles. With this backdrop in mind, I recently posted an article on SSRN entitled “Tax Expenditures and Business Cycle Fluctuations” that applies Keynesian insights on macroeconomic stabilization to the income tax code.

My article discusses a popular substitute for government spending—the “tax expenditure”. A tax expenditure is a provision in the tax code that provides a tax incentive for one type of spending rather than another. A noteworthy example of a tax expenditure is the deduction for spending on charitable contributions. If I spend my money on a hot dog, my taxes are unchanged. If I spend the same money on a charitable gift to a hot dog museum, however, my taxes go down. This gives me an incentive to donate to the hot dog museum rather than buy the hot dog. Instead of subsidizing the museum by reducing taxes on my charitable gift, the government could have given money to the museum directly. Interestingly, the total value of deductions, exclusions, and credits such as the charitable deduction nearly equals the value of direct government spending. (For more details and numbers, see the Tax Policy Center's fine discussion of tax expenditures.)

Unlike government spending, the article explains that tax expenditures amplify the business cycle. When times are flush, I give more money to the hot dog museum; the government's implicit subsidy to the museum in the form of taxes not collected out of my donation is high. When times are difficult, I reduce my donation; the government's implicit subsidy to the museum goes down. The government thus spends more money supporting the hot dog museum in good times than in bad-- exactly the opposite of Keynesian stabilization prescriptions. The effect holds true for almost all other tax expenditures; a tax expenditure means that the government's subsidy is greater in boom times than in busts. In a period where economic stabilization is a top priority, this destabilizing effect may justify a rethinking of our heavy reliance on tax expenditures rather than direct government spending.

The remainder of the article further develops the mechanism whereby tax expenditures amplify business cycles by changing tax payments. The article also discusses circumstances that make tax expenditures more or less destabilizing. To give just one example, a tax expenditure for an expense that is very sensitive to the economic cycle, such as vacations in Las Vegas, will be much more destabilizing to the economy than a similarly sized tax expenditure on a business cycle insensitive expense, such as food staples.

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