Tax expenditures can rescue Congress from the next shutdown threat

President Bill Clinton famously tried to wriggle out of trouble by saying “it depends on what the meaning of the word ‘is’ is.”

Congress can similarly avoid even more trouble — in this case, a government shutdown — by reconsidering the conventional meaning of “expenditure.” With some fancy semantic footwork, it can likely circumvent this debacle in a way that is not only economically justifiable, but also consistent with sound budgetary practice.

A current goal of both Republicans and Democrats is — or at least should be — to cut the federal deficit. Where they disagree is that the Republicans demand expenditure cuts, while Democrats prefer revenue increases.

Congress controls expenditures, at least partly, by passing the twelve annual appropriation bills. By contrast, Congress manages revenues mainly by modifying the tax code. Revenue policy is thus seldom, if ever, coordinated with the appropriation process. 

Here’s why the definition of “expenditures” matters, and why an economically sound definition can promote a compromise letting Republicans boast that they have cut the deficit by cutting costs and Democrats by raising revenues. “Tax expenditures” are provisions of the tax code that allow special credits, exemptions or deductions from gross income that benefit an identifiable class of taxpayers. They are reductions in tax revenue. Tax expenditures are the economic equivalent of spending, but they are not accounted for as such.

Suppose that the federal government wishes to subsidize the development of a new drug to the tune of $500 million. It could appropriate and then write checks totaling that amount to various pharmaceutical firms that would undertake the research. Or it could allow the companies to take a direct credit against their tax bills for their allowable research costs. The former would be reported on the government’s books as an expenditure. The latter would never be recorded on the government’s books — neither as an expenditure nor as revenue. The impact on the federal deficit would be the same — an increase of $500 million. Hence, for the purposes of budgetary negotiations, it is a reasonable linguistic leap to refer to “tax expenditures” as simply “expenditures.”

A key benefit of focusing congressional negotiations on tax expenditures is that they target both conservative and liberal causes. That is, they allow each side to claim victory in their quest to reduce the deficit — Republicans by cutting expenditures; Democrats by increasing taxes.

The Treasury Department has identified 178 tax expenditures, which would sum to almost $1.6 trillion in fiscal year 2024. The most prominent of these — like the exclusion from income of employer contributions for medical insurance and the deductibility of charitable contributions — are likely inviolable. Others, however, although nowhere as significant in size, are the low-hanging fruit of deficit reduction. Some were incorporated into the tax code years ago, and the rationale for them has long since gone. Others meet the political definition of pork.

While tax expenditures may be a well-intentioned means of providing aid to the needy or promoting other worthy causes, they are a poor substitute for direct subsidies. Unlike direct expenditures subject to annual appropriation, once they are incorporated into the tax code, they tend to remain there permanently. Further, they are administered by the Internal Revenue Service, an agency unable to monitor the credits and deductions by virtue of shortages of staff, as well as lack of program-specific experience. Hence, they are subject to greater risk of fraud and abuse than direct expenditures, which are in the purview of a department or agency with expertise in the area. 

Despite their shortcomings, tax expenditures cannot — and indeed should not — be eliminated entirely from our tax structure. As but one example, the deductibility of charitable donations has been shown to efficiently and effectively facilitate the creation of medical research institutions that are unmatched globally.

There are, however, measures that could both limit the use of tax expenditures and mitigate their negative characteristics. At the very least, Congress should incorporate tax expenditures into the tax code only after explicitly considering whether a direct subsidy would be a feasible alternative. In addition, Congress should routinely impose sunset provisions on all future tax expenditures to ensure that, just like ordinary expenditures, they are subject to periodic review.

Significant ongoing reductions in federal deficits will unquestionably require a combination of major changes to entitlement programs (and other large-scale programs) and increases in taxes. That’s clearly beyond the capability of the current Congress. For now, characterizing tax expenditures as ordinary expenditures may offer Congress a path to sparing itself from the ridicule of being totally dysfunctional — and the country from the trauma of another government shutdown.

Michael Granof is the EY Professor of Accounting Emeritus at the University of Texas at Austin McCombs School of Business. He served a 10-year term on the Federal Accounting Standards Advisory Board. Martin J. Luby is an associate professor at the University of Texas at Austin LBJ School of Public Affairs.