Tax Breaks: Setting out the case for and against

Note: The Task Force for the Study of State Tax Credits and Economic Incentives, created by HB 1285, is meeting over the interim to scrutinize tax credits. This blog post excerpts an OK Policy issue brief from last year titled “Let There Be Light: Making Oklahoma’s Tax Expenditures More transparent and Accountable”. You can read the full brief or a 2-page summary of our recommendations.  Also see our blog post on the Task Force’s first meeting.

Tax expenditures are a widely utilized policy tool, with each legislative session seeing the introduction of dozens of bills calling for new or expanded tax breaks for individuals and businesses.  Proponents of most specific tax break proposals tend to make the argument in their favor on one or both of the two following grounds:

• Tax preferences are instruments for accomplishing worthwhile public purposes. If policymakers agree, for example, that encouraging individuals to save for a college education is a worthy goal, then allowing a tax deduction or deferral for some or all of one’s contributions to a 529 College Savings account may be the appropriate policy tool.  Tax policy can also be used as a way to target assistance and benefits to groups deemed worthy of support, because of such factors as age, income level, disability, military service, or occupation. Providing assistance through the tax code is often seen as a more effective, less expensive, and politically more palatable mechanism for providing support than operating a government spending program.
• Tax preferences are needed to encourage economic development.  Oklahoma, like other states, has adopted a plethora of tax credits, exemptions, and incentive payments that support certain kinds of economic activity. Tax preferences are generally justified as worthwhile when targeted to economically risky endeavors, emerging companies and sectors, export-oriented companies, and companies that will create high-paying jobs. In some cases, the explicit argument is that in a world of mobile capitol and competitive localities, businesses will locate or move elsewhere in the absence of incentives.  As long as other jurisdictions are offering incentives, failure to “play the game” is tantamount to unilateral economic development disarmament.

Yet if tax expenditures can serve a necessary and justifiable means to accomplish certain public policy goals, they also raise serious problems and concerns, which include:

• Hidden Expenditures. Tax expenditures are largely invisible.  Unlike direct spending programs, tax expenditures do not require annual appropriations or legislative review.  Even with greater disclosure in recent years, it remains hard to get consistent and reliable information about the cost and beneficiaries of tax breaks.
• Efficiency. While incentives are intended to get an individual or business to do something it would not otherwise do, it is often hard to establish whether a tax advantage makes a decisive difference in influencing behavior.  Good Jobs First, among the most vocal critics of state incentives policies, emphasizes that, “A mountain of evidence suggest that development subsidies are often abused by companies that would have done exactly what they did anyway.”In many instances, only a portion of the total cost of an incentive will produce an incremental increase in the behavior being promoted; the remainder is “wasted” as a pure subsidy or giveaway. This is also true of tax breaks intended to influence individual behavior: for example, at least some of those claiming a tax credit for first-time homebuyers would have purchased a home irrespective of the tax break.
• Accountability. While tax incentive programs are generally created as a way to promote specific public goals, such as capital investment or the creation of high-paying jobs, there are frequently weak accountability provisions to ensure that goals are met.  Many incentive programs impose few, if any, requirements that companies must meet to qualify for benefits, provide little ongoing monitoring or auditing, and rarely include oversight provisions or sanctions that can be imposed on companies that fail to uphold their commitments. As a result, some states have adopted “clawback” provisions as a component of incentive programs that require companies to refund all or part of their incentives if they fail to meet specified job or investment targets, or leave the state after receiving incentives.
• Neutrality. Tax neutrality is the widely recognized principle that tax policies should “not interfere with the natural flow of capital toward its most productive use.” The practice of offering preferential tax treatment to certain individuals, businesses, and organizations rather than others tends to substitute political choices for market decisions in the allocation of resources.  In many cases, there does not appear to be any clear or consistent reason why some economic sectors or activities are granted preferential tax treatment while others are not.  These provisions can create competitive differences between similarly-situated firms and individuals. For instance, two waste recycling firms operating in the same county may be subject to different tax treatment based on one having received tax incentives to relocate, while the other has not.
• Equity. While certain tax expenditures, such as the standard deduction or the earned income tax credit, provide preferential treatment for lower-income individuals, many of the largest tax expenditures, such as deductions for home-mortgage interest, pension contributions, and college savings, primarily benefit upper-middle class Americans. This is because many lower-income families do not have income tax liability against which to claim deductions, or do not have sufficient income to allocate to preferential forms of spending.  A study by the Urban Institute-Brookings Institute Tax Policy Center found that households in the top fifth of income received twice as much benefit from federal tax expenditures as did households in the bottom fifth.In Oklahoma, data supplied by the Oklahoma Tax Commission revealed that some 72 percent of households claiming a tax deductions for contributions to the state’s 529 college savings program in 2005 had annual income over $75,000, a group that represents  just 14 percent of total Oklahoma households (see the Chart on page 6 of this issue brief).
• Fiscal Impact. The fiscal impact of tax expenditures is significant. Nationally, the Tax Policy Center study calculated the cost of tax expenditures claimed by individuals at $760.5 billion in 2007, more than the total budget for either national defense or non-defense discretionary spending. The total cost of tax expenditures for which the OTC was able to determine the cost  exceeded $5.6 billion in 2008, which was not much less than that year’s  total appropriated state budget ($7.1 billion). This total is revenue that is unavailable to sustain public services in Oklahoma or to lower tax rates. More significantly, perhaps, the cost of particular tax expenditures is generally unlimited. Typically, deductions and credits can be claimed in unlimited amounts so long as the credit’s eligibility criteria are met. If an exemption or incentive proves popular, it can have a large and unanticipated impact on the budget. An example cited in a recent national report is of an Arizona tax credit for vehicles that can run on alternative fuels; the credit was expected to cost $3 million to $10 million per year but ended up costing $680 million in its first year.In Oklahoma, when businesses uncovered a way to exploit a loophole in the Venture Capital Tax Credit, the cost of the credit soared from $2 million to $66 million in one year.

• Local Impact. Tax policies adopted by the state legislature can have a large impact on the revenues available to local governments. With a few exceptions, the sales tax base for municipal and county governments is set by the state legislature, so that every new sales tax exemption adopted at the Capitol erodes the sales tax base of cities and counties across the state. On property taxes, while the Legislature cannot directly enact new exemptions, it can and does send proposals for statewide property tax exemptions to votes of the people.

As much as tax preferences can be faulted on all these grounds, incentives and subsidies will still be defended as necessary tools for states competing against one another to attract or retain investment and jobs.  But as Arthur J. Rolnick, the Senior Vice-President of the Federal Reserve Bank of Minneapolis has contended, this competition “interferes with interstate commerce and undermines the national economic union by misallocating resources and causing states to provide too few public goods.” Even if the subsidies war as a whole leaves no winners other than the companies that can wring concessions from state and local governments, states are unlikely to withdraw unilaterally. Accordingly, Rolnick is among those who have called on Congress to exercise its Commerce Clause power to put an end to  the economic war  among the states. Conservatives and libertarian supporters of free-market principles have also consistently urged states to abandon the use of subsidies as a form of economic development.