Off-radar tax breaks draw new scrutiny

Red ink and a presidential tax-reform panel may put focus on 'tax expenditures.'

A little money - $100 million - to help shipping companies buy new vessels; $230 million to encourage drug companies to develop treatments for rare diseases. Half a billion to assist oil and gas exploration. Another half billion to allow ministers to deduct housing allowances from their taxes.

Together, they represent the black hole in the US budget universe.

As Capitol Hill plunges into negotiation over the tightest budget since the Reagan era, there's more than $900 billion in a murky area that's all but invisible in the debate over a proposed $2.57 trillion budget. Economists call them "tax expenditures." Tax breaks are akin to spending but not included formally in the budget process.

Some, such as the home mortgage deduction, enjoy broad popularity. Others, such as tax credits for electricity production from poultry waste or "orphan drug" research (on rare diseases), are obscure. In total, the lost revenues are more than enough to eliminate federal deficits, mop up Medicare, and set Social Security on a more secure path. But these sums - slated to exceed $1 trillion in 2008 - have been effectively off the table in budget discussions for years.

Now, as US lawmakers take up the president's budget this week, that protected status could be in jeopardy, as the nation grapples with a new era of federal red ink and as President Bush encourages discussion of sweeping tax reform.

Indeed, last week some experts urged the president's tax reform commission to take up the issue as part of its mandate.

"The tax system has scores of programs which are not materially different from expenditure programs, and they should get the same sort of attention that one gives expenditure programs," says Joel Slemrod, director of tax policy research at the University of Michigan, who testified before the panel on March 3.

So far, neither major party is eager to include such tax breaks in the annual budget scrum. "No Democrat wants to look like they're raising taxes," says a top Democratic aide. Conservative activists say that cutting tax breaks (unless matched dollar for dollar with other tax cuts) is as severe a violation of a politician's "taxpayer protection pledge" as a vote to raise tax rates.

"When the government doesn't steal your money, it's not an 'expense' of government," says Grover Norquist, president of Americans for Tax Reform.

But with federal deficits at a levels that many experts deem unsustainable, there's growing pressure to bring this class of expenditures directly into the process.

"In many years, the total value of tax preferences exceeds the total value of discretionary spending. These items are off the radar screen, and they should not be," said US Comptroller General David Walker, in an interview this week.

Since the 1970s, fiscal hawks have urged Congress and the White House to keep an eye on expenditures in the tax code in making budget decisions. In the Budget Act of 1974, Congress required the White House to publish a list of tax expenditures as part of its annual budget submission.

The tax reform act of 1986 swept away many of the exclusions and breaks in the tax code. But by the Clinton era, the trend to spend through the tax code was back in force. Tax expenditures now cover the whole range of the budget, from defense and international affairs to education and health. The top tax expenditures in President Bush's budget are exclusion of employer health insurance at $125.6 billion, the home mortgage interest deduction at $76 billion, and the exclusion for 401(k) savings at $48 billion.

Others include deductibility of medical expenses at $9.1 billion, the earned income tax credit at $5.4 billion, and deductibility of education charitable contributions at $3.7 billion. But there's also $140 million for maintaining railroad tracks, $40 million for income averaging for farmers, $10 million for employer-provided child care credits, and a $30 million biodiesel tax credit

"If you're a lobbyist and want something done for your client, the best way to do it is to couch your special program in tax language and slip it in as part of a tax bill," says Richard Pomp, a professor at the University of Connecticut School of Law. "Once it's enacted, that tax expenditure will escape scrutiny by the budget folks because it will never appear on the spending side of the budget."

In his Jan. 7 executive order launching the President's Advisory Panel on Federal Tax Reform, Bush signaled that he expected the panel to protect at least some of these tax breaks. He calls on the panel to develop "revenue neutral" policy options that simplify the tax code "...while recognizing the importance of homeownership and charity in American society" - a reference to two of the most popular tax breaks. But the panel isn't ruling any options out.

By 2009, the home-mortgage interest deduction will be worth some $99 billion, with most of the benefit going to families with incomes over $100,000 a year.

One of the most politically charged tax expenditures possibly on the block is the deductibility of state and local taxes. "The administration has floated the possibility of eliminating the state and local tax deduction. This is a red state/blue state issue, because blue [Democratic-leaning] states such as New York and Connecticut are high-tax states," says Chris Edwards, director of tax policy studies at the Cato Institute.

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