With lawmakers under pressure to find ways to reduce the deficit while avoiding the more painful spending cuts in the sequester, the Senate Budget Committee held a hearing to examine how to reduce the deficit by eliminating wasteful spending in the Tax Code.

Tuesday’s hearing scrutinized the trade-offs between increasing taxes on the wealthy and large corporations as opposed to cutting programs relied on by families, seniors, and communities nationwide.

University of Southern California law professor Edward D. Kleinbard testified on the need for tax reform. “The United States can afford to increase the total taxes it collects as a fraction of GDP,” he said. “Just a decade ago, the country ran budget surpluses and enjoyed both a robust economy and job growth, while tax collections exceeded 20 percent of GDP. This means directly tackling some of the deliberate congressional subsidy programs baked into the tax code, which is to say, tax expenditures.”

Kleinbard contended that the adverse budget deficit picture over the next decade is the result of forgone tax revenues. “As a result of the Great Recession, we lost about $2 trillion in revenue over the last few years, relative to our historic rate of tax collections as a percentage of GDP,” he said. “Looking ahead, the fiscal cliff tax deal will reduce future tax revenues by $4 trillion, relative to what CBO had projected under its 2012 baseline. Together, these past and future forgone revenues amount to a roughly $7 trillion contribution to our deficits from 2008 to 2023, including interest costs on increased borrowings. To a large extent, both sequestration and the budget caps of the 2011 Budget Control Act are efforts to recoup on the spending side monies that were forgone from the revenue side.”

Kleinbard argued that the most important tax expenditures to address in tax reform are personal itemized deductions, such as the deductions for home mortgage interest, charitable contributions and state and local taxes. “They are extraordinarily costly subsidies, about $250 billion per year in forgone tax revenues,” he said. “They are inefficient, in that they lead to major misallocations of economic resources, particularly with respect to housing. They are poorly targeted, in that the government subsidies go to individuals who would have behaved the same without the subsidies. And they are unfair, in that they are ‘upside down’ subsidies. They subsidize high-income Americans more than low-income ones.”

Kleinbard recommended replacing the personal itemized deductions and the standard deduction with 15 percent tax credits, estimating that would raise approximately $1.5 trillion in revenues over the next 10 years, without taking into account any transition relief.

“My suggestion would still preserve about one-half the aggregate current economic value of personal itemized deductions, but would do so in a way that adds to the progressivity of the Tax Code,” he added. “Nonetheless, the scale-back in the value of the personal itemized deductions should be phased in over several years.”

Kleinbard also called for scaling back the home mortgage deduction. “I fully recognize that the home mortgage interest deduction and other personal itemized deductions invariably are described as ‘sacred cows.’ But they are sacred cows that we can no longer afford to maintain,” he said. “Either we corral these sacred cows, or we allow them to stampede over us.”

Jared Bernstein, a senior fellow at the Center for Budget and Policy Priorities, testified that tax expenditures’ usefulness, or lack thereof, should be assessed using a three-part test. 

“Members will not be surprised that it is far too easy to find many tax expenditures that are ‘trifectas’: they forego significant revenue, they induce inefficiencies, and they return most of their benefits to the wealthiest households, boosting after-tax inequality and failing on the fairness criterion,” he said.

Bernstein favors capping most deductions for taxpayers above a certain income level. “This solution scores highly on the three criteria,” he said. “President Obama has proposed to limit the value of itemized deductions and certain other tax expenditures to 28 cents on the dollar, which would raise about $500 billion in revenue, otherwise forgone, over the next decade. Regarding the fairness criterion, it reduces the ‘upside down’ problem, by partially closing the gap between the value of deductions claimed by those with the highest incomes relative to lower income tax units. And while the lower deduction amount reduces incentives at the margin, such incentives still exist, a feature which distinguishes this approach to reform tax expenditures to those which cap expenditures at a certain dollar amount or at a set percentage of income. Under those approaches, no marginal incentives exist above the cap.”

However, Bernstein acknowledged that such a cap would miss other tax expenditures that he considers to be “ripe for reform,” including carried interest, like‐kind exchanges, and tax deferrals by multinational corporations on profits earned by foreign subsidiaries.

“Tax expenditure reform offers an excellent option to reduce wasteful spending through the tax system, while helping to meet our fiscal challenges in ways that will simultaneously improve our deficit outlook, increase economic efficiency, and add much‐needed fairness back into the code,” he said.

Sen. Patty Murray, D-Wash., who chairs the Senate Budget Committee, sees good reason to eliminate some tax expenditures as a way to achieve tax reform.

“Now, there’s no question that we do need to look at government programs carefully, so that we can make fair, responsible cuts that put families and our economy first,” she said. “But a big source of spending, and one that deserves to be just as closely examined, is expenditures in our Tax Code. While we don’t often think of tax expenditures as a form of spending, they require us to make the same kinds of tradeoffs that other forms of government spending would, and lots of them. There’s no good reason, for example, that taxpayers currently subsidize millionaires more, when they purchase a second home, or a yacht, than they do middle-class families purchasing their first home. And why should a hedge fund manager pay a lower tax rate on his income than a soldier, police officer or a teacher?”

Russell Roberts, a research fellow at the Hoover Institution, contended that it was also important to reduce wasteful spending in addition to eliminating wasteful tax expenditures. “I am wildly enthusiastic about eliminating wasteful spending in the Tax Code,” he said. “Our tax system should be more transparent, simpler, and fair. We should get rid of special exemptions for the rich, for people with children, for farmers, home owners, and all the other ways that the Tax Code panders to special interests. But how we finance government—the structure of the tax system and the mix between taxes and borrowing—is rarely as important as whether government spends money wisely. It’s not just that we spend more than we take in. We spend too much and much of it we spend poorly. Raising taxes doesn’t solve that problem—it turns it into the status quo.”