The Senate Finance Committee held a hearing Wednesday on the effectiveness of various tax incentives.

The hearing was one of a series that the committee has been holding as it prepares for reform of the Tax Code. 

“Today, we have all sorts of incentives in the code,” said Senate Finance Committee Chairman Max Baucus, D-Mont.  “Many incentives are meant to encourage or discourage certain behavior. The research and development credit is meant to encourage innovation and create jobs. The higher education incentives are meant to help students pay for college. The retirement savings incentives are meant to encourage saving for those later years. In 2010, we used $109 billion for more than a dozen different incentives to help Americans save for retirement. We used $91 billion to promote homeownership through the mortgage interest deduction. All in all, incentives in the income tax code cost more than $1 trillion each year.  That’s about the same as the total amount raised by the income tax code.”

Baucus noted that there are a huge number of temporary tax incentives, and the prevalence of them has risen dramatically over the past decade.  “There are now 141 temporary provisions that expire nearly every year,” he pointed out. “These temporary tax incentives hinder taxpayers’ ability to plan. As a result, they may only benefit those people who would have acted anyway.”

Orrin Hatch, R-Utah, the ranking Republican member of the committee, said the Tax Code has become too complicated. “The Internal Revenue Code has become so complex that it is colliding with human nature,” he said. “On balance, taxpayers are inclined to behave according to the political economic theory of Rod Tidwell, the star wide receiver in the film Jerry Maguire. Tidwell operated by a simple philosophy—Show...Me…the…Money.”

Hatch said he believes that the entire tax system, and not just the corporate tax system, needs to be reformed.  “We can’t simply raise taxes on flow-through businesses, a large proportion of which are small businesses, by taking tax incentives away without lowering tax rates in return,” he added.

Raj Chetty, an economics professor at Harvard University, said Congress should minimize non-transparent tax credits. “There is little justification for tax credits and expenditures whose intended incentives are not understood by families,” he said in his prepared testimony. “Such tax expenditures cost the government money but have little impact in changing economic behavior as intended. For instance, a non-transparent Saver’s Credit program essentially gives money to families who were already saving but does not encourage other families to start saving.” Chetty also recommended that the government invest more in “marketing” tax incentives like the Earned Income Tax Credit to the public.

Dr. Robert Carroll, a principal at Ernst & Young, noted that the many expiring and oft-extended tax incentives made too much of the Tax Code temporary. “There are also a large number of provisions—expiring provisions—often extended a year at a time,” he said. “In principle, the periodic extension of expiring provisions provides Congress an opportunity to reconsider and reevaluate their effectiveness, but the lack of their permanence may undermine the ability of taxpayers to rely upon and base decisions on the benefits they provide. Moreover, expiring provisions are no longer limited to several dozen business tax provisions, but now also include the alternative minimum tax patch and the 2001 and 2003 tax cuts. The result is a tax system where large portions of the Code are in effect temporary.”

Dr. Eric Toder, co-director of the Urban-Brookings Tax Policy Center, noted that the increased complexity of the Tax Code and its temporary nature reduce the extent to which the government can rely on targeted incentives to influence behavior.

“Increased use of software and tax preparers and improved efficiency in the tax preparation industry may have kept compliance costs from rising in spite of a more complex Tax Code and helps taxpayers make use of available tax benefits, based on their economic behavior,” said Toder. “But the increased reliance on preparers and software also reduces taxpayers’ awareness of how the tax law works and makes them less likely to change their behavior to optimize their net benefit from tax incentives.”

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