The sequester (pdf) cut approximately $85 billon from Fiscal Year 2013 spending—half from reductions in defense spending and half from elsewhere in the budget. OMB calculated (pdf) that it would result in a 5 percent reduction in nondefense discretionary spending—funding for programs like education and housing assistance, veterans’ benefits and services, medical and scientific research, and health and safety regulations.
I have long argued that cuts to government spending are uncalled for, given the lack of a robust economic recovery. However, if you are searching for sensible ways to shrink the deficit, there are better alternatives to sequestration. For example, we could eliminate the nondefense discretionary spending cuts in the sequester and shave $26 billion annually from the deficit by eliminating or closing a handful of tax loopholes.
Tax loopholes, formally known as tax expenditures, reduce tax revenues by over $1 trillion every year. There are many reasons to keep tax loopholes in the tax code: some are very popular (e.g., the mortgage interest deduction), some provide incentives to socially beneficial behaviors (e.g., the earned income tax credit), and some are technically difficult to change (e.g., the exclusion for employer retirement plans).
It is rather easy, however, to come up with a handful of tax loopholes that could be modified or eliminated to replace the sequester. As an example, this chart compares the nondefense discretionary spending reduction due to the sequester with the revenue that could have been gained by eliminating five tax expenditures for fiscal 2013, which are described below. Of course, there will be disagreements among reasonable people on which tax expenditures to eliminate, which ones to modify, and which ones to keep. Nevertheless, when faced with a decision, Congress took both the sequester and the tax loopholes, rather than trading off the sequester for the elimination or modification of some tax loopholes.
The five tax expenditures are:
- Percentage depletion. Firms that extract oil, gas, and other minerals are allowed a deduction to recover their capital investment; depletion is a form of capital recovery. Using the method of percentage depletion, firms are allowed deductions that exceed the original capital investment (cost depletion). This tax expenditure reflects the revenue lost due to this excess of percentage depletion over cost depletion.
- Reduced tax rate on first $10 million of corporate taxable income. Corporations are taxed on a graduated tax rate schedule on the first $10 million of taxable income. The tax expenditure represents the difference between the tax paid on the first $10 million and what would have been paid if the first $10 million were taxed at a flat 35 percent tax rate.
- LIFO inventory method. Inventory accounting allows taxpayers to reduce their tax burden on the difference between the sales price and the cost of inventories. LIFO (Last In, First Out) assumes that the most recent good sold is the last one purchased. The tax expenditure is the revenue lost due to accounting for inventory under this method compared to what firms actually do, which is to sell the oldest items in inventory before the newest. Rep. Charles Rangel, then House Ways and Means Committee chairman, included the repeal of this provision in his 2007 tax reform plan, and President Obama has proposed the elimination in his budget proposals.
- Foreign earned income exclusion. Taxpayers are normally taxed on their worldwide with a tax credit allowed for foreign taxes paid. However, a U.S. taxpayer (citizen or permanent resident) living abroad can exclude $95,100 and certain excess housing costs from U.S. taxation (foreign tax credits are not allowed on the excluded income). The Kennedy Administration tried to scale back the exclusion in 1962.
- Domestic production activities deduction. Since 2005, net income from qualified production activities is allowed a deduction (now 9 percent of the net income) from taxable income. The deduction was originally aimed at corporate manufacturing, but has been expanded to other industries and unincorporated businesses. Now, about two-thirds of the corporate claims to the deduction are in the manufacturing sector. The repeal of this deduction was included in Chairman Rangel’s 2007 tax reform plan.