Tax deductions are popular, but penalties may work better

October 27, 2011

The National Zoo's baby panda Tai Shan munches on a carrot in the Giant Panda Habitat of the new Asia Trail area at the zoo in Washington October 11, 2006. REUTERS/Molly RileyWhen making tax policy, there’s a choice between carrots or sticks: Does the government give taxpayers credits or deductions for doing the right thing (buying their homes, giving money to charity, not emitting greenhouse cases) or penalize them for doing the wrong thing?

Brian Galle, who is on leave as an assistant professor at Boston College Law School and currently a fellow at the Urban Institute in Washington, DC, has been analyzing those choices, and come to a surprising conclusion: Expenditures may be politically expedient, but penalties would often be preferable for fiscal policy.

In his forthcoming paper in the Stanford Law Review, called “The Tragedy of the Carrots,” Galle argues that carrots are overproduced and often misguided, costing the Treasury funds that would be better spent elsewhere in an effort to nudge people towards the behavior it hopes to reward.

“The problem with tax expenditures is not that they are in the tax code, but that they are expenditures,” Galle explains in a recent telephone interview.

As Washington debates tax policy and budget cuts, Galle’s ideas are particularly relevant. Tax expenditures — those credits and deductions that favor some taxpayers over others — have grown dramatically over the years, and their cost to the Treasury is over $1 trillion dollars.

Last year, when the national deficit commission, co-chaired by Alan Simpson and Erskine Bowles, released its bold tax proposals, one of them called for eliminating all the expenditures and lowering marginal tax rates to 8 percent, 14 percent and 23 percent. The commission’s ideas went nowhere, and today the congressional supercommittee is hashing out its plan for budget cuts and tax reform.

Galle’s theory goes one step further in thinking about rewards versus penalties. Economists consider carrots and sticks pretty much indistinguishable. There’s not much difference, as Galle points out, between taxing someone a dollar for each cigarette smoked, versus giving someone a dollar for each cigarette thrown in the trash. Either way, smoking is penalized, and the cost to you (whether explicitly in the tax or implicitly in the foregone reward) is one buck.

There are some differences, though: The reward will cost the government funds, while the penalty will increase its funds. So if the goal is to move Americans toward a desirable behavior (or away from a negative one) and produce revenue rather than spend, why not replace some tax expenditures with well-designed penalties that would get a similar result and save money?

In today’s real world application, only those above a certain level of income benefit from many tax expenditures. For example, those who buy modest homes in inexpensive parts of the country and those who give money to charity but don’t earn enough to itemize on their tax returns see little or no benefit from those deductions. In fact, the biggest benefits of the home mortgage interest deduction go to those with the most income who spend the most on their homes.

Galle argues that, perhaps, those who don’t give to charity or save for retirement could be penalized for failing to do so, rather than giving tax incentives to those who do both of those (desirable) things. (Last week, indeed, a Senate hearing delved into possible changes to the charitable deduction.)

While no one would dispute that Americans need to save more money for retirement, the question is how to get there. “It may be that you could get better results, in the sense of more cost-effective results, if you instead penalized people who did not save for retirement,” he says. Such a penalty would need to be geared only to those who could afford to save, and not harm those who make too little to do so. “That is one of the crazier aspects of the paper,” he admits. “But because retirement savings are such a big cost it is worth at least thinking about whether we are getting our money’s worth. It may turn out that it’s worth it, but we haven’t really thought about it.”

Of course, there’s economics and law — the basis of good tax policy — and political reality. But it’s still worth thinking about.


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even worse when the carrots are made of paper….. trillions of paper carrots, some very stale

Posted by gregnazvanov | Report as abusive

Nothing reeks of government control more than the control of United States citizens via the tax code. This is another compelling argument for a flat tax with few if any deductions. Free society, ha!

Posted by Oilfieldtrash | Report as abusive

Eliminating unfair tax incentives — good. But penalize people for not buying homes, not saving for retirement, not having children? Ridiculous. Some tax breaks are meant to give a break to already financially stressed people, not necessarily encourage a particular behavior. These tax breaks cannot be simply reversed into tax penalties. Get rid of tax deductions like mortgage interest — its not fair to those who responsibly live within their means and rent their homes. Get rid of the tax deduction for each dependent child, but leave it for dependent aging family members. Responsible parents consider their children a blessing, not a way to get a better tax break. They will make the necessary self-sacrifices to raise them.

Posted by chairsandtables | Report as abusive

Flat tax on all income from whatever source above the poverty level for the area the taxpayer lives in. And, FWIW, there is no discrete, empirical scientific evidence that tobacco use causes anything — all the studies are statistical and include the phrase, “in susceptible persons.” Tobacco use/smoke may aggravate existing conditions in some people (such as asthmatics) but not cause them. Lung cancer was virtually unknown and did not become a concern until the 50s. Most doctors then blamed vehicle exhaust. And it’s interesting that the rate of lung cancers has lessened after the implementation of catalytic converters and the banning of cheap diesel use in our trucks — except for major ocean ports where their neighbors are still exposed to rotgut diesel fumes. All this fuming over tobacco use seems to be (1) government disinformation to protect auto makers and (2) popular distaste for the odor of cigarette smoke.

Posted by grinder | Report as abusive

The bottom line is that the biggest tax penalties are a result of being born in the USA to parents with incomes below the 90th percentile.

Be born rich or born with foreign citizenship and you will be ok. If the US Government can get a good grip on your neck, you are doomed.

Posted by txgadfly | Report as abusive

Please forget about all this social engineering. Just set up the three brackets envisioned by the committee, eliminate the carrots and sticks, and let the people do what they want.

As to Grinder, I note that you have written a rarely seen defense of tobacco. You must know more about that poisonous weed than the Surgeon Generals, American Cancer Society, American Heart Association and countless others.

Posted by Yowser | Report as abusive

There are different kind of tax expenditures, this article make no different among them, which oversimplify things.
The first kind is the kind of tax expenditures simply for the sake of taxing, that is, (to hope) for more efficient tax collection, thus more tax revenue. No direct connection can be proven, and indeed there is nothing prohibits corporations to just keep the profit for themselves and still evading tax. In this case, the stick will be the better option.
The second kind, however, is for an entirely different purpose. The US economy, however you put it, is consumer driven – 70% of it is consumer based. In the crisis, however, the consumers simply have no cash left to spend. The unemployed, are obviously cash strapped. Even more significant, the employed had seen their salary and bonuses reduced, higher credit cost, while still have to cope with mortgage payment, utilities and rising healthcare premium. Indeed, US saving rate have been reduced to zero for sometime now. In short, consumers have no money to spend anymore.
Less spending – reduced economy. Reduced economy – lay offs, bankruptcy, reduced credit. Lay offs, bankruptcy, reduced credit – even less spending. This is stagflation – and it is destructive. Therefore the second kind of tax break and tax credit is necessary, IN TIME OF CRISIS, to spur spending. It is especially effective when target consumer groups that spend MOST or a LARGE percentage of their income on consumption versus investment or saving – which is low and middle income class. The higher the income, the lower the percentage of that will be spent for consumption versus investment. That is why tax break on high income group is not effective.
This has NOTHING to do with welfare or class warfare. It is simply a system that encourage spending to fight stagflation.

Posted by hereiam2005 | Report as abusive

Chairsandtables writes: “Get rid of tax deductions like mortgage interest — its not fair to those who responsibly live within their means and rent their homes.” While your comments were thoughtful and inciteful, I wonder if you have considered the economics of renting. While the renter does not deduct interest, the property owner does deduct the interest and is able to keep rent prices down because of that tax break. There are also ripple effects of eliminating the tax break of interest. Many of those who purchased a house and calculated their budgets based on the interest deduction would ultimately default if that deduction were taken away. Certainly home prices would fall which would affect the economy in many other ways. You note that responsible parents consider their children a blessing as if responsible children don’t consider their aging parents a blessing. I suspect the purpose of the tax break for children is to take into account the fact that the income to the family feeds and houses more people. Certainly responsible parents want to take care of their children but their responsible behavior doesn’t increase the paycheck to cover the extra clothes and food.

Posted by rulesrlr | Report as abusive

I always find these discussions interesting when talking about percentage of income for the wealthy versus the middle or lower class. No question that the middle and lower classes spend a higher percentage of their income on goods and services (which is why flat taxes are regressive and hurt the middle class and poor). There is another fact and reality that seems to be often missed…. weathly people spend more overall dollars than middle class or the poor. So your top 10% of wage earners will pump a smaller percentage of their income but a larger overall dollar amount into the economy. Does that mean they deserve a greater tax break? No, but I don’t know that penalizing them makes sense either.

Posted by RMEickhoff | Report as abusive