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Reducing 'Tax Expenditures' Can Hurt Economic Growth

In my last TaxBytes column, I laid out the strange economics of so-called “tax expenditures.” I gave as an example the tax deduction for mortgage interest. That provision leads some people to own rather than rent and others to buy a more expensive house than they would have. Those are bad effects. But, I noted, it would be more straightforward for economists and politicians to say that those provisions have bad effects rather than using the convoluted language of tax expenditures.
It gets worse. Sometimes economists and politicians use the term tax expenditures to refer to tax provisions that have good effects on economic growth. They do that because they are stuck in the Haig-Simons view of income. According to this view, named after early 20th century tax scholars Robert M. Haig and Henry C. Simons, it doesn't matter whether income comes from working or from interest and capital gains—all should be taxed equally. This view has sometimes been summarized as “A buck is a buck.”
Other scholars have pointed out that if the tax system treated all this income the same, it would tax saving more than consumption, which would discourage investment, thus hurting economic growth.
How so? Assume someone earns $1,000 from working and pays a 24 percent income tax rate on it. He keeps $760 and spends it on food, clothing and entertainment. On some of those expenditures, he pays a sales tax, but the sales tax rate is typically under 10 percent.
But what if he takes the $760 and invests it in a company? Then the company does well and it pays dividends. Its stock price also increases, and he sells the stock, making a capital gain. If the dividends and capital gains are taxed at the same 24 percent rate that ordinary income is taxed, or even at a 15 percent rate, that means he is taxed more by saving than if he had just spent the $760. That’s how taxing according to the Haig-Simons method systematically favors consumption over saving.  
Many tax economists say that failing to tax dividends and capital gains creates a “tax expenditure.” Their implicit assumption is that dividends and capital gains should be taxed at the same rate as ordinary income. But by using the term “tax expenditure,” they avoid having to make the case and dealing with the bad consequences for saving and economic growth.
Beware tax scholars and politicians using the term “tax expenditures.”