When 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.
