Thursday, September 01, 2011

On Tax Breaks

For those who don't know my biases, I support the notion that that government is best which governs least.  The question in this post is how to apply that principle to specific tax policy decisions.


On a regular basis, governments propose to exempt certain favored activities from taxation.  Some libertarians support these tax breaks because it reduces the government's overall tax revenue.  I think the market manipulation embodied in targeted tax breaks exceeds any benefit from reduced revenue.  If existing tax breaks can be removed in a revenue neutral way, that's ideal.  If not, I think the market is still better off to have them removed; even if it means higher government revenue in the short term.

A Vain Street Thug

Consider the following scenarios:

  • A street thug walks up to me and says, "I'll shoot you unless you give me $20". He then spends $20 to have his shoes polished
  • A street thug walks up to me and says, "I'll shoot you unless you give me $20 or polish my shoes"

The first scenario mirrors taxation.  We pay taxes because of threatened force.  Both the tax revenue and subsequent expenditures appear in government budgets for all to debate.

The second scenario is like a tax break.  To retain my money, I must act as the government directs.  Neither my lost labor nor his polished shoes appear in the government budgets.

In both cases, the government manipulates the market to obtain its desired result.  In one case it's transparent and obvious.  In the second, it's hidden behind a facade of choice.  The offer to polish his shoes doesn't make the thug's hold up any less objectionable.

Wind Production Tax Credits

Here's a real example.  Uncle Sam offers a 2.2¢ per KWh tax credit for producing electricity from wind. Depending on the time of year and local market conditions, the tax credit alone can exceed revenue from selling the electricity.  Even when electricity rates are high, wind farms aren't profitable enough to use the entire tax credit themselves, so they sell their tax credits to investors who use the credits to offset their own tax liability.  Obviously, the wind farmers aren't "keeping their hard earned money", they're selling political favors granted to them by Congress.

These kinds of tax credits also create a dangerous bubble in the market.  In a free market, the price of electricity would drop as new generation capacity comes on line.  The lower electricity prices tell producers that they should reconsider any plans to build additional capacity. Highly efficient projects may proceed despite the lower prices, but inefficient projects will be abandoned before they're built.

The tax credit changes this dynamic. The credit exists at a fixed price until Congress changes it (ignoring inflation adjustments).  Anyone that builds a qualifying wind farm gets the tax credit.  As new electrical capacity goes online, the price of electricity still drops, but the tax credit stays the same.  Since the tax credit revenue accounts for such a large portion of the wind farm's total revenue, wind farmers don't hear the market's message to stop building.  They construct wind farms whether they're needed or not.  Once Congress removes the tax credit, the completed, inefficient wind farms immediately become unprofitable and are abandoned; leaving a mess for someone to clean up.

From this perspective, Wyoming's .1¢ per KWh tax on wind electricity can be seen as a 4.5% push back against Federal manipulations of the electricity market.  If Wyoming's tax were set to exactly match the Federal tax credit, it could be seen as an old-fashioned nullification of manipulative Federal policies.

Health Care Benefits and Income Tax

In 1942, Congress passed the Stabilization Act which prohibited employers from increasing wages faster than a certain rate.  Since businesses still wanted to compete for the best employees, they began offering benefits as a way to skirt the price controls.  In 1943, an administrative ruling declared these benefits exempt from income tax.  This created the third-party payer system of health care we have today.  When employees consume health care, they're doing it on their employer's dollar.  Since it's not their money, employees consume more than they otherwise would.  Employees are also less sensitive to price increases.

The subsequent rise in health care costs caused by this market manipulation provided the impetus for government health care programs like Medicaid and Medicare.  These programs now account for a substantial portion of Federal expenditures.  The wage and price controls were fortunately abandoned decades ago, but the health insurance tax break remains.

Even if eliminating this particular tax break were to increase government revenue by $200 billion annually, as some estimates state, it's hard to imagine it would be as damaging to the U.S. health care market as the manipulative tax breaks themselves have been.

Encouraging the Lobbyists

Because Congress has granted so many tax breaks in the past, people expect that they might grant tax breaks in the future.  It's hard for industry to resist the temptation of exempting themselves from taxes and leaving their competitors to carry the burden.  Those who give in to temptation hire lobbyists to lavish kickbacks on politicians who might be the slight bit inclined to carve out another loophole.  As long as this kind of power exists, it will be bought.

Keep Your Eye on the Prize

In the end, the goal is to eliminate all general taxes.  Once the income tax and sales tax is abolished, it's no longer possible to manipulate the market with tax breaks or the threat of higher tax rates.  Until that day, I think a flatter, broader tax structure, which requires everyone to feel the pain, is the option least harmful option.


JJ Hendricks said...

Great summary of tax credit policy. My thoughts exactly but stated perfectly. Loved the two scenarios.

Mothman said...

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