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Tax Expenditures and Business Cycle Fluctuations

Link to Paper

Most experts agree the cause of the current economic downturn—the bursting of the housing bubble in 2007.  Some economists argue the creation of the bubble was the result of government intervention in the housing market, e.g. low interest rates, support of Fannie Mae and Freddie Mac, and through the tax code with the deduction of interest payments and property taxes on a home owner’s federal taxes. 

 

Economists refer to tax deductions as tax expenditures, which are defined as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”

 

This paper by Yale law professor Yair Listokin looks at tax expenditures from the stand point of their impact on the business cycle.  Listokin’s conclusion is tax expenditures are pro-cyclical.  This means when the economy is growing, they add to the growth, but when the economy slides into a recession, they deepen the contraction. 

 

The paper comes from the Keynesian viewpoint that government intervention in the economy can smooth the business cycle, i.e. dampen the peaks and troughs.  Listokin believes it is better for government to use government spending rather than manipulation of the tax code to achieve its policy goals.  Though the paper does not advocate a decline in the size of the federal government, free-market economists, who believe the use of targeted tax deductions distorts the economy, would benefit from reading this paper.

© 2009 Tax Policy Forum.