The 4 worst tax breaks

June 3, 2013: 2:55 AM ET
how many tax breaks
Over the past 40 years, the number of tax breaks - deductions, credits, exemptions and other tax benefits - has more than tripled. Tax policy experts say it's time to rethink many of them.
NEW YORK (CNNMoney)

If you live in California, you'll probably hate this story. So will anyone who gets health benefits at work or stands to inherit stocks. And if you're one of those guys who manages billions of dollars? Let's just say you'll be less than delighted.

CNNMoney asked several tax experts to identify some of the worst tax breaks for individuals that lawmakers should reform or eliminate.

"It's hard to rank stupid tax provisions because there are so many candidates," said Len Burman, the incoming director of the Tax Policy Center.

"Worst" can mean a provision that disproportionately benefits some more than others, doesn't serve its intended purpose or otherwise provides an unjustified windfall.

Here are just four that experts flagged:

Carried interest: Managers of private equity, venture capital and hedge funds don't pay ordinary income tax rates on a portion of their income.

That portion, known as carried interest, represents a share of profits from the funds they manage. They are paid that share even if they were not required to invest their own money in the funds.

Carried interest is taxed at the long-term capital gains rate of 20% -- well below the top two income tax rates of 35% and 39.6%.

Proponents of the special rate contend that managers assume some risk because they provide hands-on management, connections and their reputations to the companies their funds buy, often for long periods. And there's no guarantee the investments will turn a profit.

Critics of the lower rate contend, among other things, that the managers are really performing a service for a fee -- and therefore should be paying regular income tax rates.

Related: Top 1% get big bang from tax breaks

"Fund managers claim risk-based compensation, which require no financial investment on their part," said Martin Sullivan, chief economist of Tax Analysts.

President Obama has repeatedly proposed taxing carried interest as ordinary income. Such a change could raise $17.4 billion over 10 years, according to estimates from the Joint Committee on Taxation.

Tax exclusion for health insurance: Besides a steady paycheck, one of the biggest workplace benefits for 160 million Americans is the employer subsidized health insurance they receive.

Yes, workers pay for some of the cost of their insurance. But their employers pick up the lion's share, and that share is treated as tax-free income to the worker. It's not subject to income or payroll taxes.

Where to find tax breaks in your home

That "health exclusion" also accounts for the lion's share of the cost of federal tax breaks to the government. The Joint Committee on Taxation estimates it will cost $760.4 billion over the next five years, just counting the exclusion from income tax. If the payroll tax exclusion were also counted, the cost would jump by tens of billions of dollars a year.

"Health care benefits represent a large and growing share of compensation, and the exclusion exacerbates the problems of excessive spending on health care, the high cost of health care, and the lack of mobility of health insurance," said Will McBride, chief economist of the Tax Foundation.

State and local tax deduction: Only about one-third of tax filers itemize deductions. Those who do may deduct their state and local taxes (income or sales tax, plus property taxes).

The deduction is a form of federal subsidy to state and local governments. "Theory would suggest that taxpayers are willing to accept higher state and local tax rates and greater state and local public spending because of lower federal income taxes arising from the deduction," according to the nonpartisan Congressional Research Service.

As with other itemized deductions, the state and local deduction disproportionately benefits higher income filers. And it disproportionately benefits those who live in high-tax states and cities. The deduction has become even more valuable to high-income residents in California, where top state income tax rates recently rose to as high as 13.3%.

For this reason, Burman thinks lawmakers should rethink this break.

"The subsidy is most valuable in states with lots of high-income people, which are the places that least need fiscal assistance because they have a robust tax base," Burman said.

If the federal government wants to offer states a hand, he'd rather it give straight grants to states most in need of aid.

The JCT estimates the state and local deduction will cost federal coffers about $278 billion over five years.

Exclusion of capital gains at death: This provision is known among tax wonks as a "step-up in basis."

Essentially, if someone bequeaths to you an investment that has appreciated in value since the day it was first purchased, you won't have to pay any tax on the capital gains that accrued before you inherited it. You would only owe tax on the capital gains that accrue from the day you get it -- and only if you choose to sell the asset.

"Holding stock until death exempts it from capital gains tax. This is a huge and largely unnoticed tax benefit for the super-rich," Sullivan said.

The provision will cost federal coffers an estimated $258 billion over five years.

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