tax policy center
Tax Policy Center
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Tax Expenditures: Why are they controversial?

To some, tax expenditures are spending items which do not belong in the tax code. To others, they are merely are a way of reducing taxes, and repealing them would amount to a tax increase. In fact, as budget items, tax expenditures perform very much like spending programs, which means they may be bad or good, depending on whether they serve a legitimate public purpose in the best manner possible. Controversy also surrounds the identification and measurement of tax expenditures.

  • Both political parties like to provide subsidies and expenditures in the form of tax breaks, because they cause the measure of net tax revenue to fall without increasing the measure of spending. Thus, they give the appearance of reducing government’s size. For this reason, tax subsidies have strong political appeal. In fact, however, tax expenditures can actually expand government’s interference in the economy, partly because they induce changes in taxpayers’ behavior. Also, like direct spending, tax expenditures must also be paid for through higher taxes elsewhere.
  • Imagine, for instance, a government that did only two things: it provided tax expenditures for energy equal to 20 percent of national income, and it collected an income tax on workers. Then it would have to assess tax rates high enough to collect 20 percent of national income from workers before it granted back the tax breaks for energy.
  • Tax expenditures are based on deviations from a given tax system. Traditionally, they represent reductions in the revenue that would be collected under a comprehensive income tax. If the current income tax were replaced wholly or in part by a consumption tax, some provisions now classified as tax expenditures would no longer be regarded as such. For example, under a comprehensive consumption tax system, the tax-preferred treatment of capital gains and retirement savings would not be considered tax expenditures. In-kind benefits such as food stamps and public housing, however, would be regarded as tax expenditures under either type of system.
  • In some cases it is less clear whether a given provision is a tax expenditure so their identification becomes a matter of judgment. For instance, what is the right measure of "normal depreciation" in an inflationary economy? The congressional Joint Committee on Taxation uses a different definition of what would be included in a normal or comprehensive income tax, and therefore it classifies some different items as tax expenditures than does the Treasury Department
  • The value of any single tax expenditure can be measured as the revenue loss due to that tax expenditure alone (or, equivalently, as the amount by which total revenue would rise if that tax expenditure only were repealed). However, tax expenditures may interact with each other, so that the actual effect on revenue of changing several tax expenditures simultaneously could differ from the sum of their individual effects. For example, if several tax expenditures were repealed simultaneously, some individuals might be pushed into higher tax brackets, thereby changing the value of each subsidy and possibly their resulting behavior.
  • Tax expenditures can also be reported as outlays equivalents rather than as revenue losses. They then reflect the amount of taxable direct spending that would be required to match the benefit of the tax provision. The difference between outlay equivalent losses and revenue losses usually arise when a tax subsidy itself is nontaxable. For instance, it would take a taxable outlay equivalent of $1,000 (or $1,000 in taxable wages) to give a person in a 50 percent tax bracket the same level of benefit as $500 in tax credits. While the fact that tax benefits are not themselves taxed often adds to their value, the Treasury Department in 2006 stopped reporting outlay equivalents that took this extra value into account. Its main justification was that the criteria “...were often judgmental and hard to apply with consistency." Of course, this leads itself to inconsistency, as when the tax expenditure budget counts the benefit of not taxing a direct outlay but ignores the parallel benefit for an equivalent tax provision.
   Entry 3 of 5