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Tax Expenditures: What are they and how are they structured?

Tax expenditures are revenue losses attributable to tax provisions that often result from the use of the tax system to promote social goals without incurring direct expenditures. How tax expenditures are structured affects both who will benefit from them and how much they will reduce federal revenues.

  • Income tax provisions generally seek to promote one or more of three broad objectives: measuring income accurately, distributing fiscal benefits and burdens based on a household’s ability to pay, and promoting activities or behavior that are considered socially desirable. Tax expenditures are tax provisions that are not structural features of the income tax or necessary to measure income accurately.
    • There is some debate about whether distributionally-oriented tax provisions should be considered tax expenditures and, if so, which ones should be. Similarly, commentators debate which provisions should be considered structural features of the income tax.
    • Each year the Office of Tax Analysis at the Treasury Department and the Joint Committee on Taxation publish separate lists of income tax expenditures and their estimated cost in foregone revenue. Some commentators have suggested that this Tax Expenditure Budget should be broadened to include tax expenditures within the payroll, wealth transfer, and excise taxes.
  • Tax expenditures can take many forms. Some result from tax provisions that reduce the present value of taxable income through deferral allowances, or special exclusions, exemptions, or deductions from gross income. Others affect a household’s after-tax income more directly through tax credits or preferential rates for specific activities.
    • Individual income tax expenditures are typically structured either as deductions or exclusions, non-refundable tax credits, or refundable tax credits. With non-refundable credits, taxpayers may only use the credit to reduce or eliminate positive income tax liability. In contrast, refundable credits do not have that restriction: if the credit exceeds pre-credit tax liability, the tax filer still receives the excess as a payment.
    • Deductions and exclusions accounted for more than 80 percent of the major individual income tax expenditures in 2008 (see figure 1). However, the use of refundable tax credits has increased over time, primarily because of the growth of the earned income tax credit (EITC) (see figure 2).
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  • The structure of a tax expenditure is important because it determines its value for different families.
    • Generally, deductions and exclusions are most valuable for high-income households because their value is the amount deducted or excluded times the taxpayer’s marginal tax rate. Thus, a $100 deduction or exclusion typically saves $35 for someone in the 35 percent top income tax bracket, but only $10 for someone in the 10 percent bracket.
      • Most deductions are itemized deductions as opposed to above-the-line deductions. Itemized deductions have value only when listed and claimed; they thus are worth nothing for the roughly two-thirds of households that claim the standard deduction.
    • Non-refundable credits generally have the same value for all tax units whose income tax liability exceeds the credit. However, their value is limited to the taxpayer’s positive tax liability so they have no value for households that owe no tax.
    • By contrast, refundable tax credits are the only form of tax expenditure that can provide the same subsidy for all households.
    • All three types of tax expenditures may contain income limits or phase in or out in order to further target their distributional effects.
  • Only three tax credits—the earned income tax credit (EITC), the child tax credit (CTC), and the small Health Coverage Tax Credit (HCTC)—are refundable, so households in the bottom half of the income distribution reap relatively little benefit from tax expenditures.
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    • More than two-fifths of all households—and over half of those with children—have no federal income tax liability (see figure 3) and thus cannot benefit from deductions, exclusions and non-refundable tax credits.
    • Many such households do, however, pay substantial payroll taxes and would benefit if income tax credits could be used against those levies, or against income taxes paid in the past or future. For example, over a 25 year period, more than 80 percent of tax units with no income tax liability in the current year end up paying a positive amount of income taxes, and more than 99 percent end up paying a positive amount of income and payroll taxes, on net.
  • The best way to structure a tax expenditure depends on its purpose.
    • Tax provisions intended to measure taxable income accurately should be exclusions or non-itemized deductions. Such provisions are not generally considered tax expenditures.
    • Tax expenditures designed to redistribute income must take into account which households they aim to benefit. In particular, only refundable tax credits can assist tax units at the bottom of the income distribution.
    • Tax expenditures intended to spur socially-desirable behavior or activities should focus on the relative responsiveness of targeted groups. Unless there is good reason to exclude low-income households, such tax expenditures may be most effective if they are refundable credits.
 
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