Why are tax expenditures controversial?
Because they operate very much like spending programs but are hidden in the tax code. Indeed, providing benefits through tax expenditures gives the appearance of reducing the size of government without actually doing so. But identifying and measuring tax expenditures requires assumptions about what the baseline tax system would look like.
To some, tax expenditures are spending items that 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.
Tax expenditures perform very much like spending programs, which means they may serve or harm the public depending on whether they serve a legitimate public purpose in the most efficient manner possible. But the identification and measurement of tax expenditures is controversial.
Subsidies and expenditures in the form of tax breaks reduce net tax revenue instead of increasing measured spending. Thus they give the appearance of reducing government’s size. For this reason, tax subsidies have strong political appeal. In fact, tax expenditures are an alternative way for government to intervene in the economy and, like direct spending, must be paid for through higher taxes or reduced spending elsewhere.
Imagine, for instance, a new government program that provides tax credits for energy production at a cost of $5 billion per year, and finances it by raising income tax rates. To pay for the energy tax credit, it would have to raise tax rates enough to collect an additional $5 billion—no different than what it would need to do if the subsidies for energy production were provided by a Department of Energy grant instead of by tax credits.
Here’s the conceptually tricky part: tax expenditures are defined as deviations from a baseline tax system. In the example above, it is straightforward to see the equivalence between an energy tax credit and a spending program. Often, however, the definition and estimated magnitude of tax expenditures is a matter of judgment because what belongs in the baseline tax system itself reflects the judgment of analysts. Since the government began regular reporting of tax expenditures in the 1970s, the baseline against which tax expenditures are measured has been a version of a comprehensive income tax. But there have always been exemptions for income deemed too difficult to assess, such as unrealized capital gains or imputed rental income on owner-occupied housing. Recently, however, the Treasury Department, but not the Joint Tax Committee, has added imputed rental income to its baseline used for estimating tax expenditures.
If the current income tax were replaced wholly or partly by a consumption tax, as some economists and political leaders favor, some provisions now classified as tax expenditures would no longer be regarded as such. For example, under a comprehensive consumption tax system, the deferral of earnings contributed to retirement savings accounts and the exemption of income earned within those accounts would not be considered tax expenditures. Most other tax expenditures, however, including the deductibility of home mortgage interest, charitable contributions, and state and local taxes, and the exemption of employer contributions to health insurance plans would still be so classified.
In other cases, estimating the size of a tax expenditure becomes a matter of judgment. For example, under an income tax, firms can recover the costs of capital investment over time with depreciation deductions that reflect the decline in the value of their assets. But what is the right measure of depreciation in an inflationary economy? For these and other items, Congress’ Joint Committee on Taxation and the Treasury department use different definitions of what would be included in a normal or comprehensive income tax. Therefore their classification and measurement of some tax expenditures differ.
Office of Management and Budget. Budget of the U.S. Government, FY 2017, Analytical Perspectives, Table 14-1.
Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal Years 2015–2019, JCX-141R-15, December 7, 2015.
Burman, Leonard E. 2003. “Is the Tax Expenditure Concept Still Relevant?” Washington, DC: Urban-Brookings Tax Policy Center.
Burman, Leonard E., and Marvin Phaup. 2011. “Tax Expenditures, the Size and Efficiency of Government, and Implications for Budget Reform” Research Report. Washington, DC: Urban-Brookings Tax Policy Center.
Marron, Donald, and Eric Toder. 2013. “Tax Policy and the Size of Government.” Washington, DC: Urban-Brookings Tax Policy Center.
Toder, Eric, Joseph Rosenberg, and Amanda Eng. 2014. “Evaluating Broad-Based Approaches for Limiting Tax Expenditures” Research Report. Washington, DC: Urban-Brookings Tax Policy Center.
Toder, Eric. 2005. “Tax Expenditures and Tax Reform: Issues and Analysis.” Presented at the National Tax Association meetings, Miami, FL, Nov. 19.
———. 2000. “Tax Cuts or Spending: Does It Make a Difference?” Washington, DC: Urban-Brookings Tax Policy Center.