Tax expenditures

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Jane G. Gravelle
Congressional Research Service, Library of Congress

Revenue losses resulting from federal tax provisions that grant special tax relief designed to encourage certain kinds of taxpayer behavior or to aid taxpayers in special circumstances.

Tax expenditures may, in effect, be viewed as spending programs channeled through the tax system. They are classified in the same functional categories as the federal budget. Section 3(3) of the Congressional Budget and Impoundment Control Act of 1974 specifically defines tax expenditures as

those 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.

In the legislative history of the Congressional Budget Act, provisions classified as tax expenditures are contrasted with those provisions that are part of the "normal structure" of the individual and corporate income tax necessary to collect government revenues. Tax expenditures, therefore, do not cover all departures from the economist’s concept of income. In particular, they do not include imputed and unrealized income (such as capital gains accruals and imputed rent on owner-occupied housing). Nor do they measure tax penalties (such as the failure to index for inflation).

The measurement of tax expenditures is sometimes arbitrary. For example, the single largest business tax expenditure, for depreciation, is based simply on differences between regular tax depreciation and depreciation used in the alternative minimum tax. Tax expenditures represent cash flow measures of benefits, as would be the case in a budget document, rather than the economic value of a subsidy. Thus, the depreciation tax expenditure reflects the difference in current depreciation deductions and not the timing value of accelerated depreciation.

Tax expenditure budget

The listing of tax expenditures, taken in conjunction with the listing of direct spending programs, is intended to allow Congress to scrutinize all federal programs relating to the same goals-both nontax and tax-when developing its annual budget. Only when tax expenditures are considered will congressional budget decisions take into account the full spectrum of federal programs. The tax expenditure budget also identifies provisions that could be considered in any basebroadening tax reform program.

Because any qualified taxpayer may reduce tax liability through use of a tax expenditure, such provisions are comparable to entitlement programs under which benefits are paid to all eligible persons. Because tax expenditures are generally enacted as permanent legislation, they are not renewed each year and thus are not subject to automatic review. Indeed, the original rationale for some tax expenditures may no longer be relevant.

Tax expenditure budgets that list the estimated annual revenue losses associated with each tax expenditure have to be published in the administration’s budget (since 1975) and by the Budget Committees (since 1976). The congressional Joint Committee on Taxation has also published estimates. The tax expenditure concept is still being refined; therefore, the classification of certain provisions as tax expenditures continues to be discussed.

As defined in the 1974 act, the concept of tax expenditure refers to corporation and individual income taxes. Other parts of the Internal Revenue Code-excise taxes, employment taxes, estate and gift taxes-also have exceptions, exclusions, refunds, and credits (such as a gasoline tax exemption for nonhighway uses) that are not included in the formal tax expenditure budget.

Major forms of tax expenditures

Tax expenditures may take any of the following forms:

• 1. Exclusions, exemptions, and deductions, which reduce taxable income;
• 2. Preferential tax rates, which apply lower rates to part or all of a taxpayer’s income;
• 3. Credits, which are subtracted from taxes as ordinarily computed;
• 4. Deferrals of tax, which result from delayed recognition of income or from allowing in the current year deductions that are properly attributable to a future year.

The amount of tax relief per dollar of each exclusion, exemption, and deduction increases with the taxpayer’s tax rate. A tax credit is subtracted directly from the tax liability that would otherwise be due; thus, the amount of tax reduction is the amount of the credit—which does not depend on the marginal tax rate.

Order of presentation

The tax expenditures are presented in an order that generally parallels the budget functional categories used in the congressional budget; tax expenditures related to "national defense" are listed first, those related to "international affairs" are listed next, and so on. This parallel format is consistent with the requirement of section 301(d)(6) of the act, which requires that the Budget Committees present the estimated levels of tax expenditures "by major functional categories" in the tax expenditure budgets that they publish in their April 15 reports.

Although it is not strictly correct to add tax expenditure items, a sum of tax expenditures provides some information on their size and importance. Data from the Joint Committee on Taxation show $903 billion in tax expenditures in fiscal year 2004-$790 billion in the individual income tax and $113 billion in the corporate tax. In both cases, the largest major budget function was commerce and housing, reflecting, in the individual tax case, tax benefits for owner-occupied housing and capital income, and, in the corporate tax case, depreciation and industry-specific tax provisions. The second largest category for individuals was income security, with pension benefits the largest single tax expenditure in that area.

If tax expenditures are viewed in terms familiar to tax practitioners rather than budget analysts, the largest category of benefits for individuals was investment income subsidies ($204 billion), with about 60 percent resulting from capital gains and dividend subsidies, and the remainder largely from life insurance, tax-exempt bonds, and individual retirement accounts (IRAs). Itemized deductions accounted for $167 billion. Employer fringe benefits were also large ($101 billion for pensions, $96 billion for health, and $35 billion for other fringe benefits). Retirement income exclusions and other benefits for the elderly were also substantial at $52 billion. Business-related provisions for individuals were relatively small ($24 billion). For corporate tax expenditures, depreciation accounted for $55 billion, industry-specific provisions for $13 billion, tax-exempt bonds for $9 billion, and small business benefits for $3 billion.

Distributional issues

Tax expenditures tend to benefit higher-income individuals compared with many other spending programs, which has caused some observers to refer to them as "upside-down" subsidies. Not only are higher-income individuals likely to be subject to higher tax rates, but they are also more likely to itemize deductions, to have significant capital investments, and to own their homes-all characteristics associated with tax expenditures. Of course, if we were to adopt a broaderbased tax system, we might also adopt flatter tax rates, so that eliminating tax expenditures need not necessarily lead to a more progressive tax system.

ADDITIONAL READINGS

• Brannon, Gerard M. "Tax Expenditures and Income Distribution: A Theoretical Analysis of the Upside-Down Subsidy Argument." In The Economics of Taxation, edited by Henry J. Aaron and Michael J. Boskin (87-98). Washington, DC: Brookings Institution Press, 1980.
• Burman, Leonard E. "Is the Tax Expenditure Concept Still Relevant?" National Tax Journal 56, no. 3 (September 2003): 613-28.
• The Century Foundation. Bad Breaks All Around: The Report of The Century Foundation Working Group on Tax Expenditures. New York: The Century Foundation Press, 2002.
• Ladd, Helen. "The Tax Expenditure Concept after 25 Years." Presidential address to the National Tax Association 86th Annual Conference on Taxation, Charleston, Nov. 1994.
• Mikesell, John L. "The Tax Expenditure Concept at the State Level: Conflict between Fiscal Control and Sound Tax Policy." In National Tax Association Proceedings of the Ninety-Fourth Annual Conference on Taxation (265-72). Washington, DC: National Tax Association, 2001.
• Polackova, Hana Brixi, Christian M.A. Valendue, and Zhicheng Swift, eds. Tax Expenditure: Shedding Light on Government Spending through Taxation. Washington, DC: World Bank, 2004.
• Surrey, Stanley S., and Paul R. McDaniel. "The Tax Expenditure Concept and the Legislative Process." In The Economics of Taxation, edited by Henry J. Aaron and Michael J. Boskin (123-44). Washington, DC: Brookings Institution Press, 1980.
• U.S. Congress, Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal Years 2004-2008. Prepared for the Committee on Ways and Means and the Committee on Finance. Committee Print, 108th Cong., 1st sess. Washington, DC: U.S. Government Printing Office, December 22, 2003.
• U.S. Congress, Senate Committee on the Budget. 107th Cong., 2nd sess. Tax Expenditures: Compendium of Background Material on Individual Provisions. Washington, DC: U.S. Government Printing Office, December 2002.
• U.S. General Accounting Office. Tax Expenditures: A Primer. PAD 80-26. Washington, DC: U.S. Government Printing Office, 1979.
• U.S. Office of Management and Budget. "Tax Expenditures." Budget of the United States Government Fiscal Year 2005, Analytical Perspectives. Washington, DC: U.S. Government Printing Office, 2004.