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The Basics of Tax Breaks, Explained

Federal policymakers are considering options for reforming the tax code, including scaling back or eliminating credits, deductions, and exemptions.  We explain the basics of these subsidies, known as tax expenditures, in a new backgrounder.

A few facts to know about these tax breaks:

They’re costly. In 2012, tax expenditures reduced federal income tax revenue by $1.1 trillion, and they reduced payroll taxes and other revenues by an additional $112 billion.  For comparison, the federal income tax expenditures together cost more each year than Social Security, or the combined cost of Medicare and Medicaid, or defense or non-defense discretionary spending.

They’re spending delivered through the tax code. The distinction between these tax breaks and spending is often artificial and without economic basis.  Consider education as an example.  On the spending side of the budget, the federal government provides Pell Grants to help low- and moderate-income students afford college.  On the tax side of the budget, funds used to meet college expenses can grow tax free in special college savings accounts.  Both of these policies are subsidies intended to promote higher education, and although the government categorizes them differently, they both represent a type of government spending.

Their value skews toward the top. The value of these tax breaks increases as household income rises — the higher one’s tax bracket, the greater the tax benefit for each dollar that is deducted, exempted, or excluded.

As a result, these tax expenditures provide their largest subsidies to high-income people (see chart), even though they are the individuals least likely to need financial incentives to engage in the activities that tax expenditures are generally designed to promote, such as buying a home, sending a child to college, or saving for retirement.  Meanwhile, moderate- and low-income families receive considerably smaller tax-expenditure benefits for engaging in these activities.


Click here for the Federal Tax Expenditures Policy Basic, and here for more on necessary tax expenditure reform.