Policy Basics: Federal Tax Expenditures
“Tax expenditures” are subsidies delivered through the tax code as deductions, exclusions, and other tax preferences. In fiscal year 2017, tax expenditures reduced federal income tax revenue by roughly $1.5 trillion, and they reduced payroll taxes and other revenues by an additional $130 billion.
September 12, 2019
Tax expenditures reduce the amount of tax that households or corporations owe. To benefit from a tax expenditure, a taxpayer must undertake certain actions or meet certain criteria. For example, some households that have a mortgage can reduce their taxes by claiming a tax deduction for their spending on mortgage interest, and corporations can receive a tax subsidy for investing in machinery.
Tax expenditures are costly. For comparison, the cost of all federal income tax expenditures was higher than Social Security, the combined cost of Medicare and Medicaid, or the combined cost of defense and non-defense discretionary spending. (See first chart, below.)
The largest individual income tax expenditure in 2017 was the provision that allows households to exclude from taxable income the value of employer-provided health insurance. The next three largest were tax breaks on owner-occupied housing (such as the home mortgage interest deduction), the lower rates at which capital gains are taxed relative to earned income, and the exclusion for employer-based retirement plans. The largest corporate tax expenditures for 2017 included “deferral of income from controlled foreign corporations,” a tax break that allows multinational companies to delay paying U.S. taxes on their foreign profits (the treatment of multinationals’ foreign profits will change significantly in 2018 under the new tax law) and “accelerated depreciation,” effectively a tax subsidy for spending on machinery and equipment.
Spending Through the Tax Code
Tax expenditures are intended to promote policy goals. The distinction between these tax breaks and spending is often artificial and without economic basis.
Education is one 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 are both a type of government spending.
Child care is another example. On the spending side of the budget, the government provides some households a subsidy for their child care costs through a spending program (the Child Care Development Fund). It also provides a tax credit for child care to some families, which is another form of spending to subsidize child care costs.
Similarly, business tax breaks targeted at specific industries, such as the tax breaks for oil and gas corporations, are the equivalent of subsidy programs for those industries.
Any tax filer — whether individual or corporate — that meets the requirements for a tax break can receive it. This feature makes tax expenditures similar to entitlement programs like Social Security or Medicare, where all people meeting eligibility criteria can receive benefits. The Joint Committee on Taxation, Congressional Budget Office, and Alan Greenspan, former Federal Reserve chairman, have all noted this similarity. For example, the child care tax credit is like an entitlement program, because all families eligible for the tax credit can receive it.
Tax Expenditures Are Tilted Toward Higher-Income Earners
The bulk of each year’s spending on individual tax expenditures is delivered in the form of deductions, exemptions, or exclusions. 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, 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. (See second chart, below.)
Limiting Tax Expenditures Increases Income Subject to Tax
Many policymakers have proposed cutting tax expenditures to reduce the deficit, increase investments made on the spending side of the budget, reduce tax rates, or a combination of those aims. Tax expenditures lose revenue because they shrink the “tax base” — that is, they reduce the amount of income that is subject to tax. That means scaling back tax expenditures raises revenue by increasing the size of the tax base, so it is often called “base broadening.”