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Understanding the Budget Debate Part 5: Tax Expenditures

Editor’s Note: This is the fifth and last in a series of articles about the federal budget. In the first article, we examined deficits and the mounting federal debt, in the second we looked at government revenues and individual taxes, in the third we focused on business taxes, particularly corporate taxes, and in the fourth we covered spending policies. In this final installment, we will cover tax expenditures such as tax deductions and credits.

Millions of Americans and U.S. companies benefit from special exclusions, exemptions, deductions, special credits, preferential tax rates, and tax liability deferrals that help reduce income taxes.

These are known as "tax expenditures," and, while they benefit individuals and corporations, they cost the federal government billions of dollars in tax revenue.

You may be familiar with many of these deductions and exemptions, such as the home mortgage interest deduction, exclusion for employer-provided health insurance and the charitable deduction.

Tax expenditures total a surprisingly large sum – about $1.44 trillion in 2016 according to an analysis of the Tax Policy Center. This is equal to 39.6% of income, payroll, and corporate taxes collected in 2016. Some critics consider tax expenditures to be hidden spending in the tax code.

exhibit
      1Exhibit 1 is a modified version of the federal spending graph used in Part 4 to reflect tax expenditures as spending. Looking at it this way, tax expenditures amounted to 27% of total federal spending in 2016.

Some politicians use the term "loopholes" to refer to tax expenditures that they don't like, and "tax incentives" for those they do like.

When they talk about simplifying the tax code, or lowering the rates and broadening the base, what they mean, at least in part, is reducing tax expenditures.

Many legislators in both parties agree that tax expenditures should be reduced, but they typically don't agree on what to do with increased tax revenue that might be generated from such reductions – should they lower tax rates, reduce the deficit or increase spending. But eliminating or reducing tax expenditures is a lot easier said than done.

Exhibit 2 summarizes the estimated tax expenditures for 2016 to 2020 from the U.S. Congress Joint Committee on Taxation (JCT) report. Included are those items totaling $100 billion or more.

exhibit
      2According to the Congressional Research Service (CRS) "the largest 20 tax expenditures account for 90% of the total revenue loss of all tax expenditures."

Most of the large tax deductions and exclusions are very dear to many taxpayers and are meant to help achieve important societal goals.

For example, according to the CRS, "almost 30% of the revenue loss of tax expenditures is from provisions directed at encouraging savings."

As you can see in Exhibit 2, the single largest category is "net exclusion of pension contribution and earnings, and IRAs," which accounts for more than $1.2 trillion.

The JCT report also includes an analysis of the distribution by income of the benefits of 12 tax expenditures.

The two largest categories analyzed are earned income credit, with all of the benefit going to taxpayers with incomes of less than $200,000, and the home mortgage deduction, with 54% of the benefit going to taxpayers with incomes of less than $200,000.

The two expenditures that favor those with incomes of more than $200,000 include state and local income, sales, and personal property tax deduction, with 70.5% of the benefit going to those with incomes in excess of $200,000, and the charitable contribution deduction, with 70.7% of the benefit going to those with an income of more than $200,000.

The JCT does not analyze the categories on dividends and capital gains, but according to other reports, those skew to higher incomes. Estimating who benefits from some of the categories can be difficult.

The JCT report does not analyze the tax exclusion on municipal bonds, but it leans toward higher income taxpayers; however, it is municipalities, rather than investors, who benefit most from the tax exclusion through lower borrowing rates.

Politicians sometimes talk about corporate tax loopholes; however, corporate tax expenditures amount to less than 20% of total tax expenditures.

The only categories large enough to show up in the above table are exclusion of interest on public purpose state and local government bonds, and deferral of active income of controlled foreign corporations, which has grown significantly in recent years.

Four years ago, this category accounted for only $86.3 billion, but has grown to $587.2 billion.

Although the money is referred to as "deferral of active income," taxes on it may never be collected by the U.S. Federal Government.

Over the past few years, Congress has explored ways to bring some of that revenue to the U.S. Federal Government, but so far has not been able to come up with a solution.

President Trump has vowed to introduce legislation that would help solve the problem, but that proposal would collect only a fraction of the "deferred" income.

It is important to recognize that although the cost of tax expenditures is estimated at more than $1.44 trillion, it does not mean we should expect to see the same amount in new revenue if some or all tax expenditures are eliminated.

According to the Congressional Budget Office, "repealing a particular tax expenditure would lead taxpayers to modify their behavior in ways that would mute the revenue impact of the repeal."

Bottom line, we cannot expect to collect the same amount in revenue as the tax expenditures are estimated to cost if they are eliminated.

Summary

  1. Tax expenditures are tax deductions, exclusions or special rates that reduce the amount of tax collected.
  2. Tax expenditures total a significant amount – perhaps as much as the amount of income tax collected.
  3. Some say that tax expenditures are hidden spending. Measured on this basis, they would amount to about a quarter of total government spending.
  4. Some say that tax expenditures help fulfill important policy or societal goals such as encouraging savings, home ownership, work and charitable giving.
  5. When politicians talk about simplifying the tax code, or lowering rates and broadening the base, they are at least in part talking about reducing tax expenditures. Some in both parties want to reduce tax expenditures. The difference is what to do with any increased tax revenue from such reductions.
  6. The vast majority of tax expenditures apply to individual rather than corporate taxes.
  7. If eliminated, we cannot expect to collect the same amount of revenue as tax expenditures are estimated to cost.
  8. Meaningfully increasing tax revenues by reducing tax expenditures will require a thoughtful analysis and will be politically difficult.

 

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