We recently blogged about the various types of federal tax expenditures, which in total, will cost about $1.4 trillion in Fiscal Year (FY) 2014. In this post, we highlight ten of the largest, each of which policymakers will likely need to consider in the context of comprehensive tax reform. According to a 2013 Congressional Budget Office (CBO) report and cost estimates from the non-partisan Joint Committee on Taxation (JCT), just these ten provisions comprise roughly half ($709 billion) of the total annual cost of all tax expenditures.
The table below details JCT’s cost estimates for these ten major tax expenditures.1 Notably, the figures only account for changes in taxpayers’ income-tax liability and do not consider payroll, estate, excise, and other taxes. JCT figures cited in this post measure the change in taxpayers’ income-tax liability that would result from repealing given tax expenditures, assuming no change in taxpayer behavior. Importantly, the estimates do not measure how much additional income-tax revenue the government would take in if tax expenditures were repealed because taxpayers would almost certainly change behavior to lower their tax burdens – making the savings from repeal smaller than the cost estimates reported here. Estimates for some tax expenditures, such as the exclusion for employer-sponsored health insurance and the exclusion of net pension contributions and earnings, would change considerably if effects on payroll and other taxes were included.
BPC has offered a number of proposals to reform particular tax expenditures and the entire tax code as part of both our Healthcare Cost Containment Initiative and our Domenici-Rivlin Debt Reduction Task Force.
- Exclusion of Employer-Sponsored Health Insurance: $143 billion in FY 2014Under federal tax law, all employee compensation, whether provided in cash or some other form, is taxable unless otherwise specified. Since employer-sponsored health insurance is a form of non-cash compensation, employer premium contributions would normally be taxable. The tax code, however, specifically excludes employer and most employee premium contributions to health insurance policies, as well as benefits obtained by employees under those policies, from employees’ taxable income. This exclusion is the largest tax expenditure in the federal tax code, and its estimated cost would be considerably larger if effects on payroll tax liability (in addition to income tax liability) were included.The exclusion has more neutral distributional effects than many of the other tax expenditures on this list, with 41 percent of the income tax benefits going to Americans in the bottom 60 percent of the income distribution. Since payroll taxes are generally more regressive than income taxes, the exclusion would likely appear more progressive if JCT figures accounted for payroll tax effects.
- Exclusion of Net Pension Contributions and Earnings: $109 billion in FY 2014 Under current law, employee contributions made through payroll deduction to qualifying retirement accounts – such as traditional 401(k)s and individual retirement accounts (IRAs) – and investment earnings in those accounts are excluded from taxable income until distributed to the employee (though contributions are not excluded from payroll taxes, and individual contributions to IRAs are technically a deduction). Employer contributions are also excluded from taxable income (as well as payroll taxes). Employees are then taxed on the distributions from those accounts as ordinary income.Unlike many other tax expenditures, the exclusion of pension contributions and earnings defers tax liability to the future rather than eliminating it altogether. Thus, JCT’s cost estimate – which is computed by subtracting tax revenue on account distributions in a given year from revenue forgone on tax-deferred contributions in that year – is not particularly indicative of the true cost of the exclusion. Moreover, taxable distributions on present contributions largely take place outside the cost estimate’s ten-year window, so the score overstates the cost of the exclusion. Similarly, the JCT method understates the cost of Roth-style retirement accounts, in which contributions are made from after-tax income, but distributions (mostly outside the ten-year window) are tax-free. An alternative scoring approach, called net present value, would measure impacts of current contributions on both current and future tax receipts. In a future post, we’ll compare the two approaches.
- Preferential Tax Rates on Capital Gains and Dividends: $91 billion in FY 2014 The government taxes capital gains and dividends at a lower rate than ordinary income with the aim of supporting investment and economic risk-taking. Currently, the top marginal rate for individual income taxes is 39.6 percent, whereas the top rate on dividends and long-term capital gains is just 23.8 percent (including the net investment income tax).The capital gains and dividends rates are lower than the ordinary income rate at all income levels, not just for high earners. Nonetheless, CBO estimates that almost the entire expenditure – 93 percent – goes to Americans in the highest quintile of the income distribution.
- Deduction of Mortgage Interest: $72 billion in FY 2014 Taxpayers who itemize deductions on their tax returns can currently deduct certain mortgage interest payments from their taxable income. The deduction is limited to first and second homes and is limited to $1,000,000 in mortgage debt (or $500,000 if married filing separately).2 This tax expenditure provides a subsidy for homeowners and is intended to increase the attractiveness of owning a home. This deduction, however, can only be claimed by taxpayers who itemize and is more valuable for those with larger mortgages and who pay higher tax rates, so more than 70 percent of the tax expenditure goes to Americans in the top quintile of the income distribution.
- Earned Income Tax Credit (EITC): $67 billion in FY 2014The EITC is designed to encourage and support work for low- to moderate-income households by providing a credit to workers that is worth a particular percentage of their income. The credit completely phases out as household income increases beyond an income threshold. The threshold and the value of the credit depend on filing status as well as the number of qualifying children in the family. The credit is fully refundable, meaning that households can receive a tax refund from the government for credit in excess of their tax liability. Since this expenditure is specifically constructed to benefit relatively low-income Americans, it is unsurprising that those in the lowest quintile of the income distribution receive 51 percent of the benefits, the largest share of any tax expenditure on this list.
- Child Tax Credit: $58 billion in FY 2014 Taxpayers can claim an annual Child Tax Credit of up to $1,000 for each qualifying child under the age of 17. The credit phases out at higher income levels (starting at $110,000 of modified adjusted gross income for married joint filers). It is not refundable, but people whose credit exceeds their total tax liability may be eligible for the Additional Child Tax Credit, which is refundable. (The cost of the Additional Child Tax Credit is included in JCT’s cost estimate.)
- Deduction of State and Local Taxes: $52 billion in FY 2014 The federal tax code allows taxpayers who itemize deductions to deduct state and local income and personal property taxes from their taxable income.3 This deduction provides a disproportionately larger tax benefit to higher earners, who tend to itemize deductions and face higher income tax rates.
- Exclusion of Capital Gains on Assets Transferred at Death: $48 billion in FY 2014 Under federal law, the basis for capital gains taxes for an asset transferred at death is the fair market value of the asset at the time of the transfer (rather than its original purchase price). For instance, suppose a father purchases stock for $100 and bequeaths the stock – now worth $1,000 – upon his death to his son. Because of this tax exclusion, if the son chooses to sell the stock, capital gains tax will only be applied to proceeds in excess of $1,000 (as opposed to $100). The earlier $900 gain ($1,000 market value less $100 purchase price) is excluded from the son’s taxable income and is never subject to capital gains tax.4 JCT’s estimate is computed against a counterfactual in which all capital gains on assets transferred at death are immediately taxable.
- Deduction of Charitable Contributions (other than education and health): $35 billion in FY 2014 Taxpayers who itemize deductions may deduct their charitable contributions to qualifying organizations, subject to various disclosure and verification requirements.5 This tax preference provides individuals with an added incentive to make charitable contributions. JCT’s cost estimate for this deduction does not account for donations to non-profit educational institutions and medical providers, though such donations are tax-deductible. Americans in the top quintile of the income distribution, who are far more likely to itemize deductions and give to charity than lower earners, receive 84 percent of the deduction’s benefits.
- Exclusion of Untaxed Social Security Benefits: $34 billion in FY 20146Social Security benefits are fully tax-free below certain income levels. Above those thresholds, up to 85 percent of benefits may be subject to income tax. Notably, however, only some of the tax-free benefits are included in the cost estimate of the exclusion. Since benefits directly resulting from the amount of payroll taxes paid during one’s working years have already been subject to income tax, they are not counted in JCT’s cost estimate of the exclusion. Only tax-free benefits in excess of this amount are counted.
The federal tax code includes dozens more expenditures for both individuals and corporations, many of which are smaller and more targeted than those we have discussed here. BPC’s Economic Policy Project hopes that lawmakers will carefully evaluate the benefits and costs of all tax expenditures, large and small, as they consider base-broadening, pro-growth tax reform.
Alex Gold and Alex Cave contributed to this post.
1 This list omits the exclusion for Medicare benefits, which would rank sixth at $66 billion in FY 2014. CBO’s report does not analyze this exclusion as its distributional effects are difficult to quantify. BPC’s list represents the ten largest individual tax expenditures other than the Medicare exclusion.
2 Also included in the tax expenditure are limited deductions for interest on home equity loans and lines of credit.
3 Additionally, before December 31, 2013, taxpayers had the option to deduct state and local general sales taxes instead of state and local income taxes (but not both). The state and local sales tax deduction is one of roughly 60 tax extenders, or temporary tax expenditures that have repeatedly been renewed in the past. The extenders expired in 2013 and Congress is currently considering whether to reinstate them.
4 While such gains are not subject to capital gains taxes, they may be subject to estate taxes.
5 Charitable deductions are generally limited to a total of 50 percent of modified adjusted gross income, with some exceptions depending on the type of contribution.
6 JCT’s estimate also accounts for untaxed Tier 1 Railroad Retirement benefits. These benefits are administered by the Railroad Retirement Board, an independent government agency. The Board provides retirement, survivor, unemployment, and sickness benefits to railroad workers, who do not participate in the Social Security system.