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Tax expenditures: How do they work?

By Shai Akabas, Brian Collins

Wednesday, July 9, 2014

Alex Cave contributed to this post.

Several recent comprehensive tax reform proposals, including plans put forward by House Ways and Means Chairman Dave Camp (R-MI) and the Bipartisan Policy Center’s Domenici–Rivlin Debt Reduction Task Force, have called for lower corporate and individual rates alongside limiting tax expenditures to broaden the tax base. But what exactly are tax expenditures?

Often colloquially called “tax breaks” or “loopholes,” tax expenditures are provisions in law that reduce the amount that households or businesses pay on their tax bills relative to a hypothetical system of taxation where all income is fully taxed as ordinary income. Tax expenditures can take the form of deductions, exclusions, exemptions or deferral from income or can be credits or preferential rates.

Here’s how the main types of tax expenditures work:

  • Tax deductions, exclusions, and exemptions reduce taxable income by subtracting the value of the deduction or, in the case of exclusions and exemptions, not including the value being excluded or exempted in the definition of taxable income at all.
      • Example: Most people can claim the standard deduction. This year, the standard deduction is $6,200 for a single, non-blind person. If such a person’s only income in 2014 is $50,000 in wages and they claim the standard deduction, then
    their gross wage income $50,000
    would be reduced by the standard deduction -$6,200
    to $43,800 for tax purposes.
    • Example: Municipal bond interest payments and the value of employer-sponsored health insurance are both excluded from taxable income, which means that the value of each is not included when taxable income is calculated. The type(s) of tax impacted by deductions, exclusions, and exemptions varies; for instance, the value of employer-sponsored health insurance is excluded from taxable income for the purposes of both income and payroll taxes.
  • Tax deferral: Unlike deductions, exclusions, and exemptions, tax deferral delays taxation to the future rather than foregoing taxation entirely. Tax deferral deducts, excludes, or exempts income from current taxation, but taxes the income in the future.
    • Example: Employee contributions to qualified workplace retirement plans, such as 401(k)s, are excluded from income taxes (but not payroll taxes) at the time of contribution, and investment earnings on plan balances are not taxed each year. (Employer contributions to such plans are excluded from both income and payroll taxation at contribution.) Distributions from these plans are subject to ordinary income taxes, but not payroll taxes.
  • Preferential rates lower the marginal tax rates (relative to ordinary income tax rates) on certain types of income, most notably capital gains, dividends, and collectibles (such as art).
    • Example: Cash dividends (such as those paid to the shareholders of common stock) are subject to preferential tax rates. If someone was filing singly in 2013 and earned $90,000 of wage income (after deductions) and received $1,000 of dividends on stocks that they owned, the wage income would be taxed at rates up to 28 percent while the cash dividends would all be taxed at only 15 percent.
  • Tax credits are amounts that are taken off of an individual’s tax liability. Some tax credits are refundable – meaning that taxpayers can receive a refund check from the government for credit in excess of tax liability – and some of those are advanceable, meaning that they can be paid before filing the following year’s tax return.
    • Example: The Earned Income Tax Credit (EITC) is a refundable tax credit that reduces tax liability for low-income wage earners, and in many cases provides them with additional income. The maximum EITC in 2013 for an individual with one child was $3,250. If that person had a total income tax liability of $3,500, then they would have to pay $250 in income taxes to the government. If that person’s income tax liability had been only $3,000, then they would get a check from the government for the $250 by which the value of the refundable credit exceeded their tax liability.

Many tax expenditures essentially represent government spending conducted through the tax code. This is particularly true of refundable tax credits. For instance, a taxpayer claiming EITC benefits sees a reduction in their tax liability, which is essentially indistinguishable from that taxpayer receiving a check during tax season for the equivalent amount under a comparable spending program. Moreover, tax expenditures in the aggregate have the same effect on the federal deficit as would equivalent government spending. CBO estimates that in Fiscal Year (FY) 2014, individual and corporate tax expenditures will cost about $1.4 trillion in total, or about 8.2 percent of U.S. gross domestic product (GDP).1 In comparison, CBO estimates that all federal discretionary spending will total $1.18 trillion in FY 2014.

The cost of the dozens of individual and corporate tax expenditures in the federal tax code, however, is not limited to the federal budget. Many of these provisions also impose substantial complexity and efficiency costs on our economy, driving up tax preparation and compliance costs and encouraging behavior that is not necessarily productive. We urge policymakers to remain mindful of the budgetary and distortionary costs of tax expenditures as they pursue a comprehensive tax reform package.

Alex Gold contributed to this post.

1 This figure measures the change in taxpayers’ income tax liability that would result from repealing all tax expenditures, assuming no change in taxpayer behavior. Importantly, the estimate does not measure how much additional revenue the government would take in if tax expenditures were repealed. The difference lies in the aforementioned behavioral assumption: the estimate assumes that taxpayers would not take steps to minimize their overall income tax liability following repeal of tax expenditures. For instance, CBO notes that if preferential tax rates on capital gains and dividends were repealed, taxpayers would likely realize fewer capital gains, thereby offsetting some of the resulting increase in tax revenue. The estimate does not account for such offsets, and therefore is likely larger than a corresponding revenue estimate. The figure also only accounts for effects on income taxes and does not consider employment, estate, excise, and other taxes.

“Discretionary spending” is the portion of government spending that Congress must approve (appropriate) each year. It makes up about one-third of the federal budget. Discretionary spending funds many programs, including almost the entire defense budget, scientific research, head start, the FBI, and much more.

Other programs, so-called “mandatory spending,” are automatically funded every year without congressional action. Mandatory spending currently makes up about 60 percent of the federal budget and funds Medicare, Medicaid, and Social Security, among other programs.

The final portion of the federal budget—around 6 percent—is interest paid on public debt.