While testifying at Congressional hearings at the beginning of this month, CBO’s Director was asked a number of questions about tax expenditures. Answers during hearings need to be brief, so this blog post provides some additional information.
Current tax law includes an array of exclusions, deductions, preferential rates, and credits that reduce revenues for any given level of tax rates in the individual, payroll, and corporate income tax systems. Some of those provisions are called tax expenditures because, like many government spending programs, they provide financial assistance for particular activities or to certain entities or groups of people. The Joint Committee on Taxation (JCT) regularly reports on the provisions that it identifies as tax expenditures.
Like conventional spending, tax expenditures contribute to the federal budget deficit. They also influence people’s choices about working, saving, and investing, and they affect the distribution of income among people. Tax expenditures are more similar to mandatory programs such as Social Security than they are to discretionary spending programs: They are not subject to annual appropriations, and any person or entity that meets the legal requirements can receive the benefits. Because of their budgetary treatment, however, tax expenditures are much less transparent than spending on benefit programs.
How Large are Tax Expenditures?
The largest tax expenditures in 2017 are the following (and see the figure below):
- The exclusion from workers’ taxable income of employers’ contributions for health care, health insurance premiums, and premiums for long-term care insurance;
- The exclusion of contributions to and the earnings of pension funds (minus pension benefits that are included in taxable income);
- Preferential tax rates on dividends and long-term capital gains;
- The deferral for profits earned abroad, which certain corporations may exclude from their taxable income until those profits are returned to the United States; and
- The deductions for state and local taxes (on nonbusiness income, sales, real estate, and personal property).
Other significant tax expenditures include the earned income tax credit, the deduction for mortgage interest, the immediate deduction for investments in certain business property, and the deduction for charitable contributions.
In 2013, CBO estimated that more than half of the combined benefits of 10 major tax expenditures would accrue to households with income in the highest quintile (that is, the highest fifth) of the population; furthermore, 17 percent would go to households in the top 1 percent. In contrast, 13 percent of those tax expenditures would accrue to households in the middle quintile and only 8 percent to those in the lowest quintile.
Tax expenditures have a substantial effect on the projected federal revenues reported in CBO’s The Budget and Economic Outlook: 2017 to 2027. On the basis of estimates prepared by JCT, CBO expects that tax expenditures will equal over 8 percent of GDP in 2017—an amount that is equal to nearly half of all federal revenues projected for the year (see the figure below).
However, the total amount of tax expenditures does not equal the increase in revenues that would occur if the tax expenditures were eliminated, because repealing a tax provision would change incentives and lead taxpayers to modify their behavior in ways that would diminish the impact on revenues. For example, if preferential tax rates on realizations of capital gains were eliminated and those gains were instead taxed as ordinary income, taxpayers would reduce the amount of capital gains that they realized, diminishing the additional revenues that would be produced.
What are the Effects of Tax Expenditures?
Tax expenditures are generally designed to further societal goals. For example, the tax expenditures for health insurance costs, pension contributions, and mortgage interest payments may help to promote a healthier population, adequate financial resources for retirement and greater national saving, and stable communities of homeowners. However, tax expenditures have a broad range of effects that do not always further societal goals.
First, tax expenditures may lead to an inefficient allocation of economic resources by encouraging more consumption of goods and services receiving preferential treatment; they also may subsidize activity that would have taken place without the tax incentives. For example, the tax expenditures mentioned above may prompt people to be less cost-conscious in their use of health care services than they would be in the absence of the tax expenditure for health insurance costs; to reallocate existing savings from accounts that are not tax-preferred to retirement accounts, rather than add to their savings; and to purchase more expensive homes, investing too much in housing and too little elsewhere relative to what they would do if all investments were treated equally.
Second, by providing benefits to specific activities, entities, or groups of people, tax expenditures increase the size and scope of federal involvement in the economy. Indeed, adding tax expenditures to conventional federal outlays makes the federal government appear notably larger relative to GDP.
Third, tax expenditures reduce the amount of revenue that is collected for any given set of statutory tax rates—and thereby require higher rates to collect any chosen amount of revenue. All else being equal, those higher tax rates lessen people’s incentives to work and save and therefore decrease output and income. At the same time, some tax expenditures more directly affect output and income. For example, the preferential rate on capital gains and dividends raises the after-tax return on some forms of saving, which tends to increase saving and boost future output. As another example, the increase in take-home pay arising from the earned income tax credit appears to encourage work effort by some people.
Fourth, tax expenditures have mixed effects on the societal goal of limiting the complexity of the tax code. On the one hand, most tax expenditures, such as itemized deductions and tax credits, require that taxpayers keep additional records and make additional calculations, increasing the complexity of the tax code. On the other hand, some exclusions from taxable income simplify the tax code by eliminating recordkeeping requirements and the need for certain calculations. For example, in the absence of the exclusion for capital gains on assets transferred at death, taxpayers would need to calculate the appreciation in the value of their assets since the original purchase—a calculation that would require records of the purchase of assets acquired by deceased benefactors, perhaps many decades earlier.
Fifth, tax expenditures affect the distribution of the tax burden in ways that may not always be recognized, both among people at different income levels and among people who have similar income but differ in other ways.
Joshua Shakin is an analyst in CBO’s Tax Analysis Division.