Tax Expenditures

Policymakers use the tax system to raise revenue and to promote social policy goals. For example, tax breaks may be provided to encourage home ownership. Some of these tax provisions simplify particularly cumbersome tax calculations. 

Collectively, these preferences built into the tax code result in tax expenditures: spending that occurs through the tax code in the form of foregone revenue. It is different from traditional direct spending programs. In that case, the government pays for a service or sends money directly to someone. Still, a dollar of uncollected revenue has the same budgetary impact as a dollar spent directly. 

Tax expenditures can take many forms. They can include reduced tax rates on some forms of income, credits and deductions, and the exclusion of certain forms of compensation or certain benefits from taxation. Examples of tax expenditures include the child tax credit, the mortgage-interest deduction, and the lower tax rate for income from capital gains. 

Many tax preferences generally meet their policy goals. However, research questions the effectiveness of others. Effective or not, all tax expenditures combine to make the tax system more complex, even though individually some of them simplify certain aspects. They also shrink the tax base (the amount of money subject to tax). This forces policymakers to increase tax rates on other forms of income to yield the same amount of revenue. These provisions also introduce differences in tax liabilities of similarly situated taxpayers. For example, two couples with the same total income may owe different taxes depending on whether they have children. 

Research suggests that, as a whole, existing tax expenditures are regressive. A tax is considered regressive if the total benefit skews toward taxpayers with higher incomes. Tax deductions are worth more to people with higher tax rates than people with lower rates. Nonrefundable tax credits do not offer relief to taxpayers with lower incomes who have no tax liability.