Policymakers use the tax system not only to raise revenue but also to promote social policy goals. For example, they may encourage desirable behaviors, such as home ownership, by providing special tax benefits for activities associated with owning a home.
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. They have the same financial impact on the government budget as traditional direct spending programs where the government pays for a service or writes a check to a benefit recipient. In contrast to direct spending, however, tax expenditures escape regular congressional examination. Examples of tax expenditures include the child tax credit, the mortgage-interest deduction, and the preferential capital gains tax rate.
Although some tax preferences generally meet their policy goals, research questions the efficiency of many others. Effective or not, all tax expenditures make the tax system more complex. They also shrink the tax base (the amount of money subject to tax), forcing policymakers to increase tax rates on other forms of income to yield the same amount of revenue. Finally, these provisions 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 or qualify for another tax benefit.
Research suggests that existing tax expenditures as a whole are regressive (total benefit skews towards taxpayers with higher incomes). Tax deductions are worth more to people with higher tax rates than to people with lower rates. Nonrefundable tax credits do not offer relief to taxpayers with lower incomes who have no tax liability.
TAX EXPENDITURES: Policy
Policymakers should broaden the tax base by limiting tax preferences that do not efficiently achieve important policy goals.
Tax expenditure reform can be an important method for raising revenue to address budget deficits and for making the tax system more progressive. Any reform should increase the effectiveness of the provisions in accomplishing their goals, improve fairness, and minimize complexity.
Tax expenditure reform should:
- result in a more progressive distribution of the tax system,
- increase the effectiveness of the tax code in supporting important social goals for people with low and moderate incomes,
- be implemented with enough transition time to allow for taxpayer education and adjustments by both individuals and states,
- avoid adding complexity to the tax code,
- not result in a disproportionately adverse impact on older Americans, and
- not negatively affect state budgets.
The creation, limitation, or elimination of tax expenditures warrants at least as much scrutiny in deficit reduction and budget balancing discussions as direct spending decisions do.
The impact of tax expenditures should be monitored carefully to ensure that corporations and upper-income taxpayers bear their fair share of the overall tax burden, in accordance with progressive tax principles.