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.
TAX EXPENDITURES: Policy
TAX EXPENDITURES: Policy
Policymakers should broaden the tax base by limiting tax preferences that do not efficiently achieve important policy goals.
Tax expenditure 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.