Policymakers use the tax system to raise revenue and to promote social policy goals. For example, they may want to encourage desirable behaviors, such as home ownership. This can be accomplished 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. It is different from traditional direct spending programs. In that case, the government pays for a service or sends money directly to someone. Still, they have the same financial impact on the government budget. In contrast to direct spending, however, tax expenditures generally escape regular congressional examination.
Tax expenditures can take many forms, including 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 creditTax credits directly reduce the amount of taxes owed. , the mortgage-interest deductionReduction in the amount of income that is subject to tax. A dollar of a deduction reduces taxes by only a fraction of a dollar, as determined by the taxpayer’s applicable tax rate , and the lower tax rate for income from capital gainsCapital gains occur when an investor sells an asset for more than its purchase price, or "basis." .
Some tax preferencesProvisions in the tax code—such as exclusions, deductions, credits, or special tax rates—that reduce the amount a person owes in taxes. generally meet their policy goals. However, research questions the effectiveness 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). 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 or qualify for another tax benefit.
Research suggests that existing tax expenditures are regressiveIn taxation, a situation in which people with lower income pay a larger percentage of their income than do people with higher income. . A tax is considered regressiveIn taxation, a situation in which people with lower income pay a larger percentage of their income than do people with higher income. if the 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
TAX EXPENDITURES: Policy
Policymakers should broaden the tax base by limiting tax preferencesProvisions in the tax code—such as exclusions, deductions, credits, or special tax rates—that reduce the amount a person owes in taxes. that do not efficiently achieve important policy goals.
Tax expenditureMoney spent through the tax code, such as through exclusions, deductions, credits or special tax rates. reform should increase the effectiveness of the provisions in accomplishing their goals, improve fairness, and minimize complexity.
Tax expenditureMoney spent through the tax code, such as through exclusions, deductions, credits or special tax rates. reform should:
- result in a more progressiveIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income. 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 deficitThe amount by which annual expenditures exceed annual revenues. 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.