The Congressional Budget Act of 1974 defines tax expenditures as “revenue losses attributable to … a special exclusion, exemption, or deduction from gross income or … a special credit, a preferential rate of tax, or a deferral of tax liability.” Such provisions are analogous to direct spending programs, as either can be used to channel public funds to accomplish policy objectives. Examples of tax expenditures include itemized deductions, the child tax credit, and the preferential tax rate applied to income from capital gains and dividends. Tax expenditures are often used to encourage certain behaviors that policymakers consider desirable.
Tax expenditures can make it difficult to ensure the equity and efficiency of the overall tax structure. Often their effectiveness in achieving policy goals is questionable, but they indisputably narrow the tax base, decreasing revenues or leading to higher tax rates.
Tax expenditures as a whole benefit higher-income taxpayers more than others. Tax deductions, for example, are worth more to people with higher tax rates than to people with lower rates (see Box 1: Overview of Individual Income Tax Concepts). Nonrefundable tax credits do not offer relief to lower-income taxpayers without tax liability.
States and localities have tax expenditures of their own. In addition to the ones analogous to the federal tax expenditures, they often create special tax incentives to attract businesses to their jurisdiction. The benefits of these incentives are unclear.
For policy on retirement savings tax incentives, see Chapter 4, Retirement Income; for tax incentives to expand health coverage, see Chapter 7, Health; for tax credits to caregivers and incentives for buying private long-term care insurance, see Chapter 8, Long-Term Services and Supports; for tax credits to preserve affordable housing and minimize property tax burdens, and the Low-Income Housing Tax Credit program, see Chapter 9, Livable Communities; and for incentives to adopt broadband technologies, see Chapter 10, Utilities: Telecommunications, Energy, and Other Services.
Tax Expenditures and Incentives: Policy
AARP supports efforts to broaden the tax base by limiting tax preferences that do not efficiently achieve important policy goals.
The creation, limitation, or elimination of tax expenditures warrants at least as much scrutiny as direct spending decisions.
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.
Reform of personal income tax expenditures can be an important method for raising revenue to address budget deficits and for making the tax system more progressive. Any reform to tax expenditures should:
- result in a more progressive distribution of the tax system,
- increase the effectiveness of the tax code in supporting important social goals for low- and moderate-income people,
- 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.
State and local incentives for businesses
States and localities should carefully evaluate the incentives they offer to attract or retain business, since such subsidies must be offset by greater tax burdens on consumers, other taxpayers, and public institutions. Any incentives offered to business should be transparent with respect to costs and beneficiaries.