What Are Tax Expenditures and How Do They Work?

Tax expenditures are specific provisions within the tax code designed to reduce tax liabilities for certain activities or taxpayers. These provisions represent revenue the government forgoes, rather than collecting, to achieve various policy objectives. They function as a form of indirect government support, influencing economic and social behaviors through the tax system. While they may appear as tax reductions to individuals or businesses, they are essentially government programs delivered through a different mechanism than direct spending. Understanding tax expenditures provides insight into how government policy extends beyond traditional budgetary outlays and impacts the economy.

Defining Tax Expenditures

Tax expenditures are deviations from a “normal” or “benchmark” tax structure, representing provisions that reduce tax liability for specific activities, entities, or groups of people. These are not simply general tax laws, but rather exceptions designed to encourage certain behaviors or provide financial relief. For example, a benchmark tax system would tax all income, but a provision allowing a deduction for mortgage interest creates a tax expenditure. Their core characteristic is “revenue forgone,” meaning the government does not collect tax revenue it would otherwise receive under a normal tax system. This forgone revenue acts as a subsidy delivered through the tax code.

Unlike direct government spending, where money flows from the government to recipients, tax expenditures reduce the amount of money flowing to the government. They are considered a form of government spending because they reallocate private resources to publicly selected purposes. The U.S. Department of the Treasury defines tax expenditures as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” This definition highlights that these provisions serve as alternatives to other policy instruments, such as direct spending programs or regulations.

Common Types of Tax Expenditures

Tax expenditures take various forms, each designed to reduce tax liability in a distinct way. These include exclusions, deductions, credits, preferential tax rates, and deferrals.

Exclusions

Exclusions represent income that is not included in the tax base, meaning it is never subject to taxation. A common example is employer-provided health insurance premiums, which are generally excluded from an employee’s taxable income. Interest earned on state and local government bonds, known as municipal bonds, is also typically excluded from federal gross income.

Deductions

Deductions allow taxpayers to subtract certain amounts from their gross income to arrive at a lower taxable income. This reduces the amount of income subject to taxation, thereby lowering the overall tax bill. Examples include the mortgage interest deduction, which allows homeowners to deduct interest paid on their home loans, and deductions for charitable contributions. Contributions to traditional Individual Retirement Accounts (IRAs) and 401(k) plans are also common deductions, reducing current taxable income.

Credits

Credits provide a direct reduction in the amount of tax owed, dollar-for-dollar. This makes them generally more valuable than deductions, which only reduce taxable income. Examples include the Child Tax Credit, which provides a credit for each qualifying child, and the Earned Income Tax Credit, which supports low- to moderate-income working individuals and families. Some credits are refundable, meaning a taxpayer can receive a refund even if the credit amount exceeds their tax liability, while others are nonrefundable and can only reduce the tax bill to zero.

Preferential Tax Rates

Preferential tax rates apply a lower tax rate to specific types of income or activities compared to the ordinary income tax rates. Long-term capital gains, which are profits from the sale of assets held for over a year, are a prominent example. These gains are often taxed at rates lower than the rates applied to regular income.

Deferrals

Deferrals allow taxpayers to postpone tax liability to a future date. This means taxes are not paid until a later time, allowing investments to grow on a tax-deferred basis. Retirement savings plans like 401(k)s and traditional IRAs are prime examples, where contributions and earnings are not taxed until withdrawal, typically in retirement. This deferral can provide a significant advantage by allowing investments to compound without annual tax erosion.

How Tax Expenditures Function

Tax expenditures reduce the amount of tax revenue the government collects, rather than directly disbursing funds. When a taxpayer qualifies for a tax expenditure, their tax liability is lowered, which means less money flows into the government’s coffers. This mechanism effectively allows individuals or businesses to keep more of their income, which can then be used in ways the government aims to encourage.

For instance, a deduction for home mortgage interest aims to encourage homeownership by making it less costly. Similarly, tax credits for education expenses are designed to promote college enrollment. The incentive works by altering the after-tax cost or benefit of an activity, making the favored action more financially attractive.

While tax expenditures and direct government spending both aim to achieve policy objectives, their administrative and visibility aspects differ. Direct spending involves appropriations and money flowing from government agencies to recipients, which is typically subject to annual review and appropriation processes. In contrast, tax expenditures reduce revenue that would otherwise be collected and are often embedded in the tax code without the same level of annual scrutiny or direct budgetary appropriations. This difference can make tax expenditures less transparent than direct spending programs, even though they represent significant government resource allocation.

Measuring and Reporting Tax Expenditures

Measuring tax expenditures involves identifying and estimating the revenue lost due to these specific provisions in the tax code. This process requires establishing a “normal” or “benchmark” tax system against which deviations are measured. The estimates reflect the difference in tax paid by those who benefit from a provision compared to what they would pay under the benchmark system, assuming no change in behavior.

Several key governmental bodies play a role in preparing these estimates. The U.S. Department of the Treasury’s Office of Tax Analysis (OTA) and the Congressional Budget Office (CBO) are primary entities involved in this work. They analyze tax laws and taxpayer data to calculate the revenue impact of various tax expenditure provisions. These estimates are typically published in annual reports, providing transparency on the financial impact of these provisions. For example, the Analytical Perspectives of the U.S. Budget often includes detailed information on tax expenditures.

The estimates are based on specific assumptions, including the premise that other parts of the tax code remain unchanged and that taxpayer behavior is not altered by the existence of the tax expenditure itself. These estimates do not necessarily reflect the amount of revenue that would be gained if a tax expenditure were eliminated, as behavioral responses to such a change are not typically factored into the initial revenue forgone calculation.

The Policy Purpose of Tax Expenditures

Governments utilize tax expenditures as tools to achieve a variety of economic and social policy objectives. One common policy goal is to promote economic growth by encouraging specific investments or activities, such as research and development or investment in certain industries. Another objective is to support particular sectors of the economy or provide relief to specific groups of taxpayers, like encouraging homeownership or supporting education.

Tax expenditures are also used to redistribute income or provide social welfare benefits, such as the Earned Income Tax Credit which supplements the income of low-wage workers. Other provisions encourage behaviors like saving for retirement or making charitable contributions. Their effectiveness is subject to ongoing evaluation to ensure they meet their intended goals.