What Is a Tax Expenditure and How Do They Work?
Explore what tax expenditures are and how these tax provisions function as indirect government spending to achieve public policy objectives.
Tax expenditures represent a significant yet often overlooked aspect of government policy. They are special provisions within the tax code that reduce the tax liability for specific activities or groups of taxpayers. Rather than directly spending money, the government uses these provisions to provide financial benefits indirectly. Understanding tax expenditures is key to comprehending the full scope of government involvement in the economy.
Understanding Tax Expenditures
Tax expenditures are essentially revenue losses to the government that result from specific tax code provisions designed to provide financial advantages. These provisions diverge from a “normal” or “baseline” tax structure. The Congressional Budget and Impoundment Control Act of 1974 defines them 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.”
The concept of a “baseline” tax system is central to identifying tax expenditures. This baseline represents a general tax structure that applies broadly, without preferential treatment for particular activities or taxpayers. Deviations from this neutral baseline, such as allowing certain deductions or credits, are then classified as tax expenditures. For instance, if a general income tax system applies to all income, then an exclusion for a specific type of income would be considered a tax expenditure.
These provisions function differently from direct government spending, such as grants or subsidies. With direct spending, money is explicitly appropriated and disbursed from the treasury. In contrast, tax expenditures deliver benefits by reducing the amount of tax owed, meaning the government foregoes revenue it would otherwise collect. Both mechanisms serve to achieve policy objectives, but tax expenditures operate through the tax system, often without the same level of annual review as direct appropriations.
Common Tax Expenditures
Many common tax provisions taxpayers encounter are tax expenditures designed to encourage certain behaviors or provide financial relief. Deductions are a frequent form, reducing the amount of income subject to taxation. For example, the mortgage interest deduction allows homeowners to reduce their taxable income by the interest paid on their home loan. The deduction for charitable contributions allows taxpayers to deduct donations made to qualified organizations, incentivizing philanthropy.
Tax credits represent another category of tax expenditures. Unlike deductions, which reduce taxable income, credits directly reduce the amount of tax owed. The Child Tax Credit provides eligible families a direct reduction in their tax liability for each qualifying child. Energy credits, such as those for installing energy-efficient home improvements, also promote environmental sustainability.
Exclusions from gross income also function as tax expenditures. These provisions allow certain types of income to be excluded from taxable income. A notable example is the exclusion of employer-provided health insurance premiums from an employee’s taxable income. This means the health insurance benefit’s value is not counted as income for tax purposes, reducing the employee’s tax burden and representing foregone revenue.
Measuring Tax Expenditures
Quantifying tax expenditures involves estimating the revenue the government foregoes due to these provisions. This process relies on establishing a “baseline” tax system and calculating the revenue difference between this benchmark and the actual tax law. Estimates typically reflect the revenue loss for a specific fiscal year.
Measurement presents inherent challenges, partly due to the difficulty in precisely defining the “normal” tax baseline from which deviations are measured. Another complexity arises from behavioral responses; if a tax expenditure were eliminated, taxpayers might alter their economic activities, meaning the government would not necessarily gain back the full estimated amount of foregone revenue. For instance, removing a deduction might reduce the activity it once incentivized.
In the United States, government entities such as the Treasury Department and the Joint Committee on Taxation (JCT) are responsible for estimating and publishing these figures. These estimates are usually prepared annually and provide an overview of the financial impact of these provisions. The reported figures represent the direct revenue loss to the government, assuming taxpayer behavior remains unchanged.
Purpose of Tax Expenditures
Tax expenditures are created with specific policy goals, serving as an alternative mechanism to achieve objectives also pursued through direct government spending programs. A primary purpose is to encourage behaviors or activities beneficial for society or the economy. For instance, provisions like the deduction for contributions to retirement accounts (e.g., 401(k)s and IRAs) incentivize individuals to save for their future, reducing reliance on public assistance in old age.
Similarly, tax expenditures aim to promote homeownership, education, and charitable giving. The mortgage interest deduction supports homeownership, while various education credits and deductions help offset the costs of higher education. Provisions allowing deductions for charitable contributions encourage individuals and corporations to support non-profit organizations.
These provisions can also provide financial relief to specific groups or industries. For example, credits like the Earned Income Tax Credit (EITC) support low-to-moderate income working individuals and families. By delivering benefits through the tax code, policymakers can address social and economic issues without directly allocating funds from the annual budget, using the tax system as a tool for public policy.