Order Code RL34622
Tax Expenditures and the Federal Budget
August 19, 2008
Thomas L. Hungerford
Specialist in Public Finance
Government and Finance Division

Tax Expenditures and the Federal Budget
Summary
Americans often mention economic issues as the most important problem facing
the United States. Recent economic issues mentioned include rising gasoline prices,
rising unemployment, falling home prices, and rising mortgage interest rates.
Relatively few, however, mention long-term federal budget concerns. But many
policy makers and analysts rate long-term federal budgetary problems high on their
list of economic problems facing the United States For example, Representatives Jim
Cooper and Frank Wolf introduced the Securing America’s Future Economy
Commission Act (H.R. 3654), which would create a bipartisan commission to
develop solutions to the long-term federal fiscal problem.
Budget experts from think tanks and academia have developed proposals for
dealing with long-term fiscal difficulties. Many argue that the federal budget deficits
are unsustainable and threaten the future of the economy, but they differ on the
causes of federal deficits. One group claims that Social Security, Medicare, and
Medicaid are the major drivers of escalating deficits, and proposes that the budget
process be reformed so these three programs are no longer on “autopilot.” Another
group proposes reducing projected deficits by reducing the growth of Medicare and
health care spending, increasing Medicare premiums for higher income beneficiaries,
eliminating or limiting many tax expenditures, reforming farm subsidy programs, and
adhering to pay-as-you-go budget rules.
Among the options likely to be considered to deal with the long-term fiscal
problem is reform of the federal tax system. The growth of the alternative minimum
tax (AMT) and the expiration of the 2001 and 2003 tax cuts in 2010 will likely force
some action on tax policy. Past efforts to reform the federal tax system have
included policies to rein in the use and expense of tax expenditures, which account
for a large proportion of the resources the federal government uses to achieve various
national goals. By 2007, it is estimated that tax expenditures amounted to about $1
trillion and accounted for about a quarter of total expenditures. When combined with
outlays for mandatory spending programs and net interest payments, almost three-
quarters of total expenditures are for permanent programs that many claim are more
or less on “autopilot.” The proportion of total expenditures subject to annual review
by the Appropriations Committees in the appropriations process has been declining
over the past two decades.
Estimates of the revenue losses and distributional effects of tax expenditures
depend on the parameters of the tax code. Both will change not only because of
direct changes to the tax expenditures themselves, but also because of changes
elsewhere in the tax code. Consequently, while many tax expenditures may be
considered permanent, the revenue losses can vary year to year because of changing
economic conditions and changes to the tax code. For example, the revenue loss and
distributional impacts of many tax expenditures will change after 2010 when the
individual income tax rates are scheduled to revert back to their pre-2001 levels.
This report will be updated as legislative developments warrant.

Contents
Tax Expenditures and Federal Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Tax Expenditure Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
The Joint Committee of Taxation Pamphlet
on Tax Expenditure Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Issues in Measuring Tax Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
List of Figures
Figure 1. Federal Outlays, Fiscal Year 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Figure 2. Total Expenditures, FY1981 to FY2011 . . . . . . . . . . . . . . . . . . . . . . . . 5
Figure 3. Composition of Total Expenditures, Selected Years . . . . . . . . . . . . . . . 6
List of Tables
Table 1. Expenditures by Selected Functional Categories as
a Percentage of the Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Table 2. Revenue Losses and Progressivity Measures of
Selected Tax Expenditures under Alternative Scenarios . . . . . . . . . . . . . . . 12
Table 3. Average Tax Savings from Schedule A Itemized Deductions
Under Alternative Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Table 4. Average Tax Savings from Above-the-Line Deductions
Under Alternative Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Table 5. Average Tax Savings from Income Exclusions
Under Alternative Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Tax Expenditures and the Federal Budget
Americans often mention economic issues as the most important problem facing
the United States. Recent economic issues mentioned include rising gasoline prices,
rising unemployment, falling home prices, and rising mortgage interest rates.
Relatively few, however, mention long-term federal budget concerns.1 But many
policy makers and analysts rate long-term federal budgetary problems high on their
list of economic problems facing the United States. For example, Representatives
Jim Cooper and Frank Wolf introduced the Securing America’s Future Economy
Commission Act (H.R. 3654), which would create a bipartisan commission to
develop solutions to the long-term federal fiscal problem.
The Congressional Budget Office’s baseline projection of the budget shows a
steadily improving deficit after 2011 with a budget surplus equal to 1% of gross
domestic product (GDP) by 2018.2 The baseline analysis, however, assumes that
current law does not change over the projection period (for example, the 2001 and
2003 tax cuts will expire in 2010 as scheduled). Furthermore, these projections omit
the recently enacted supplemental appropriations act (P.L. 110-252) and the
economic stimulus package (P.L. 110-185). CBO also puts out a long-term
projection that captures current fiscal policy.3 In this alternative scenario, the
alternative minimum tax (AMT) is indexed to inflation and none of the scheduled tax
changes after 2007 take effect. The federal budget deficit under the alternative
scenario reaches 10.1% of GDP in 2030 and 54.5% of GDP by 2082. CBO estimates
a 75-year fiscal gap of 6.9% of GDP.4 In comparison, CBO’s estimate of the fiscal
gap under a scenario that simply extends their baseline assumptions is 1.7%.
Economists Alan Auerbach, Jason Furman, and William Gale preform the same
exercise as CBO but with different assumptions and conclude from their analysis that
“[u]nder assumptions that reflect the conduct of fiscal policy in recent years and more
appropriate treatment of the retirement funds, the nation faces significant medium-
term shortfalls and massive long-term deficits.”5
1 About 60% of respondents to a recent New York Times-CBS News poll mention economic
issues as the most important problem facing the country. Only 1% mention the budget
deficit or federal debt. See New York Times-CBS News Poll, July 2008.
2 See Congressional Budget Office (CBO), The Budget and Economic Outlook: Fiscal Years
2008 to 2018
, Jan. 2008.
3 See CBO, The Long-Term Budget Outlook, Dec. 2007.
4 The fiscal gap is a measure of the nation’s fiscal imbalance adjusting for the time value of
money. It is expressed as a percentage of GDP.
5 Alan J. Auerbach, Jason Furman, and William G. Gale, “Facing the Music: The Fiscal
Outlook as the Bush Years End,” Tax Notes, June 2, 2008, pp. 988-989.

CRS-2
In April 2008, a team of 16 budget experts from Washington think tanks issued
proposals for dealing with long-term fiscal difficulties.6 These experts argue that the
federal budget deficits are unsustainable and threaten the future of the economy.
They claim that Social Security, Medicare, and Medicaid are the major drivers of
escalating deficits. As a first step to establishing budget responsibility, they propose
that the budget process be reformed so these three programs are no longer on
“autopilot.” Specifically they recommend that (1) explicit long-term budgets for the
three programs be enacted, which “are sustainable, set limits on automatic spending
growth, and reduce the relatively favorable budgetary treatment of these programs
compared with other types of expenditures”; (2) the programs be regularly revised
to determine whether they are within budgeted amounts; and (3) “significant long-
term deviations from budgeted amounts trigger automatic adjustments in benefits,
premiums, provider payments, or other revenues.”7 These budget experts do
acknowledge that there are “other mandatory or entitlement programs and tax
subsidies that grow automatically without review” (p. 6), but they recommend
starting with Social Security, Medicare, and Medicaid.
More recently, another team of 16 budget experts from think tanks and academia
criticized the Antos and others’ proposal as unbalanced for focusing solely on Social
Security, Medicare, and Medicaid; ignoring the broader problem of rising health care
costs; and advocating automatic budget cuts, which have proved ineffective in the
past.8 This group of budget experts proposes reducing projected deficits by reducing
the growth of Medicare and health care spending, increasing Medicare premiums for
higher income beneficiaries, eliminating or limiting many tax expenditures, using a
different version of the consumer price index (CPI) for calculating cost-of-living
adjustments, reforming farm subsidy programs, and adhering to pay-as-you-go budget
rules.
Among the options likely to be considered to deal with the long-term fiscal
problem is reform of the federal tax system. The growth of the alternative minimum
tax (AMT) and the expiration of the 2001 and 2003 tax cuts in 2010 will likely force
some action on tax policy. The perception that the federal tax system is too complex
and unfair could lead to public support for tax reform. Past efforts to reform the
federal tax system have included policies to rein in the use and expense of tax
expenditures — the special deductions, exclusions, exemptions, and credits resulting
in revenue losses. This report examines tax expenditures within the context of the
federal budget and discusses tax expenditure analysis.
6 Joseph Antos and others, Taking Back Our Fiscal Future, The Brookings Institution and
The Heritage Foundation, available at [http://www.brookings.edu/~/media/Files/rc/papers/
2008/04_fiscal_future/04_fiscal_future.pdf], visited July 28, 2008.
7 Antos and others, p. 2.
8 Henry Aaron and others, A Balanced Approach to Restoring Fiscal Responsibility, The
Brookings Institution, July 2008, available at [http://www.brookings.edu/~/media/Files/rc/
papers/2008/07_fiscal_responsibility_aaron/07_fiscal_responsibility_aaron.pdf], visited July
28, 2008.

CRS-3
Tax Expenditures and Federal Spending
Federal spending is split into discretionary spending and mandatory spending
(often referred to as direct spending). Discretionary spending is provided in and
controlled by the annual Appropriations Acts under the jurisdiction of the
Appropriations Committees. Mandatory spending is controlled by substantive
legislation under the jurisdiction of the legislative committees, primarily the House
Ways and Means Committee and the Senate Finance Committee. Most, but not all
mandatory spending is permanent in nature. In some instances, such as for the
Medicaid program, funding is provided in the annual Appropriations Acts, but the
Appropriations Committees do not effectively control it.9
Figure 1 displays the FY2007 outlays by the type and category of spending.
Overall, discretionary spending accounted for 38% of total outlays split between
defense (20%) and nondefense (18%) spending. Mandatory spending accounted for
53% of outlays while interest on the federal debt held by the public (net interest
payments) accounted for 9% of FY2007 outlays. Social Security, Medicare, and
Medicaid are the largest mandatory programs accounting for 42% of total outlays.
Outlays, however, provide an incomplete picture of federal resources used to
achieve national economic and social goals. Tax expenditures — special deductions,
exclusions, exemptions, and credits in the tax code — are often used instead of direct
expenditures (mandatory and discretionary spending) to achieve these national
goals.10 Tax expenditures, in many ways, are similar to entitlement spending. Eric
Toder notes that tax expenditures are available to everyone who qualifies and federal
budgetary costs depend on program rules (the tax code), economic conditions, and
behavioral responses.11 Furthermore, they often remain in the tax code until changed
or eliminated by congressional action.12
9 See CRS Report 98-721, Introduction to the Federal Budget Process, by Robert Keith.
10 See CRS Report RL33641, Tax Expenditures: Trends and Critiques, by Thomas L.
Hungerford.
11 Eric J. Toder, “Tax Cuts or Spending — Does it Make a Difference?” National Tax
Journal
, vol. 53, no. 3, part 1 (Sept. 2000), pp. 361-372.
12 David A. Weisbach and Jacob Nussim, “The Integration of Tax and Spending Programs,”
Yale Law Journal, vol. 113, no. 5 (March 2004), pp. 955-1028.

























































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































































CRS-4
Figure 1. Federal Outlays, Fiscal Year 2007
Net Interest Payments
9%
Other Mandatory
National Defense
Programs
20%
5%
Means-tested
Entitlements
6%
Nondefense
Discretionary
Medicare, Medicaid
18%
21%
Social Security
21%
Source: Office of Management and Budget (OMB).
Figure 2 shows the trend of the three major components of outlays (mandatory
spending, discretionary spending, and net interest payments) plus the aggregate
revenue loss of tax expenditures as a percentage of GDP since 1981.13 Several points
are worth highlighting:
! in FY1987, mandatory spending, discretionary spending, and tax
expenditures were each approximately equal at about 9.7% of GDP;
! by FY2007, discretionary spending was approximately equal to the
estimated revenue loss of tax expenditures (about 7.6% of GDP);
! estimated tax expenditures experienced a large decline relative to
GDP between 1987 and 1989 largely because of the effects of the
Tax Reform Act of 1986, which broadened the tax base by
eliminating several tax expenditures and reduced tax rates;
13 The Joint Committee on Taxation (JCT) estimates tax expenditures in terms of revenues
lost to the U.S. Treasury. The revenue loss is a straightforward and easily understood
concept — it is simply the taxes not paid and represents revenues forgone by the
government. Simply aggregating the individual tax expenditures as estimated by the JCT
ignores the interactions among tax expenditures. A recent study estimates that the sum of
revenues lost under the separate tax expenditures is about 8% less than the revenue loss
when the tax expenditures are taken as a group. See Leonard E. Burman, Christopher
Geissler, and Eric J. Toder, “How Big Are Total Individual Income Tax Expenditures, and
Who Benefits from Them?” American Economic Review, papers and proceedings, vol. 98,
no. 2 (May 2008), pp. 79-83.

CRS-5
! discretionary spending for the most part steadily declined relative to
GDP until 2001 while mandatory spending remained fairly constant;
and
! discretionary spending increased relative to GDP between 2002 and
2005, primarily because of increases in defense spending.
Figure 2. Total Expenditures, FY1981 to FY2011
14
Actual Projected
12
Mandatory Spending
10
Discretionary Spending
P
D

8
f G
o
ge
ta
n
e

6
rc
Pe

Tax Expenditures
4
Net Interest
2
0
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
Fiscal Year
Source: OMB, JCT, and CBO.
Figure 3 provides a different view of the information presented in Figure 2 for
selected years. The figure breaks total expenditures down into its components
(discretionary spending, mandatory spending, net interest payments, and tax
expenditures).14 At the top of each bar are the two discretionary spending categories
(defense and nondefense), which represent the proportion of total expenditures
considered annually in the appropriations bills by the two Appropriations
Committees. The bottom three categories — tax expenditures, mandatory spending,
and net interest payments — represent expenditures of permanent programs more or
less on “autopilot.” Some of these expenditures are subject to annual appropriation,
but the Appropriations Committees have little discretion on the amounts provided.
In 1981, discretionary spending accounted for 32.9% of total expenditures while
the nondiscretionary categories (tax expenditures, mandatory spending, and net
interest) accounted for 67.1%. In 1994, the nondiscretionary categories accounted
14 For the purposes of this report, total expenditures is the sum of federal outlays and the
revenue loss of tax expenditures.

CRS-6
for 71.6% of all expenditures. By 2007, the nondiscretionary categories were 73%
of the total and only 27% was discretionary spending subject to annual consideration.
Figure 3. Composition of Total Expenditures, Selected Years
100
13.6
12.8
16.0
80
14.8
14.3
16.9
6.2
l
10.6
a
7.4
60
Tot
Discretionary: Nondefense
of
Discretionary: National Defense
ge
Net Interest
39.9
ta
Mandatory Spending
n
e

35.3
39.5
Tax Expenditures
40
rc
e
P

71.6
73.0
67.1
20
26.9
24.4
21.5
0
1981
1994
2007
Fiscal Year
Source: OMB, JCT, and CBO.
In 2007, the big three mandatory programs — Social Security, Medicare, and
Medicaid — accounted for 17% of total expenditures. Under CBO’s long-term
alternative projection (the alternative scenario) and the assumption that tax
expenditures remain a constant percentage of GDP (7.4% of GDP), discretionary
spending will account for about 9.2% of total expenditures in 2082 while Medicare
and Medicaid will account for 23.3% and Social Security for 7.7%.15
Table 1 reports expenditures for selected spending categories. These four
categories were selected because they contain 85% of all tax expenditures and are the
categories that account for most payments and services to the public.16 The four
panels report the various types of expenditures (tax, mandatory, and discretionary)
as a percentage of total expenditures for that spending category. In three of the
spending categories, the percentage accounted for by discretionary spending fell
15 Under CBO’s alternative long-term scenario, net interest payments will be 48.4% of total
expenditures in 2082. While the path under this scenario is obviously unsustainable, it does
offer a version of the consequences of extending today’s fiscal environment 75 years into
the future.
16 Social Security and Medicare are not included in these categories. Both programs are
mandatory programs with very little discretionary spending (0.8% and 1.2% of the total,
respectively).

CRS-7
between 1981 and 2007. For the fourth category, income security, the percentage of
total expenditures accounted for by discretionary spending increased from less than
5% in 1981 to almost 10% by 2007. Expenditures for income security as a
percentage of total expenditures, however, fell from 32% in 1981 to just 15% by
2007. Furthermore, tax expenditures as a proportion of total expenditures increased
for three of the four spending categories. Overall, the proportion of total federal
expenditures scrutinized annually has fallen since 1981. This is also true for several
individual spending categories.
Table 1. Expenditures by Selected Functional Categories as a
Percentage of the Total
1981
2007
A. Commerce and Housing
Tax
92.3
99.9
Expenditures
96.0
99.5
Mandatory
3.7
-0.3
Spending
Discretionary
4.0
4.0
0.5
0.5
Spending
B. Education, Training, Employment, and Social Services
Tax
30.6
61.1
Expenditures
47.0
66.2
Mandatory
16.4
5.0
Spending
Discretionary
53.0
53.0
33.8
33.8
Spending
C. Income Security
Tax
17.9
37.1
Expenditures
95.5
90.3
Mandatory
77.6
53.2
Spending
Discretionary
4.5
4.5
9.7
9.7
Spending
D. Health excluding Medicare
Tax
42.6
33.8
Expenditures
80.5
87.0
Mandatory
37.9
53.2
Spending
Discretionary
19.4
19.4
13.0
13.0
Spending
Source: OMB and JCT.

CRS-8
Tax Expenditure Analysis
Special deductions, exclusions, and exemptions (sometimes characterized as
“loopholes”) have been in the tax code since the passage of the progressive income
tax in 1913.17 Since then, over 100 special deductions, exemptions, and credits have
been added to the tax code. Of course, for the first 25 years of the income tax, tax
expenditures were relatively unimportant. Prior to World War II, the federal income
tax was of little economic importance — individual and corporate income tax
receipts amounted to less than 2% of gross domestic product (GDP). By 1945,
however, income tax receipts accounted for over 15% of GDP. As the income tax
became more economically important, so did the tax subsidies from the special
deductions, exemptions, exclusions, and credits.
In the mid-1960s, the Department of the Treasury became interested in tracking
and accounting for these tax subsidies.18 Indeed, the term “tax expenditures” was
first used at this time.19 With the enactment of the Congressional Budget and
Impoundment Control Act of 1974 (P.L. 93-344), tax expenditures were officially
defined as “those 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.”20 Both the Department of the Treasury and the JCT prepare annual lists
and estimates of tax expenditures.
Tax expenditures include reductions in tax liability resulting from special tax
provisions. To determine if a provision is a tax expenditure, the JCT defines a
baseline or reference income tax structure referred to as the “normal income tax law,”
which has a broader concept of income than under U.S. tax law.21 The committee
staff uses its judgement to distinguish between what are normal income tax
provisions and what are special provisions.
17 The United States had an income tax in the years during and immediately following the
Civil War. The income tax was repealed in 1872 because the revenue was no longer needed.
An income tax was re-established in 1894, but was declared unconstitutional by the Supreme
Court in 1895. Ratification of the 16th Amendment on Feb. 3, 1913 permitted the federal
government to tax income. The graduated income tax was established on Oct. 3, 1913. See
Roy G. Blakey and Gladys C. Blakey, The Federal Income Tax (New York: Longmans,
Green and Co., 1940) for a history of early years of the income tax.
18 See Jonathan Barry Forman, “Origins of the Tax Expenditure Budget,” Tax Notes, Feb.
10, 1986, pp. 537-545 for a review of the beginnings of tax expenditure analysis.
19 See Stanley S. Surrey and Paul R. McDaniel, Tax Expenditures (Cambridge, MA: Harvard
University Press, 1985). The first author was the Assistant Secretary for Tax Analysis at
the Department of Treasury at the time.
20 2 U.S.C. § 622.
21 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2007-2011
, joint committee print, 110th Cong., 1st sess., JCS-3-07 (Washington:
GPO, 2007).

CRS-9
The U.S. Department of the Treasury uses a similar procedure to identify tax
expenditures, but uses two baseline income tax structures: the normal income tax
baseline and the reference income tax baseline. The reference tax baseline is closer
to existing tax law and, consequently, identifies fewer tax expenditures. This
baseline has been used by the Treasury since 1982. Prior to 1982, there were few
differences between the tax expenditures lists of the JCT and the Department of the
Treasury, since both used the same baseline. After 1982, the differences between the
two lists have grown. The JCT has used a consistent methodology to define and
estimate tax expenditures over time, whereas the Department of the Treasury’s
methodology has changed from administration to administration.22
Other baseline tax law structures have been proposed. One commonly proposed
baseline is the consumption tax baseline, which is used as one of the baselines in the
Administration’s annual list of tax expenditures. This baseline has fewer built-in
distortions than the income tax. For example, the choice between future
consumption (that is, saving) and current consumption is not biased as it is when
income is taxed. Many of the largest tax expenditures would no longer be defined
as tax expenditures using this baseline concept, and an alternative set of tax
expenditures would be produced. The current tax system, however, is an income tax.
Furthermore, many observers believe it is unlikely that the U.S. income tax will be
replaced by a consumption tax in the foreseeable future.
The choice of the baseline tax law system is probably the most controversial
aspect in defining and measuring tax expenditures.23 Stanley Surrey had in mind a
Haig-Simons definition of income as the basis for tax expenditure analysis.24 Simons
defined personal income as “the algebraic sum of (1) the market value of rights
exercised in consumption and (2) the change in the value of the store of property
rights between the beginning and end of the period in question.”25 The normal tax
baseline, however, is an attempt to apply the Haig-Simons concept to the real world.
It does not include some items that would be considered income (for example,
imputed rent, home produced consumption goods, and accrued capital gains) and
22 The current Bush administration, which has questioned the whole concept of tax
expenditures, stated in the FY2002 budget: “Because of the breadth of this arbitrary tax
base, the Administration believes that the concept “tax expenditure” is of questionable
analytic value.” See “Tax Expenditures,” ch. 15 in OMB, Analytical Perspectives, Budget
of the United States Government, Fiscal Year 2002
, Feb. 2001, p. 61.
23 See Douglas A. Kahn and Jeffrey S. Lehman, “Tax Expenditure Budgets: A Critical
View,” Tax Notes, Mar. 30, 1992, pp. 1661-1665, for a critical review of various baseline
tax law structures.
24 See Stanley S. Surrey, Pathways to Tax Reform (Cambridge, MA: Harvard University
Press, 1973), p. 12; and Stanley S. Surrey and Paul R. McDaniel, Tax Expenditures
(Cambridge, MA: Harvard University Press, 1995), p. 14.
25 Henry C. Simons, Personal Income Taxation (Chicago, IL: University of Chicago Press,
1938), p. 50.

CRS-10
includes other items that would not be considered income (for example, inflationary
gains).26
Criticisms of tax expenditures appeared almost immediately after the concept
was introduced. Boris Bittker points out the “many ambiguities that become apparent
as soon as one attempts to apply the Haig-Simons definition to the protean stream of
economic life.”27 He further argues that the baseline is arbitrary and, consequently,
tax expenditures will be defined as disparities between the tax code and whatever the
observer thinks the tax code should be. This theme was extended by Douglas Kahn
and Jeffrey Lehman who argue that tax expenditure analysis creates “an illusion of
value-free scientific precision in a heavily politicized domain.”28 Leonard Burman,
however, argues that even with the lack of theoretical rigor the current list of tax
expenditures is a useful list of the extent of deviations of the tax code from an
economic ideal and notes that many tax expenditures would exist against any
baseline.29 He concludes that tax expenditure analysis shows “how government
affects the allocation of resources both directly — by financing public activities via
tax concessions — and indirectly, by altering after-tax prices and thus distorting the
allocation of resources.”30
The Joint Committee of Taxation Pamphlet
on Tax Expenditure Analysis

Even with the criticisms, the need for analysis of tax expenditures has long been
recognized. Walter Blum in a 1955 Joint Economic Committee report stated that tax
expenditures are “hidden in technicalities of the tax law; they do not show up in the
budget; their cost frequently is difficult to calculate; and their accomplishments are
even more difficult to assess.”31 As a result of this lack of transparency, analysts
argue that tax expenditure analysis is a critical tool in achieving a more accountable
process for enacting and tracking government programs.32 In May 2008, the Joint
26 See Eric J. Toder, “Tax Expenditures and Tax Reform,” paper presented at the Ninety-
eighth Annual Conference on Taxation, National Tax Association, Miami, FL, Nov. 17-19,
2005.
27 Boris R. Bittker, “Accounting for Federal ‘Tax Subsidies’ in the National Budget,”
National Tax Journal, vol. 22, no. 2 (June 1969), p. 260.
28 Douglas A. Kahn and Jeffrey S. Lehman, “Tax Expenditure Budgets: A Critical View,”
Tax Notes, Mar. 30, 1992, p. 1663.
29 Leonard E. Burman, “Is the Tax Expenditure Concept Still Relevant?” National Tax
Journal
, vol. 56, no. 3 (Sept. 2003), pp. 613-627.
30 Ibid, p. 626.
31 Walter J. Blum, “The Effects of Special Provisions in the Income Tax on Taxpayer
Morale,” in U.S. Congress, Joint Economic Committee, Federal Tax Policy for Economic
Growth and Stability
, report, 84th Cong., 1st sess. (Washington, DC: GPO, 1955), 251-252.
32 See, for example, J. Clifton Fleming and Robert J. Peroni, “Reinvigorating Tax
Expenditure Analysis and its International Dimension,” Virginia Tax Review, vol. 27, no.
3 (Winter 2008), pp. 437-562.

CRS-11
Committee on Taxation (JCT) released a pamphlet justifying the need to reconsider
their implementation of tax expenditure analysis.33
The JCT acknowledges the criticisms of the use of a normal tax system and sets
out to modify tax expenditure analysis so it will serve as an “effective and neutral
analytical tool for policymakers.”34 Their approach is to revise the classification of
tax expenditures without reference to the normal tax system. The revised
classification creates two broad categories of tax expenditures: tax subsidies and tax-
induced structural distortions.35
Tax subsidies are tax provisions that are “deliberately inconsistent with an
identifiable general rule of the present tax law.”36 Tax subsidies are further divided
into three subcategories. The first is tax transfers, which are transfers to taxpayers
regardless of their tax liability and would include the refundable portions of various
tax credits (for example, the earned income credit (EIC) and the child tax credit).
The second subcategory is social spending, which is designed to induce behaviors
unconnected to the production of business income. Examples would include the
charitable giving deduction, deductions and exclusions for individual retirement
accounts (IRAs), and the nonrefundable portions of the EIC and child tax credit. The
final subcategory is business synthetic spending, which includes subsidies designed
to induce behaviors directly related to the production of business income (for
example, various energy tax subsidies).
Tax-induced structural distortions contain the elements of the tax code that
“materially affect economic decisions in a manner that imposes substantial economic
efficiency costs.”37 An example of this category of tax expenditure is the differential
taxation of debt and equity financing. Since interest is a deductible business expense,
corporations may be encouraged to raise capital as debt rather than equity.
Issues in Measuring Tax Expenditures
There are several issues associated with measuring tax expenditures. One issue
is estimating the revenue loss of tax expenditures. Another issue is estimating their
distributional impact. Both the revenue loss and distributional effects depend on the
parameters of the tax code — both will change when the parameters of the tax code
change, such as marginal tax rates. Consequently, tax expenditure estimates can
change from year to year not only because of direct changes to the tax expenditures
themselves, but also because of changes elsewhere in the tax code. This is illustrated
in Table 2 for nine selected deductions and exclusions. The table reports the change
33 Joint Committee on Taxation, A Reconsideration of Tax Expenditure Analysis, May 12,
2008 (JCX-37-08), hereafter referred to as Reconsideration.
34 Reconsideration, p. 7.
35 The JCT also proposes to have a third category that includes tax expenditures as defined
under their current methodology but don’t fit into either of these two categories.
36 Reconsideration, p. 9.
37 Reconsideration, p. 10.

CRS-12
in revenue loss estimates and distributional effects under two scenarios with different
tax rates. The first scenario assumes that the 2000 tax rates were in effect while the
second scenario assumes a flat 20% tax rate on taxable income. No behavioral
changes are incorporated into the analysis, the AMT is ignored, and no other changes
are made to the tax code. The analysis uses the 2004 Internal Revenue Service (IRS)
Statistics of Income Public Use Data File.38
Table 2. Revenue Losses and Progressivity Measures of
Selected Tax Expenditures under Alternative Scenarios
Percentage Difference from 2004 Tax Rate
Revenue Loss Estimate
2000 Tax Rates
Flat Tax Rate
(1)
(2)
Mortgage Interest Deduction
10.0%
-10.1%
State and Local Property Tax
3.0%
-9.1%
Deduction
State and Local Nonbusiness
10.7%
-20.4%
Tax Deduction
Charitable Contribution
10.2%
-13.9%
Deduction
IRA Deduction
8.8%
6.9%
Student Loan Interest
8.2%
15.1%
Deduction
Tuition and Fees Deduction
12.0%
0.7%
Exclusions of Social Security
12.2%
37.2%
Benefits
Exclusion of State and Local
10.7%
-22.1%
Public Purpose Bond Interest
Source: Author’s analysis of 2004 IRS Statistics of Income Public Use Data File.
Note: The AMT is excluded from the analysis.
Table 2 reports the percentage difference in revenue loss estimates under the
two scenarios using the 2004 tax code as the base. The 2000 tax rates are generally
more progressive than the 2004 tax rates — higher for higher income taxpayers (for
38 The Public Use Data File is a nationally representative sample of tax returns for the 2004
tax year — the most recent year for which data are available to the public. To protect the
identity of individual taxpayers while preserving the character of the data, the IRS made
some changes to the data, especially for high income taxpayers. The unit of analysis is the
tax return for a taxpayer and IRS-provided sample weights are used throughout the analysis.
Taxpayers with negative total income or who are claimed as a dependent by another
taxpayer are omitted from the analysis sample.

CRS-13
example, the top marginal tax rate is increased from 35% to 39.6%). But there is no
10% tax bracket for low income taxpayers. The flat tax essentially raises the tax rate
for lower income taxpayers (from 10% and 15% to 20%) and lowers it for higher
income taxpayers. The revenue loss estimates are all higher under the 2000 tax rates
than under the 2004 tax rates (see the first column). The difference ranges from 3%
for the property tax deduction to over 12% for the exclusion of Social Security
benefits.
The difference in the revenue loss estimates between the flat tax rate and the
2004 tax rates vary dramatically from -20% to +37%. Since the tax rate is higher for
lower income taxpayers under the flat tax, the revenue loss estimates for tax
expenditures used primarily by lower income taxpayers increases. These tax
expenditures are the above-the-line deductions (deductions for IRAs, student loan
interest, and tuition and fees) and the exclusion of Social Security benefits. The
opposite is true for the tax expenditures utilized primarily by high income taxpayers
— the itemized deductions (mortgage interest, property taxes, nonbusiness taxes,
and charitable contributions) and exclusion of public purpose bond interest.
The next three tables report distributional measures of the various tax
expenditures. In the tables, the average reduction in tax liability (or value) due to a
particular deduction or exclusion is reported by income group. The income
distribution is divided into five income categories.39 Quintile 1 contains the poorest
20% of taxpayers while quintile 5 contains the richest 20%. Also shown is
information for the richest 10%, 5%, and 1% of taxpayers.
Table 3 reports the averages for the four itemized deductions examined in this
report. Taxpayers generally only itemize if their itemized deductions are greater than
the standard deduction. These four itemized deductions display the classic “upside
down” distributional pattern because of the progressive nature of the individual
income tax and higher income taxpayers have greater deductions. This upside down
distribution is demonstrated in column (1) of each panel in the table. The average tax
savings increases as income increases. For example, the average tax savings from
the mortgage interest deduction is $4 for the poorest 20% of taxpayers (quintile 1)
but is nearly $6,000 for the richest 1% of taxpayers.
The 2000 tax rates were slightly more progressive than the 2004 tax rates (the
tax rates were higher for higher income taxpayers). Consequently, the reduction in
tax liability from itemized deductions is greater as income increases under the 2000
tax rates than under the 2004 tax rates (see the second column in each panel). The
value of the mortgage interest deduction increases by 12% for the richest 1% of
taxpayers on average, but essentially remains the same for the poorest 20% of
39 Income is total income as reported on the tax return and includes tax exempt interest and
untaxed Social Security benefits. Total income is divided by the square root of the number
of exemptions claimed to account for differences in family size. The income categories are
based on this measure of income. The income breaks between income categories are: 20th
percentile = $11,453; 40th percentile = $21,060; 60th percentile = $33,820; 80th percentile =
$52,053; 90th percentile = $72,268; 95th percentile = $100,020; and 99th percentile =
$239,421.

CRS-14
taxpayers. Even though the income tax is more progressive under the 2000 tax rates,
the benefits of itemized deductions are more regressively distributed.
Table 3. Average Tax Savings from Schedule A Itemized
Deductions Under Alternative Scenarios
Mortgage Interest
State and Local Property Taxes
2004 Tax
2000 Tax
Flat Tax
2004 Tax
2000 Tax
Flat Tax
Rates
Rates
Rate
Rates
Rates
Rate
(1)
(2)
(3)
(1)
(2)
(3)
Quintile 1
$4
$5
$5
$2
$2
$2
Quintile 2
$48
$63
$83
$16
$21
$28
Quintile 3
$210
$223
$292
$73
$79
$104
Quintile 4
$551
$587
$604
$198
$210
$226
Quintile 5
$1,838
$2,039
$1,399
$790
$875
$609
Top 10%
$2,495
$2,770
$1,788
$1,126
$1,249
$819
Top 5%
$3,292
$3,651
$2,235
$1,543
$1,711
$1,067
Top 1%
$5,502
$6,172
$3,577
$2,810
$3,147
$1,838
State and Local Nonbusiness
Charitable Contributions
Taxes
2004 Tax
2000 Tax
Flat Tax
2004 Tax
2000 Tax
Flat Tax
Rates
Rates
Rate
Rates
Rates
Rate
(1)
(2)
(3)
(1)
(2)
(3)
Quintile 1
$2
$2
$2
$2
$2
$2
Quintile 2
$13
$19
$22
$16
$21
$27
Quintile 3
$72
$76
$99
$70
$74
$98
Quintile 4
$238
$253
$259
$186
$196
$215
Quintile 5
$1,666
$1,856
$1,203
$1,046
$1,160
$794
Top 10%
$2,724
$3,038
$1,886
$1,648
$1,831
$1,192
Top 5%
$4,387
$4,895
$2,936
$2,611
$2,901
$1,826
Top 1%
$12,796
$14,398
$8,383
$7,762
$8,674
$5,317
Source: Author’s analysis of 2004 IRS Statistics of Income Public Use Data File.
Note: The AMT is excluded from the analysis.
The flat tax rate increases the value of itemized deductions for the bottom 80%
of taxpayers and reduces the value for the richest 20% of taxpayers (see the third
column in each panel of Table 3). The primary reason is the flat tax rate raises the
tax rate for those in the bottom 80% of the income distribution and reduces the tax

CRS-15
rate for the top 20%. Taxes become less progressive but the value of deductions
becomes less regressive.
The distributional effects of the three above-the-line deductions are reported in
Table 4. These deductions are generally limited to lower and middle income
taxpayers and, unlike itemized deductions, are available to all who qualify rather than
solely to those who itemize. The average value of these deductions generally rises
with income at first and then declines with income for those taxpayers at the top of
the income distribution. The average value of these tax expenditures across the
income distribution vary by the progressivity of the tax rates (see the second and third
column in each panel).
Table 4. Average Tax Savings from Above-the-Line Deductions
Under Alternative Scenarios
IRA
Student Loan Interest
2004
2000
2004
2000
Flat Tax
Flat Tax
Tax
Tax
Tax
Tax
Rate
Rate
Rates
Rates
Rates
Rates
(3)
(3)
(1)
(2)
(1)
(2)
Quintile 1
$0
$0
$0
$0
$0
$0
Quintile 2
$3
$3
$5
$2
$3
$4
Quintile 3
$10
$11
$15
$7
$7
$9
Quintile 4
$23
$24
$27
$13
$14
$14
Quintile 5
$39
$43
$33
$18
$9
$7
Top 10%
$50
$55
$39
$3
$4
$3
Top 5%
$57
$63
$42
$0
$0
$0
Top 1%
$57
$64
$38
$0
$0
$0
Tuition and Fees
2004 Tax Rates
2000 Tax Rates
Flat Tax Rate
(1)
(2)
(3)
Quintile 1
$1
$2
$3
Quintile 2
$4
$6
$8
Quintile 3
$7
$7
$10
Quintile 4
$22
$24
$22
Quintile 5
$39
$44
$32
Top 10%
$24
$26
$19
Top 5%
$6
$7
$5
Top 1%
$2
$3
$2
Source: Author’s analysis of 2004 IRS Statistics of Income Public Use Data File.
Note: The AMT is excluded from the analysis.

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The distributional results for the two income exclusions are reported in Table
5. These two exclusions are available to all receiving Social Security benefits or
interest income from state and local public purpose bonds. But how these two
exclusions are calculated is very different. On the one hand, most or all benefits from
Social Security received by lower income individuals and families are not taxed, and
many do not file income tax returns (these individuals and families are not included
in the analysis). Part of Social Security income received by high income taxpayers,
however, is included in income and taxed. On the other hand, all state and local
public purpose bond interest income is excluded from income for tax purposes.
These bonds, however, are owned primarily by higher income taxpayers.
Table 5. Average Tax Savings from Income Exclusions Under
Alternative Scenarios
State and Local Public Purpose
Social Security Benefits
Bond Interest
2004
2000
Flat
2004
2000
Flat
Tax
Tax
Tax
Tax
Tax
Tax
Rates
Rates
Rate
Rates
Rates
Rate
(1)
(2)
(3)
(1)
(2)
(3)
Quintile 1
$1
$1
$1
$0
$0
$0
Quintile 2
$34
$47
$63
$1
$1
$1
Quintile 3
$191
$224
$304
$2
$3
$4
Quintile 4
$260
$277
$356
$16
$17
$21
Quintile 5
$142
$155
$136
$473
$523
$357
Top 10%
$153
$168
$135
$882
$978
$645
Top 5%
$170
$187
$142
$1,607
$1,786
$1,138
Top 1%
$213
$236
$162
$5,774
$6,438
$3,903
Source: Author’s analysis of 2004 IRS Statistics of Income Public Use Data File.
Note: The AMT is excluded from the analysis.
Given these differences, the distributional patterns of the value of the exclusions
differ. The average value of the Social Security benefit exclusion increases with
income up through quintile 4 and then falls for the richest 20% of taxpayers (see the
first column). The value of the exclusion does change when the tax rates change (see
the second and third column in the panel). The public purpose bond interest
exclusion displays the classic upside down distributional pattern (see the first column
in the panel). Again the magnitude of the tax savings varies and tax rates become
more or less progressive (see the second and third columns in the panel).

CRS-17
The 2001 and 2003 tax cuts reduced the tax rates to their current levels.40 The
tax rates are scheduled to revert back to their pre-2001 levels after 2010. This
reversion alone will change the revenue loss estimates and distributional impacts of
tax expenditures.
Conclusions
Tax expenditures account for a large proportion of the resources the federal
government uses to achieve various national goals. By 2007, it was estimated that
tax expenditures amounted to about $1 trillion and accounted for about a quarter of
total expenditures. When combined with outlays for mandatory spending programs
and net interest payments, almost three-quarters of total expenditures are for
permanent programs that many claim are more or less on “autopilot.” The proportion
of total expenditures subject to annual review by the Appropriations Committees in
the appropriations process has been declining over the past two decades. Given the
long-term fiscal imbalances, part of the solution will likely involve tax reform and
the limitation or outright elimination of some tax expenditures.
Tax expenditure analysis can be a useful tool for policymakers considering tax
reform proposals. But tax expenditure analysis has been criticized by several policy
analysts as well as by the Bush administration.41 In response to these criticisms, the
JCT is working to change their implementation of tax expenditure analysis.
Estimates of the revenue losses and distributional effects of tax expenditures
depend on the parameters of the tax code. Both will change not only because of
direct changes to the tax expenditures themselves, but also because of changes
elsewhere in the tax code. Consequently, while many tax expenditures may be
considered permanent, the revenue losses can vary year to year because of changing
economic conditions and changes to the tax code. For example, the revenue loss and
distributional impacts of many tax expenditures will change after 2010 when the
individual income tax rates are scheduled to revert back to their pre-2001 levels.
40 See CRS Report RL34498, Statutory Individual Income Tax Rates and Other Elements
of the Tax System: 1988 through 2008
, by Maxim Shvedov.
41 See “Tax Expenditures,” ch. 15 in Office of Management and Budget, Analytical
Perspectives, Budget of the United States Government, Fiscal Year 2002
, Feb. 2001.