Tax Expenditures and the Federal Budget
Thomas L. Hungerford
Specialist in Public Finance
May 26, 2010
Congressional Research Service
7-5700
www.crs.gov
RL34622
CRS Report for Congress
P
repared for Members and Committees of Congress
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. President
Obama created a bipartisan commission in February 2010 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.
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Tax Expenditures and the Federal Budget
Contents
Tax Expenditures and Federal Spending ...................................................................................... 2
Tax Expenditure Analysis............................................................................................................ 6
The Joint Committee of Taxation Pamphlet on Tax Expenditure Analysis .............................. 8
Issues in Measuring Tax Expenditures ................................................................................... 9
Conclusions .............................................................................................................................. 13
Figures
Figure 1. Federal Outlays, Fiscal Year 2009................................................................................. 3
Figure 2. Total Expenditures, FY1974 to FY2013........................................................................ 4
Figure 3. Composition of Total Expenditures, Selected Years....................................................... 5
Tables
Table 1. Revenue Losses and Progressivity Measures of Selected Tax Expenditures
Under Alternative Scenarios ..................................................................................................... 9
Table 2. Average Tax Savings from Schedule A Itemized Deductions Under Alternative
Scenarios ............................................................................................................................... 11
Table 3. Average Tax Savings from Above-the-Line Deductions Under Alternative
Scenarios ............................................................................................................................... 12
Table 4. Average Tax Savings from Income Exclusions Under Alternative Scenarios ................ 13
Contacts
Author Contact Information ...................................................................................................... 14
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Tax Expenditures and the Federal Budget
mericans often mention economic issues as the most important problem facing the United
States. Recent economic issues mentioned include rising gasoline prices, rising
A 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. President Obama created a bipartisan commission in February 2010 to develop solutions
to the long-term federal fiscal problem.
The federal budget deficit was almost 10% of gross domestic product (GDP) in FY2009. The
Congressional Budget Office’s (CBO’s) baseline projection of the budget shows a steadily
improving deficit until 2015 when it is projected to be 2.6% of GDP. After 2015 the deficit is
projected to slowly rise, reaching 3.0% of GDP by 2010.2 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). 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 2009 take effect. The federal
budget deficit under the alternative scenario reaches 14.6% of GDP in 2035 and 42.8% of GDP
by 2080. CBO estimates a 75-year fiscal gap of 8.1% of GDP.4 In comparison, CBO’s estimate of
the fiscal gap under a scenario that simply extends their baseline assumptions is 3.2%.
In April 2008, a team of 16 budget experts from Washington think tanks issued proposals for
dealing with long-term fiscal difficulties.5 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.”6 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.
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 2010 to 2020, January
2010.
3 See CBO, The Long-Term Budget Outlook, June 2009.
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. It represents the extent to which the federal government would have to immediately and
permanently raise revenues or reduce spending in order to maintain fiscal balance over the 75-year period.
5 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.
6 Antos and others, p. 2.
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More recently, another team of 16 budget experts from think tanks and academia criticized the
Antos and others’ proposal, mentioned above, 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.7 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.
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.8
Figure 1 displays the FY2009 outlays by the type and category of spending. Overall,
discretionary spending accounted for 36% of total outlays split between defense (19%) and
nondefense (17%) spending. Mandatory spending accounted for 59% of outlays while interest on
the federal debt held by the public (net interest payments) accounted for 5% of FY2009 outlays.
Social Security, Medicare, and Medicaid are the largest mandatory programs accounting for 37%
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.9 Tax expenditures, in many ways, are
similar to entitlement spending. Eric Toder notes that tax expenditures are available to everyone
7 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.
8 See CRS Report 98-721, Introduction to the Federal Budget Process, by Robert Keith.
9 See CRS Report RL33641, Tax Expenditures: Trends and Critiques, by Thomas L. Hungerford.
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who qualifies and federal budgetary costs depend on program rules (the tax code), economic
conditions, and behavioral responses.10 Furthermore, they often remain in the tax code until
changed or eliminated by congressional action.11
Figure 1. Federal Outlays, Fiscal Year 2009
Net Interest Payments
National Defense
5%
19%
Other Mandatory
Programs
15%
Means-tested
Entitlements
7%
Nondefense
Discretionary
17%
Medicare, Medicaid
18%
Social Security
19%
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 1974.12 Several points are worth highlighting:
• in FY1987, mandatory spending, discretionary spending, and tax expenditures
were each approximately equal at about 9.7% of GDP;
10 Eric J. Toder, “Tax Cuts or Spending—Does it Make a Difference?” National Tax Journal, vol. 53, no. 3, part 1
(September 2000), pp. 361-372.
11 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.
12 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.
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• 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;
• discretionary spending for the most part steadily declined relative to GDP until
2001 while mandatory spending remained fairly constant;
• discretionary spending increased relative to GDP between 2002 and 2005,
primarily because of increases in defense spending;
• both mandatory and discretionary spending rose after 2007 because of policy
responses to the financial crisis and the recession; and
• tax expenditures decreased relative to GDP in 2009 because of reduced tax
revenues due to the recession.
Figure 2. Total Expenditures, FY1974 to FY2013
18
16
14
Mandatory Spending
12
P
D 10
f G
Discretionary Spending
t o
en
c
8
Per
6
Tax Expenditures
4
Net Interest
2
0
6
0
2
4
6
2
4
6
8
2
6
0
2
1974
197
1978
198
198
198
198
1988
1990
199
199
199
199
2000
200
2004
200
2008
201
201
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).13 At the top of each bar are the
13 For the purposes of this report, total expenditures is the sum of federal outlays and the revenue loss of tax
(continued...)
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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 62.4%. In 1994, the nondiscretionary categories accounted for 71.6% of all expenditures. By
2009, the nondiscretionary categories were 73.4% of the total and only 26.6% was discretionary
spending subject to annual consideration.
Figure 3. Composition of Total Expenditures, Selected Years
100
16.0
13.6
12.5
14.1
80
14.8
16.9
4.0
l
10.6
a
7.4
60
Tot
Discretionary: Nondefense
Discretionary: National Defense
ge of
Net Interest
ta
46.9
Mandatory Spending
n
e
35.3
39.5
Tax Expenditures
c
40
71.6
73.4
Per
67.1
20
24.4
21.5
22.5
0
1981
1994
2009
Fiscal Year
Source: OMB, JCT, and CBO.
In 2009, the big three mandatory programs—Social Security, Medicare, and Medicaid—
accounted for 29.6% 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), interest payments on the national debt will account for about 42.0% of total
(...continued)
expenditures.
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expenditures in 2080 while Medicare and Medicaid will account for 25.0% and Social Security
for 8.6%.14
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 1913.15 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.16 Indeed, the term “tax expenditures” was first used at this time.17 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.”18 Both the
Department of the Treasury and the Joint Committee on Taxation (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.19 The committee staff uses its judgement to distinguish between what are
normal income tax provisions and what are special provisions.
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
14 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.
15 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 February 3, 1913
permitted the federal government to tax income. The graduated income tax was established on October 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.
16 See Jonathan Barry Forman, “Origins of the Tax Expenditure Budget,” Tax Notes, February 10, 1986, pp. 537-545
for a review of the beginnings of tax expenditure analysis.
17 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.
18 2 U.S.C. § 622.
19 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).
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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.20
Other baseline tax law structures have been proposed. One commonly proposed baseline is the
consumption tax baseline, which has been used in the past 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.21 Stanley Surrey had in mind a Haig-Simons definition of
income as the basis for tax expenditure analysis.22 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.”23
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 includes other items that
would not be considered income (for example, inflationary gains).24
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.”25 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.”26 Leonard Burman,
20 For example, the George W. 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, February 2001, p. 61.
21 See Douglas A. Kahn and Jeffrey S. Lehman, “Tax Expenditure Budgets: A Critical View,” Tax Notes, March 30,
1992, pp. 1661-1665, for a critical review of various baseline tax law structures.
22 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.
23 Henry C. Simons, Personal Income Taxation (Chicago, IL: University of Chicago Press, 1938), p. 50.
24 See Eric J. Toder, “Tax Expenditures and Tax Reform,” paper presented at the Ninety-eighth Annual Conference on
Taxation, National Tax Association, Miami, FL, November 17-19, 2005.
25 Boris R. Bittker, “Accounting for Federal ‘Tax Subsidies’ in the National Budget,” National Tax Journal, vol. 22,
no. 2 (June 1969), p. 260.
26 Douglas A. Kahn and Jeffrey S. Lehman, “Tax Expenditure Budgets: A Critical View,” Tax Notes, March 30, 1992,
p. 1663.
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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.27 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.”28
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.”29 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.30 In May 2008, the
JCT released a pamphlet justifying the need to reconsider their implementation of tax expenditure
analysis.31
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.”32 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.33
Tax subsidies are tax provisions that are “deliberately inconsistent with an identifiable general
rule of the present tax law.”34 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
27 Leonard E. Burman, “Is the Tax Expenditure Concept Still Relevant?” National Tax Journal, vol. 56, no. 3
(September 2003), pp. 613-627.
28 Ibid, p. 626.
29 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.
30 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.
31 Joint Committee on Taxation, A Reconsideration of Tax Expenditure Analysis, May 12, 2008 (JCX-37-08), hereafter
referred to as Reconsideration.
32 Reconsideration, p. 7.
33 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.
34 Reconsideration, p. 9.
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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.”35 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 1 for nine selected deductions and exclusions. The table reports the change 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.36
Table 1. 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 Deduction
3.0%
–9.1%
State and Local Nonbusiness Tax Deduction
10.7%
–20.4%
Charitable Contribution Deduction
10.2%
–13.9%
IRA Deduction
8.8%
6.9%
Student Loan Interest Deduction
8.2%
15.1%
Tuition and Fees Deduction
12.0%
0.7%
Exclusions of Social Security Benefits
12.2%
37.2%
35 Reconsideration, p. 10.
36 The Public Use Data File is a nationally representative sample of tax returns for the 2004 tax year. 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.
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Percentage Difference from 2004 Tax Rate
Revenue Loss Estimate
Exclusion of State and Local Public Purpose Bond Interest
10.7%
–22.1%
Source: Author’s analysis of 2004 IRS Statistics of Income Public Use Data File.
Notes: The AMT is excluded from the analysis.
Table 1 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 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 increase. 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.37
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 2 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
37 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.
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12% for the richest 1% of taxpayers on average, but essentially remains the same for the poorest
20% of taxpayers. Even though the income tax is more progressive under the 2000 tax rates, the
benefits of itemized deductions are more regressively distributed.
Table 2. 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
Rates
Rates
Rate
Rates
Rates
Flat Tax 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 Taxes
Charitable Contributions
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.
Notes: 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 2).
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 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 3. 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
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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 3. Average Tax Savings from Above-the-Line Deductions
Under Alternative Scenarios
IRA
Student Loan Interest
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
$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.
Notes: The AMT is excluded from the analysis.
The distributional results for the two income exclusions are reported in Table 4. 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.
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Table 4. Average Tax Savings from Income Exclusions Under
Alternative Scenarios
State and Local Public Purpose Bond
Social Security Benefits
Interest
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 $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.
Notes: 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).
The 2001 and 2003 tax cuts reduced the tax rates to their current levels.38 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. In 2009, 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
38 See CRS Report RL34498, Statutory Individual Income Tax Rates and Other Elements of the Tax System: 1988
through 2009, by Maxim Shvedov.
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elimination of some tax expenditures. Tax expenditure analysis can be a useful tool for
policymakers considering tax reform proposals.
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.
Author Contact Information
Thomas L. Hungerford
Specialist in Public Finance
thungerford@crs.loc.gov, 7-6422
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