Advancing Scrutiny: 55 Year of Tax Expenditures Reporting in the United States

This blog is part of the blog series on Tax Expenditure Policy Making and the Role of Parliaments.

Stanley Surrey, then Assistant Secretary of the Treasury for Tax Policy, released the first estimates of tax expenditures in 1968. Over time, accounting for tax expenditures has become an integral part of budgetary accounting in the United States. The Joint Committee on Taxation (JCT), in the legislative branch, provided its first estimates in 1972.

The 1974 Budget Act required the President to include a list of tax expenditures in budget documents. Today, an official tax expenditures report is published annually by the US Treasury and contained in the executive branch budget proposals. In the legislative branch, estimates are periodically provided by the JCT. In addition, the Senate Budget Committee has published a series of tax compendiums prepared by various committees and support agencies which examine tax expenditures. Currently, a study prepared by the Congressional Research Service (CRS) for the Committee is published at the end of each Congress. This document includes not only the cost and a description of each tax expenditure identified by the JCT, but also a brief analysis, a history of the origin and revisions, distributional effects where available, and a bibliography.

Federal tax expenditure reports are currently limited to the income tax, although tax expenditures exist in other taxes as well. The exclusion of fringe benefits, such as employer health insurance, from the base of the payroll tax, for example, leads to significant tax expenditures that are at present unaccounted for in federal reporting. Before 2003, the budget also contained estimates of tax expenditures from the estate and gift tax. The largest of these were the deductions for charitable contributions and the credit against state death taxes (which has since been converted into a deduction). Academic studies have also estimated tax expenditures for excise taxes. And all states have issued tax expenditure reports.

The Definition of Tax Expenditures

Tax expenditures are benefits granted through preferential treatment such as exemptions, deductions, and credits. Tax expenditures are measured relative to a baseline for a normal tax on income. An economist would define net income as consumption plus changes in net wealth (the Schanz-Haig-Simons definition), and this concept appears to be the starting point for defining a baseline or benchmark tax system. The 1968 study, mentioned before, discussed departures from that baseline including items of a technical or theoretical nature. From the beginning, therefore, the definition of the baseline for determining provisions included in a tax expenditure budget was subjective, whereas the definition of a base using the economic definition of income is not.

Today, the normal baseline currently used to define tax expenditures by the US Treasury remains fairly close to an economic measure of income, but with some differences. Tax expenditures include employee fringe benefits and imputed income on rents on owner-occupied housing, but not free financial services. Exclusion of unrealized capital gains is not included in federal tax expenditures reports, although exclusion of gains at death is. Deductible charitable contributions are classified as tax expenditures, but not the tax exempt status for nonprofits. Likewise, tax expenditures include the exemption of Social Security and cash transfers, but not in kind transfers (such as Medicare and Medicaid).

Moreover, the federal tax expenditures report does not include elements that create a progressive tax schedule based on ability to pay, such as graduated rates, and standard deductions and personal exemptions that create a zero bracket. At the same time, child credits are classified as a tax expenditure. The temporary provisions of the 2017 Tax Cuts and Jobs Act eliminated personal exemptions but increased child tax credits, in part, to offset the loss of personal exemptions for dependents. This change had been suggested to simplify tax compliance, but also had the consequence of increasing the value of tax expenditures.

The normal baseline includes earnings from foreign sources, with a foreign tax credit to prevent double taxation, so that lower tax rates on income abroad by multinationals is treated as a tax expenditure. This baseline including worldwide income was adopted in 1968.

Historically, there has been pushback against the comprehensive baseline (the normal baseline) used at the start of tax expenditures reporting or the concept itself in some administrations. In 1983, the Reagan administration redefined the baseline as a reference tax system so that items such as lower tax rates for capital gains, accelerated depreciation, deferral of tax earned by foreign subsidiaries, and exemption of government transfers were no longer included. The current budget uses the normal baseline but cites an alternative that reflects these elements (except lower capital gains rates) as well as the exclusion of private transfers. The entire concept of tax expenditures was questioned at that time, as well as in 2001 during the George H.W. Bush administration. Had it not been for the legal requirement to include tax expenditures, revenue forgone estimates might have disappeared from budget documents.

The JCT’s tax expenditure report uses a baseline similar to the Treasury’s, with some variations and changes over time. Their report does not include imputed rent or the exemption of cash transfers. The JCT estimates also separate tax expenditures between individuals and corporations.

Classification of Tax Expenditures

Tax expenditures have always been allocated by budget function. This classification shows disparate allocations of direct versus tax expenditures. For example, Gravelle and Marples’s CRS report shows that tax expenditures are negligible as a part of national defense but more important than direct spending for commerce and housing and for energy. The nature and distribution of the two types are also different. When it comes to international provisions, direct expenditures  constitute aid, and tax expenditures in this context are largely granted as lower rates on income of U.S. multinationals. Regarding distribution, direct spending for income security benefits low and moderate income families while tax expenditures for income security (with a few exceptions) to benefit higher income individuals.

Gravelle and Hungerford’s CRS Report used a different approach, allocating expenditures to economic functions, such as saving, business, consumption allocation, housing (which can be seen as an investment or consumption good in the case of owner occupied housing), labor supply, and government. Twenty-nine percent of the value was associated with reducing the tax on income from savings, largely through benefits for capital gains and pensions, and 13 percent was for housing. By contrast, only seven percent of the tax expenditures were for labor supply.

The Growth in Tax Expenditures

Tax expenditures have grown in number. The 1968 report by the Treasury listed about 50 tax expenditures, while the JCT list today exceeds 200, with the Treasury list being smaller at 165 (although some of that depends on how some tax expenditures are combined). While it is not technically correct to add up tax expenditures, given interactions, that sum is useful in determining the size of tax expenditures. The value relative to GDP has also grown, although less remarkably. In 1968 tax expenditures through the income tax  were around 4.5 percent of GDP. Based on JCT estimates, these tax expenditures are 6.4 percent of GDP, with corporate tax expenditures accounting for 0.5 percent and individual expenditures for 5.9 percent. Some of the slower growth observed in value is due to the decline in the value of tax expenditures as marginal tax rates  have decreased, particularly at higher income levels. For example, tax expenditures were about nine percent of GDP in 1985 before the Tax Reform Act. After the Act lowered the top individual marginal tax rate from 50% to 28%, tax expenditures fell to six percent of GDP when the transition was complete, in 1988.

Effects on the Policy Making Process

Tax expenditures reports have no formal role in the policy process and are not subject to annual review or a sunset. Proposals have been made for a systematic review but no review exists currently aside from those for a small number of temporary provisions that are periodically extended.

The major tax expenditures are not likely to change for policy reasons or are fiercely protected by a significant constituency. For example, using the JCT numbers, 26 percent of individual tax expenditures are for pension benefits, and 20 percent are for capital gains and dividends (lower rates, not taxing at death, and exclusions for owner-occupied housing). Efforts during discussions of health reform in 2020 to eliminate the exclusion for health benefits (12 percent, largely explained by the exclusion of employer health plans) failed although the legislation included a limited “Cadillac tax” on high benefit health plans. This tax was delayed and ultimately repealed in the face of opposition by labor unions and the insurance industry. These three categories account for 60 percent of individual tax expenditures. The next largest areas account for 22 percent (the child credit, earned income tax credit, the pass through deduction for noncorporate business, charitable contributions, and exclusions of social security benefits), and are also not likely to be changed for a variety of reasons..

Some tax expenditures have been eliminated since 1968, notably the investment tax credit, the itemized deduction for sales taxes and percentage depletion for oil and gas. At the same time, many have been added, most recently, subsidies for investments in renewable and clean energy. Tax expenditures make the government look smaller. Hence, since some policy makers seek to reduce the size of the government, tax expenditures can become attractive for legislators in this camp. For example, the refundable earned income tax credit could easily take the form of a direct transfer and is now one of the most important parts of the income security for lower income working individuals. A similar point could be made about the child tax credit and the credit for purchasing health insurance by low income families. Affordable low income housing could be produced directly by the government or provided through grants to states and localities, but the largest federal program is the low income housing tax credit which is awarded to private projects based on state allocations.  In recent years, clean energy tax credits, including a range of  recently enacted transferable credits, have been used to address climate change rather than through emissions regulations or a carbon tax.

The views expressed in this blog are those of the author and do not necessarily represent the views of the Congressional Research Service.

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