Last week, the Joint Committee on Taxation (JCT) released its annual report on federal taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. expenditures, listing over 150 tax provisions that are expected to reduce federal revenue over the coming years. The estimates in this year’s tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. report look significantly different than those in reports from previous years—largely due to the extensive changes made by the Tax Cuts and Jobs Act, passed at the end of 2017
For some background: a “tax expenditure” refers to any provision in the tax code that provides a special deduction, credit, exclusion, or other tax preference that wouldn’t be included in a “normal” tax code. The question of which specific tax provisions should count as tax expenditures is often up for debate; however, under any definition, it is clear that the federal government forgoes hundreds of billions of dollars in revenue each year due to tax expenditures.
To show how the size of federal tax expenditures has changed as a result of the Tax Cuts and Jobs Act, the tables below compare JCT’s tax expenditure estimates from January 2017 (before passage of the law) to the estimates released last week. Specifically, the tables tabulate how several major tax expenditures were previously and are currently expected to affect federal revenue in fiscal year 2020.[1]
Itemized Deductions
Three of the largest tax expenditures in the federal income tax code are itemized deductions: the mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. , the state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. , and the charitable deduction. The amount of revenue that the federal government forgoes due to these three deductions is expected to decline sharply as a result of the 2017 tax law.
| Source: Joint Committee on Taxation, JCX-3-17, JCX-34-18 | ||
| JCT 2017 Estimate for FY2020 | JCT 2018 Estimate for FY2020 | |
|---|---|---|
|
Deduction for mortgage interest on owner-occupied residences |
$83.4 billion | $36.9 billion |
|
Deduction for state and local taxes paid |
$122.5 billion | $24.4 billion |
|
Deduction for charitable contributions |
$66.3 billion | $47.0 billion |
For instance, the amount of revenue loss from the mortgage interest deduction, a provision which benefits homeowners, is expected to decline by over half. Last year, JCT estimated that the federal government would forgo $83.4 billion in revenue in 2020 due to the mortgage interest deduction; now, it estimates that the deduction will reduce revenue by only $36.9 billion.
Even more dramatic are the effects of the 2017 tax law on the size of the deduction for state and local taxes paid. Previously, JCT estimated that this deduction would reduce federal revenue by $122.5 billion in 2020. Now, it estimates that the revenue loss due to the state and local tax deduction in 2020 will only be $24.4 billion.
The charitable deduction, as well, is expected to cost the federal government less due to the 2017 tax law—though the difference is smaller than it is for the other two deductions. Last year, JCT estimated that the charitable deduction would lower federal revenue by $66.3 billion in 2020; now, that figure has dropped to $47.0 billion.
There are three reasons why these deductions are expected to reduce federal revenue by less than what they once did. First, the 2017 tax law substantially increased the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. , which is expected to lead fewer taxpayers to itemize, causing fewer households to make use of these provisions. Second, the law lowered marginal tax rates across the board for households, making each dollar of deductions less costly for the federal government. Finally, the 2017 tax law included explicit limits on two of these deductions: it capped the state and local tax deduction at $10,000 per household and the mortgage interest deduction at $750,000 of home acquisition debt.
It is worth noting that all three of these changes are set to expire after 2025. In eight years, the caps on the mortgage interest and SALT deductions will expire, the increase in the standard deduction will be reversed, and marginal tax rates will rise across the board—all of which will increase the revenue loss from itemized deductions.
Other Individual Tax Expenditures
An interesting feature of the 2017 tax law is that it indirectly reduced the size of several major tax expenditures, without making any direct changes to the provisions in question. This is because, for many of the provisions in question, the size of the tax expenditures varies with marginal tax rates. As a result, when the 2017 law lowered marginal tax rates across the board, it implicitly made many individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. expenditures smaller.
| JCT 2017 Estimate for FY2020 | JCT 2018 Estimate for FY2020 | |
|---|---|---|
| Source: Joint Committee on Taxation, JCX-3-17, JCX-34-18 | ||
|
Exclusion of employer contributions for health care and health insurance |
$189.5 billion | $182.5 billion |
|
Exclusion of untaxed Social Security and railroad retirement benefits |
$47.8 billion | $39.3 billion |
|
Exclusion of interest on public purpose state and local government bonds |
$42.5 billion | $31.7 billion |
To illustrate this phenomenon, consider the exclusion of employer-sponsored health insurance—which remains the largest tax expenditure in the federal tax code. Under this provision, the amount that employees receive in health insurance benefits is not counted as income that they are taxed on (even though it is surely a form of compensation like any other).
Importantly, the amount of revenue that the government loses due to this provision depends on what tax rates would have applied to health insurance benefits if they were subject to tax. For a household in the old 25 percent bracket, receiving $1,000 of tax-exempt health benefits instead of $1,000 in wages leads to $250 of tax savings, and a $250 revenue loss for the federal government. If the household is in the new 24 percent bracket, the same situation would result in $240 of tax savings and $240 in revenue loss for the government.
As a result, when the 2017 tax law lowered marginal rates across the board, it implicitly reduced the size of the exclusion of employer-provided health insurance. Last year, JCT estimated that this provision would reduce federal revenue by $189.5 billion in 2020. Now, it estimates a revenue loss of $182.5 billion in the same year.
The same phenomenon applies to a number of other major federal tax expenditures. After passage of the 2017 tax law, JCT’s estimate of the revenue loss from the exclusion of Social Security benefits fell from $47.8 billion to $39.3 billion. Similarly, its estimate of the revenue forgone due to the exclusion of municipal bond interest fell from $42.5 billion to $31.7 billion.
Importantly, all the individual income tax rate cuts in the Tax Cuts and Jobs Act are set to expire in 2025. This means that, absent congressional action, each of the tax expenditures described above would likely expand in size in 2026.
Two Business Tax Expenditures
Looking through the JCT tax expenditure report, the effect of the 2017 tax law is particularly clear when considering old tax expenditures that were eliminated and new tax expenditures that were created by the legislation.
| JCT 2017 Estimate for FY2020 | JCT 2018 Estimate for FY2020 | |
|---|---|---|
| Source: Joint Committee on Taxation, JCX-3-17, JCX-34-18 | ||
|
Deduction for income attributable to domestic production activities |
$21.1 billion | $0 billion |
|
20 percent deduction for pass-through business income |
$0 billion | $57.6 billion |
The domestic production activities deduction (section 199) was one of the few tax expenditures that was eliminated outright in the 2017 tax law. Previously, the provision offered the equivalent of a tax rate reduction to businesses that earned income from production in the United States. However, the provision was often criticized for favoring certain parts of the economy over others, as well as for being subject to abuse and gaming. The elimination of this provision is reflected in the JCT’s tax expenditure report: previously, it was estimated to cost the federal government $21.1 billion in 2020, a figure that has now fallen to $0.
On the other hand, the 2017 tax law also created a new tax expenditure: a deduction (section 199A) for households that earn income from pass-through businesses—companies that are not subject to the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , such as partnerships and S corporations. The new deduction allows households to exclude up to 20 percent of their pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income from federal tax, subject to several restrictions. Because the provision lowers the tax rate on pass-through business income below the tax rate on wages and salaries, it was an easy call for the Joint Committee on Taxation to categorize it as a tax expenditure.
The new pass-through deduction and the old domestic production deduction share a number of similar features. Both provisions include limitations based on the amount of wages that companies pay, as well as rules meant to exclude the services sector from seeing a tax benefit. Nevertheless, the new pass-through deduction is substantially larger than the old domestic production deduction: it is expected to reduce federal revenue by $57.6 billion in 2020.
Conclusion
There are many other interesting stories that can be told by comparing JCT’s tax expenditure reports from 2017 and 2018. The examples above show some of the far-reaching effects of the Tax Cuts and Jobs Act on every part of the federal tax code.
Of particular note is the fact that many of the changes to federal tax expenditures highlighted above are set to be reversed over the next ten years—due to the expiration of several individual income tax changes, including the higher standard deduction and lower marginal tax rates. Going forward, lawmakers should consider the potential side effects these scheduled changes would have on the size of federal tax expenditures.
[1] The year 2020 was chosen to avoid capturing any transitional revenue effects of changes to the federal tax code. Some of the revenue changes between JCT’s 2017 and 2018 estimates may be related to changing economic conditions or other factors, but it seems likely that the bulk of the differences are attributable to the 2017 tax law.
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