A tax expenditure is defined as a departure from the default 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. code that decreases total taxes paid. They are called tax “expenditures” because they resemble government spending.
Although a majority of 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. spending can be accounted for by a small number of provisions, the Congressional Budget Office estimates there are over 200 exemptions, deductions, and credits.
The majority of the expenses incurred through tax expenditures are for individuals. For Fiscal Year 2014, the Office of Management and Budget projects nearly $1.2 trillion in total tax expenditures – $148 billion (13 percent) in corporate tax expenditures and $1.036 trillion (87 percent) in individual tax expenditures.
Tax expenditures can be roughly divided into three categories: those that help promote neutrality, those for social welfare, and those that benefit just one favored class of corporations (corporate welfare). Over 60 percent of tax expenditures make the tax code more neutral.
A neutral tax code treats current consumption, and investment and saving (future consumption) equally. For example, the capital gains and dividends tax expenditure lowers the rate on investment income to reduce the problem of double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . When investment income is taxed twice, investment is disincentivized you get less investment in the future and more current consumption. The lower rate on capital gains is good tax policy because it moves toward tax code neutrality.
However, maintaining neutrality though tax expenditures can introduce unnecessary complexity and tax compliance issues. We would be better served by correctly defining the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
A correctly defined tax base would only tax businesses on their real profits (revenue minus costs) and only tax individuals on their personal expenditures. This would provide individuals with a system that is neutral between current consumption and future consumption and enable businesses to invest and grow.
As an added bonus, a neutral tax base would eliminate the need for any additional tax expenditures.
Below are the current largest tax expenditures by cost.
Largest Individual Tax Expenditures:
- The Exclusion of Employer Contributions for Medical Insurance Premiums ($196 billion).
- Exclusion of Net Imputed Rental Income ($76 billion).
- Deductibility of Mortgage Interest on Owner-Occupied Housing ($70 billion).
- Lower Rate for Capital Gains ($60 billion).
- Defined Contribution Employer Plans ($59 billion).
Largest Corporate Tax Expenditures:
- Deferral of Income from Controlled Foreign Corporations ($76 billion).
- Deduction for U.S. Production Activities ($10 billion).
- Accelerated DepreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. of Machinery and Equipment ($8 billion).