|Rethinking the Income Tax Calculation
Lately, talk of reducing the deficit, simplification, and a lower corporate tax rate have focused on the need to reduce or eliminate "tax expenditures." What does this really mean?
February 10, 2011
The final report of the Deficit Commission, released in December 2010, includes a recommendation to "eliminate all income tax expenditures." It also notes that these expenditures represent $1.1 trillion of annual spending. (The Moment of Truth (PDF), pages 28 to 29) The 2010 annual report of the National Taxpayer Advocate includes a section — "The Time for Tax Reform Is Now." While this report does not call for elimination of all tax expenditures, it highlights how these expenditures affect all taxpayers, not just "special interests." The Joint Committee on Taxation’s (JCT) report estimates that the $1.1 trillion of tax expenditures equals $8,000 of tax savings per return filed or roughly $32,000 of tax breaks. Per the report, if the tax breaks were not there, a taxpayer might have a nine percent tax rate rather than a 25 percent tax rate. (NTA report (PDF), pages 9 to 12)
Based on these high-profile reports, "tax expenditures" seem to be the significant culprit behind large deficits and the need for tax reform. While a focus on tax expenditures can lead to a better understanding of the tax law, there are limitations. To be an appropriate and useful focal point for reform, it is crucial that people understand what tax expenditures are and are not. This article reviews definitions of "tax expenditures" and notes some factors to consider in using them to guide tax reform efforts.
What Is Tax Expenditure?
The concept of tax expenditures dates back to the 1960s and Stanley S. Surrey, who was Assistant Treasury Secretary for Tax Policy. As he later described in his book, Pathways to Tax Reform (1973), page 6:
"The federal income tax system consists really of two parts: one part comprises the structural provisions necessary to implement the income tax on individual and corporate net income; the second part comprises a system of tax expenditure under which Governmental financial assistance programs are carried out through special tax provisions rather than through direct Government expenditures. This second system is grafted on to the structure of the income tax proper; it has no basic relation to that structure and is not necessary to its operation. Instead, the system of tax expenditures provides a vast subsidy apparatus and uses the mechanics of the income tax as the method of paying the subsidies. The special provisions under which this subsidy apparatus functions take a variety of forms, covering exclusions from income, exemptions, deductions, credits against tax, preferential rates of tax, and deferrals of tax."
Definitions used in reports that list and state the "cost" of tax expenditures use a similar definition. For example, the JCT, which issues an annual tax expenditure report, provides the following explanation:
"Tax expenditures are defined under the Congressional Budget and Impoundment Control Act of 1974 (the "Budget Act") as "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." Thus, tax expenditures include any reductions in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers."
Considerations in Using Tax Expenditures to Guide Reform
A list of tax expenditures can provide a starting point for understanding the make-up of the tax base and tax calculation. However, such a review should not occur without some understanding of how and why the particular items are included in the tax-expenditure report and how the numbers were calculated. Listed below are a sampling of factors to consider in making good use of tax-expenditure reports for tax reform:
Definitions and concepts: Tax expenditure reports are not all the same. The baseline presumptions used can vary. How the "normal" tax is defined will dictate what constitutes a "tax expenditure." For example, is the exclusion of the imputed income from owner-occupied housing a tax expenditure? It is treated as such in the Administration's reports, but not in the JCT reports (JCT, JCS-3-10, page 6). Are the graduated tax rates for corporations a tax expenditure or part of the baseline?
Presumptions can lead to particular reporting. For example, the reporting of the lower rate for capital gains and qualified dividends is different in the budgets of President Bush versus those of President Obama. As explained in the FY2011 report (PDF) (page 207):
"In the 2005 Analytical Perspectives, the treatment of capital gains was changed to exclude the portion of capital gains derived from corporate equity from the estimate of the tax expenditure for preferential tax rates on capital gains. In addition, the preferential rates on qualified dividend income that were enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003 were not identified as a tax expenditure. In this volume, the estimates reflect the pre-2005 methodology where no interaction effects among the various taxes are taken into account. ... The preferential rate on qualified dividends is identified as a tax expenditure."
Whether the effects of how various rules interact can vary among reports. For example, per the JCT report, an itemized deduction "not necessary for the generation of income is classified as a tax expenditure, but only to the extent that it, when added to a taxpayer's other itemized deductions, exceeds the standard deduction." (JCS-3-10, page 5) In contrast, the Administration's tax expenditure report does not consider interaction of rules. (Office of Management & Budget, FY2011 Analytical Perspectives (PDF), page 207)
Whether "negative" tax expenditures are reported can also vary among reports. A negative tax expenditure is something contrary to "normal" that generates tax revenue, such as the disallowance of certain lobbying expenses.
Differences can also exist in how the legal structure of the law is considered. For example, the California Department of Finance does not include services in its sales tax expenditure report because the law only applies to tangible personal property. (Tax Expenditure Report 2010-2011 (PDF), page 1) In contrast, Texas includes "exclusions" in its tax expenditure report, defining them as "transactions not taxed because they fall outside the legal definition of a taxable sale." (Texas Comptroller, FY 2009 report (PDF), page 3)
Dates and temporary provisions: Tax expenditure reports typically include more than one year. Thus, it is important to know what date was selected to identify the tax rules. For example, the Administration's FY2011 report is based on law enacted as of December 31, 2009 and shows tax expenditures for fiscal years 2009 through 2015. Thus, rules that expired after 2009 are not included in the 2010 to 2015 figures.
Type of tax: Federal tax expenditure reports, such as from the JCT and Administration, only identify and measure income tax expenditures. Therefore, there is a lot of missing information. For example, the $1.1 trillion figure noted earlier is just income-tax expenditures. There are many provisions in the income tax that affect other taxes. For example, exclusions for employees, such as for employer-provided healthcare, if removed from the income tax would not only generate more income tax, but also payroll taxes.
Totals: Tax expenditure reports of the Administration and JCT provide no totals because they can be misleading due to the omission of how rules interact with one another.
Perceptions: Some people object to the concept of tax expenditures as typically used. A 1999 report of the Joint Economic Committee noted that because the income tax has both income- and consumption-tax elements, it is difficult to identify "normal." It also noted that the concept of tax expenditures takes a government perspective rather than a taxpayer perspective, presuming that tax breaks deprive the government of revenues. (JEC, Tax Expenditures: A Review and Analysis (PDF), August 1999)
Corporate Welfare: Tax expenditures are sometimes referred to as corporate welfare. A review of any federal-income tax expenditure report indicates that in terms of quantity and cost, individual-tax provisions outnumber corporate provisions. For example, the Administration's ranking of the expenditures by size indicates that the top 26 are for individuals and the 27th is for corporations (deferral of controlled foreign corporation (CFC) income costing $32.7 billion for FY 2011). The top two individual income-tax expenditures for FY 2011 are the exclusion for employer-provided medical benefits ($177 billion) and the home mortgage interest deduction ($104.5 billion). (FY2011 report (PDF) (page 220).
Surprises: Some tax expenditures would likely surprise most people because they are viewed as necessary, for example because they make the tax system more administrable. Some reports, for example, include deferral of interest on U.S. savings bonds and use of the cash method of accounting for some businesses.
Missing information: Tax expenditures do not provide the whole picture to understanding a tax system. As noted earlier, the federal reports only address the income tax. In addition, tax reform efforts need to also consider tax compliance and administration, as well as principles of good tax policy.
Tax reform discussions focused on tax expenditures will be part of tax-reform discussions. Tax-expenditure reports provide a wealth of information, but have significant limitations. It is important for those involved in such discussions and those interested in the fate of the federal tax system, to examine this information critically by taking time to review not only the lists, but also the explanations.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA's Individual Income Taxation Technical Resource Panel and chairs the California Bar Tax Section's Tax Policy Committee. She has several reports on tax reform and a blog.