Distributional Effects of Tax Expenditures

Distributional Effects of Tax ExpendituresBenjamin H. Harris, Katherine Lim, Eric Toder

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The largest tax preferences for housing, health care, and retirement saving reduce federal revenues by about 3 percent of GDP. They raise after-tax income proportionally more for higher income groups than lower income groups, but raise income proportionately less for those at the very top. The net distributional effects depend on how these tax preferences are financed. If paid for with higher marginal tax rates, they benefit upper-middle income taxpayers at the expense of both lower-income and the highest-income taxpayers, but if paid for by lower per-capita spending, all high-income groups gain and all low-income groups lose.

The Congressional Budget Act of 1974 defines tax expenditures 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 liability." The Office of Management and Budget (OMB) and the Joint Committee on Taxation (JCT) annually report estimates of tax expenditures. The term "tax expenditure" was popularized by Stanley Surrey, Assistant Treasury Secretary for Tax Policy in the 1960s, who wanted to draw attention to the increasing use of tax provisions as disguised expenditures and develop an agenda for tax reform.

By any measure, the revenue losses from tax expenditures are large. Adding up all the tax expenditure estimates in the 2010 Federal Budget, we calculate a sum of about $1.1 trillion in fiscal year 2012, or about 6.7 percent of projected gross domestic product (GDP). Of these, about $900 billion (5.8 percent) of GDP go to support social program activities (housing; education, training, and social services; health; income security, including retirement security; veterans benefits; assistance to economically depressed regions; and aid to charities and states and localities). OMB and JCT estimate each tax expenditure provision as if all the others were in place, so simply adding them together does not take account of how eliminating some tax expenditures would affect the costs of others. Totaling all the provisions may understate their cost, however. Burman, Toder, and Geissler (2008), using the Tax Policy Center Simulation Model (Rohaly, Carasso, and Saleem, 2005), find that interactions raised the total cost of a large subset of tax expenditures in the individual income tax estimated simultaneously by between 5.1 and 8.4 percent in 2007, compared with the sum of the costs of the separate estimates.

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