Why Understanding Tax Expenditures is Important to You

There has been much discussion recently about the elimination of “tax expenditures” from the Federal budget in connection with the push for both deficit reduction and comprehensive tax reform. For instance, in its December 2010 report titled, the Moment of Truth, the National Commission on Fiscal Responsibility and Reform (the Debt Commission) noted:

“America’s tax code is broken and must be reformed. In the quarter century since the last comprehensive tax reform, Washington has riddled the system with countless tax expenditures, which are simply spending by another name. These tax earmarks – amounting to $1.1 trillion a year of spending in the tax code – not only increase the deficit, but cause tax rates to be too high.”

And, in his January 25 State of the Union Address, President Obama called for fundamental reform of the U. S. corporate tax system, the elimination of fossil fuel subsidies and other loopholes, and for the simplification of the individual tax code. In other words, Obama called for the elimination of many of the tax expenditures currently embedded in the Internal Revenue Code.

Thus, elimination of “tax expenditures” is clearly in the sights of Washington lawmakers. This article will discuss why this is important to you.

What is a Tax Expenditure?
Since enactment of the Congressional Budget and Impoundment Control Act of 1974 (the Budget Act), a list of tax expenditures has been required to be included in the annual Federal budget as a method to control spending and to make the cost of specific tax provisions more transparent.

The Budget Act defined tax expenditures as:
“revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption or deduction from gross income which provide a special credit, a preferential rate of tax or a deferral of a tax liability.”

Thus, tax expenditures include any reduction in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers. An example of one of the most recognized tax expenditures is the deduction for mortgage interest on personal residences. From the federal government’s perspective, tax expenditures are presented as equivalent to governmental outlays or spending programs.

It is important to note that the notion of tax expenditures is seen from the viewpoint of the federal government as opposed to the viewpoint of taxpayers. The tax expenditure concept is based on the government’s assumption that tax rates should be applied to a broad base of taxpayer income so as to maximize tax receipts at any given tax rate. Any tax provisions that shield components of the broad base of income from taxation are viewed by the government as depriving it of its rightful share of the maximum revenues. Since the Federal government views the lost income as properly belonging to it, the lost revenues resulting from special tax provisions are regarded as government expenditures, hence the term “tax expenditure”. Stated simply, the more tax expenditures there are in the tax law, the less money the Federal government gets.

The Federal government’s view of tax expenditures contradicts with the perceptions of most taxpayers. Most taxpayers believe that all the income they earn initially belongs to them, and is then subject to government taxation at rates set by their elected representatives. They do not believe that the government is spending its money to fund their tax deductions. For instance, would a taxpayer say that his IRA deduction is properly viewed as his property, or would he say that is it property of the Federal government given to him to put into his IRA account?

Tax Hikes in Disguise
The Federal government estimates that tax expenditures account for up to as much as one-third of all Federal spending. Thus, in the coming months, tax expenditures will be front and center in the debate over how Congress tackles the growing Federal deficit. In the Debt commission’s previously mentioned report, The Moment of Truth, their proposal for tax reform and deficit reduction relies on what they refer to as “zero-base budgeting”. This proposal would eliminate all existing income tax expenditures from the tax code (and basically start over) thereby broadening the tax base and immediately increasing tax revenues. The Commission suggests that a portion of the additional tax revenue be dedicated to deficit reduction and any remaining revenue would be used to lower future tax rates. Thus, eliminating tax deductions as a way of cutting Federal spending has the same effect as raising taxes.

Estimates of Federal Tax Expenditures
On December 15, 2010, the Joint Committee on Taxation (JCT), the congressional group that provides cost estimates and tax expertise to Congress, issued its annual report on Estimates of Federal Tax Expenditures for fiscal years 2010-2014. The 2010 report was issued based on enacted tax law through December 15, 2010; therefore, the effects of the 2010 Tax Relief Act were not included in the JCT report.

The following table lists ten of the most recognizable tax expenditures listed in the JCT’s 2010 report.

Tax Expenditures 2010-2014 (in billions)  
Deduction of mortgage interest on owner-occupied homes $484
Exclusion of employer contributions for health care, health insurance premiums $659
Exclusion of pension contribution and earnings $596
Reduced rates of tax on dividends and long-term capital gains $403
Exclusion of Medicare benefits $337
Earned income credit $269
Deduction of state and local taxes $237
Deduction for charitable contributions $187
Child tax credit $122
Exclusion of capital gains at death $194

Summary and Conclusions
Simply by looking at the list of tax expenditures above, it is easy to see that if Washington lawmakers seek to balance the budget by eliminating tax expenditures, you should know they will do it by taking more of our money in the form of higher taxes and this action will not decrease government spending at all.

For further information on tax expenditures, please contact Ron Kramer, Tax Advisory Services.

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Schneider Downs provides accountingtax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH. 

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.

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