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Abstract
I. INTRODUCTION
Government Budget Rules and the Push toward Tax Expenditures
Growth in Social Tax Expenditures
Support for Low-Income Families
II. ISSUES IN DESIGNING TAX INCENTIVES
Employer or Employee Subsidies
Universal or Limited Eligibility
Income Conditioned
Work Requirement
Higher Benefits for Families with Children
General Support or Support of Particular Activities
Credits or Deductions and Exemptions
III. TAX PROVISIONS OF SPECIAL BENEFIT TO LOW-INCOME FAMILIES
General Provisions of the Tax Code
Targeted Tax Provisions
IV. ECONOMIC EFFECTS OF TAX BENEFITS FOR LOW-INCOME FAMILIES
Effect on Federal Tax Burdens
Antipoverty Effectiveness
Distribution and Target Efficiency of Benefits
Marginal Tax Rates
V. CHOOSING BETWEEN DIRECT AND TAX-BASED INCOME SUPPORT
Accounting Period
Cash or In-Kind Transfers
Participation Rates
Error Rates
VI. CONCLUSIONS
VII. REFERENCES
I. INTRODUCTION
The federal income tax system has always been more than just a means of collecting
revenues to support federal spending programs. Legislators have used the income tax
system to promote favored forms of consumption and investment and to help selected
groups of taxpayers. In addition, since the mid-1980s, Congress has increasingly used the
federal tax code to support social program goals (Toder 1998). This support has included
a greatly expanded role for the tax code in providing income support for low-income
families, including those who do not pay federal income tax. Congress expanded the
earned income tax credit (EITC) in 1986, 1990, and 1993; enacted a new, partially
refundable child credit in 1997; and enacted further increases in both the child credit and
the EITC in The Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA).1
Government Budget Rules and the Push toward Tax Expenditures
Tax incentives are popular because they represent a way of increasing federal support for
social policy, while seeming to cut taxes rather than increase spending. Compared with
direct outlay programs with similar goals, tax incentives better meet the need of
politicians to expand programs while appearing to restrain the size of government. That
is, the incentives show up as tax cuts rather than spending increases, even if they have the
same economic effect. Consequently, they often appear more politically attractive than
spending programs designed to achieve the same ends.
Federal budget rules established in the 1990s encouraged the growth of tax
expenditures. The rules established under the Gramm–Rudman–Hollings Act were an
initial attempt by Congress to force spending discipline by setting specific dollar targets
for federal deficits. While those rules were ultimately unsuccessful, they did pave the
way for the Budget Enforcement Act of 1990 (BEA). BEA, which was extended in 1993
and 1997, constrained discretionary spending by setting specific dollar limits (spending
caps) for different categories of outlays. It also required that tax increases or spending
cuts elsewhere in the budget offset any increase in mandatory spending (which includes
most programs that provide income support to low-income families).
The discretionary outlay ceilings and pay-as-you-go requirement effectively
curtailed both new spending initiatives and significant increases in existing spending
programs. The budget discipline imposed by BEA broke down, however, once the federal
budget was no longer in deficit, and the act is set to expire after 2002. It is not clear if
Congress will impose new rules to limit further spending increases. But the reemergence
of deficits in the wake of the recent economic decline, the drop in stock prices, the
continued automatic growth of retirement and health programs, and the increase in
spending on defense and homeland security in response to the September 11 terrorist
attacks all suggest a need for new attempts to impose budget discipline. If the current
administration continues to resist tax increases, and to oppose the deferral of tax cuts
recently enacted but not yet implemented, new social spending initiatives will again be
severely squeezed. If tax "cuts" remain on the table, this fiscal pressure may lead to yet more social spending through the tax system.
Growth in Social Tax Expenditures
Some analysts refer to tax incentives as "tax expenditures," recognizing that tax
provisions often supplant direct spending programs in advancing federal policy goals.2 The Office of Management and Budget (OMB) defines "tax expenditures" as "revenue losses due to preferential provisions of the Federal tax laws, such as special exclusions, exemptions, deductions, credits, deferrals, or tax rates." In spite of the terminology, some proposals that the agencies call "tax expenditures" do not have an obvious spending program counterpart, although they do provide preferential treatment relative to a comprehensive income tax. Nevertheless, many other programs could be designed equally well as explicit outlays.
The OMB and the Congressional Joint Committee on Taxation (JCT) publish an
annual list of "tax expenditures" and their associated costs. Although not equivalent to the normal budget estimates for federal expenditures, estimates of expenditures through
the tax system provide some measure of the level of federal support for selected activities
and selected categories of recipients.
A simple comparison of tax expenditures in 1981 and in 2001 illustrates that,
while the overall growth in tax expenditures relative to GDP has not been very large—
especially because of the tax reforms of 1982, 1984, and 1986—the composition of tax
expenditures has shifted (see figure 1). Business tax expenditures—those intended to
promote specific industries or certain business activities—have declined relative to social
tax expenditures—provisions intended to promote education, health, housing, retirement
saving, and income security for low- income families. In 2001, social tax expenditures
accounted for about 80 percent of the cost of all tax expenditures, up from less than 60
percent in 1980.
Social tax expenditures increased in the 1990s, owing both to new tax legislation
and economic and demographic changes. The Omnibus Budget Reconciliation Acts of
1990 and 1993 expanded some existing social expenditures and added new ones. The
most significant change was a major expansion of the EITC in both the 1990 and 1993
acts.
The Taxpayer Relief Act of 1997 continued the trend toward expanding social tax
expenditures by introducing new tax credits for postsecondary education expenses;
broadening incentives for saving for higher education; expanding eligibility for taxadvantaged
individual retirement accounts (IRAs); providing a new, partially refundable
child credit; and expanded incentives for business to invest in economically depressed
areas and to employ disadvantaged workers.
In EGTRRA, enacted in 2001, Congress and the administration added and
extended various tax incentives to further social policy objectives. Most of the estimated
10-year revenue loss stems from the bill's marginal tax rate cuts and the elimination of
the federal estate and gift tax. EGTRRA, however, also contains numerous provisions
targeted to particular families or activities. These new and expanded tax expenditures
include an increase in the child tax credit. In 2001, the credit increased from $500 to
$600, and it will increase to $1,000 by 2010. The credit also extends partial refundability
of the credit to all families with qualified children and earnings above $10,000. Unlike
many other tax provisions, however, the $1,000 credit is not indexed for inflation, so its
real value will erode over time. Other increases include an increase in the EITC for some
married couples, an increase in the dependent care credit, expanded tax benefits for
educational savings accounts and college tuition, and expanded deductions for retirement
saving and pensions.
Support for Low-Income Families
Most social tax expenditures dollars go to middle-class families, including the four
largest tax expenditure items: exclusion of pension contributions and earnings ($140
billion), exclusion of employer-paid health insurance premiums ($107 billion), deduction
of mortgage interest on owner-occupied homes ($65 billion), and deduction of state and
local income taxes ($46 billion).3 While "middle-class" tax expenditures remain the largest social tax expenditures in dollar cost, many more tax expenditure dollars today go toward income support for lower-income families than in past decades.
At the same time that tax expenditures for low-income families have increased,
direct federal spending for transfer programs serving those families has been scaled back.
The EITC is now the largest single source of cash assistance to low-income working
families, with families claiming $31 billion of credits in 2000 (Internal Revenue Service
2001). This figure exceeds total federal spending in fiscal year 2000 on the Food Stamp
Program ($18 billion) as well as on Temporary Assistance for Needy Families (TANF)
and other family support programs ($21 billion). Total spending for Supplemental
Security Income (SSI), which mostly provides benefits to nonworking elderly and
disabled people equaled that of the EITC. Other tax provisions not directly targeted to
low-income families provide additional subsidies to low-income families. Of the more
than $19 billion claimed in child tax credits in 2000, families with adjusted gross income
of $30,000 or less claimed $4.2 billion. Families at this income level claimed another
$1.5 billion of the $2.7 billion in dependent care credits.
Tax subsidies reduce or eliminate federal income tax liabilities for low-income
families. Many low- income families actually receive a refund in excess of their income
tax liability. One rationale for such assistance might be to offset the burdens of other
taxes that low-income families pay, such as payroll taxes; excise taxes; or state and local
sales, property, and income taxes. But such assistance could also be part of a broader
program to provide a basic social safety net and reduce or eliminate poverty. Even if a
particular benefit had no policy rationale, policymakers might wish to use the income tax
as a convenient administrative way to deliver cash benefits to low-income families.
1. For a more complete discussion of EGTRRA, see Burman, Maag, and Rohaly (2002).
2. The term "tax expenditures" and the concept of a tax expenditure budget was originally developed by Stanley Surrey, who was assistant secretary for Tax Policy at the U.S. Treasury Department in the 1960s. See Surrey (1973) and Surrey and McDaniel (1985).
3. Expenditure amounts are "outlays equivalent" estimates for 2001. (U.S. Office of Management and Budget 2002)
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