The blog of the Urban Institute
February 13, 2020

When Crafting Policy through the Tax Code, Ask Three Questions

February 13, 2020

At an estimated $1.5 trillion per year, tax expenditures are a significant drain on federal tax revenue, equal to 6–7 percent of gross domestic product. But what are they, exactly?

Tax expenditures are special provisions in the tax code—credits, deductions, exemptions, deferrals, or exclusions—that promote social, economic, and environmental policy goals. These policy goals span a range of issues, including homeownership, education, health care, retirement saving, and support for low-income working families.

Speaking on a recent episode of Urban’s podcast, Critical Value, senior fellow Frank Sammartino described tax expenditures as “a major part of the federal government’s spending that doesn’t get measured as spending.” He added, “Some of the programs that operate through the tax code look a lot like spending programs, but because they’re run through the tax code, they have some features that you wouldn’t see in a normal spending program.”

Sammartino and Eric Toder, codirector of the Urban-Brookings Tax Policy Center, discussed these features of tax expenditures while pointing out that this sizable chunk of our nation’s spending deserves more scrutiny from policymakers and the public.

They raised three questions for policymakers to consider when evaluating the efficacy and design of tax expenditures.

1. Are tax expenditures the best way to execute policy?

Putting policy in the tax code comes with several consequences that should be considered before tax expenditures are implemented.

For instance, Congress must annually appropriate funding for discretionary spending programs. In contrast, once passed, most tax expenditures remain on the books indefinitely.

“Tax expenditures don’t have to be appropriated each year,” said Toder. “They’re in the law and, for the most part, permanent. If you did not keep track of them, there would be no accounting for how much the government is doing in certain areas of the economy,” Toder said.

Many tax expenditures have existed for years alongside other direct spending programs with little to no reform or periodic review. It’s difficult to determine how well tax expenditures work and contribute to their intended policy goals because their impact is not consistently monitored or evaluated.

But according to Toder, crafting policy through tax expenditures has upsides, like streamlined administration. He cited the earned income tax credit (EITC) as an example.

“The degree of administration is less [than with a spending program]. Individuals file a return and claim the credit. They don’t have to go into a government office as they would to apply for SNAP [Supplemental Nutrition Assistance Program] benefits. You’re basically making it a lot easier for people to get benefits. The take-up rate on the EITC is much higher than the rate on other government benefit programs.”

2. Who benefits from tax expenditures?

As Toder put it, “Just about everybody benefits from something because [tax expenditures] are so pervasive.”

Although benefits are widely available, Toder mentioned that tax expenditures disproportionately benefit high-income people. “On average, it’s a bit higher at the top, and that’s largely because of capital gains. Capital gains is its own category because it’s a particular form of income which is concentrated among higher-income people. Things like charitable deductions or itemized deductions are also claimed more by people at the top,” he added.

Tax expenditures also help higher-income people more when they are worth more per dollar of favored activity to higher than for lower-income taxpayers. “Because [some expenditures] are operating through the tax code in the form of deductions or exclusions, they have this upside-down characteristic,” explained Sammartino. An equal-dollar amount [of deduction or exemption] saves more in taxes for a high-income person than for a low-income person.”

Essentially, the higher the tax bracket, the greater the tax benefit.

“Overall benefits as a percentage of income is highest at the top of the income distribution,  lowest in the middle, but a bit higher in the bottom than at the middle,” Toder said. “But it depends on which programs you’re talking about. Some programs benefit the middle, some the top, some the bottom.”

3. Should the government even be involved?

“In the case of the EITC, there’s a clear role for the government to provide income support for low-income families. You can also make the case that the government does have an interest to see people have access to health insurance coverage,” Sammartino explained.

He said that the case for the government’s role in the mortgage interest deduction is less clear.

“We allow a deduction for interest, but we don’t tax the proceeds from owning a home, such as the rental equivalent value. So, we’re allowing this deduction, but there’s no commensurate income that’s being taxed,” he explained. “[The mortgage interest deduction] arose from a broad tax policy [that interest expense should be deductible as a cost of earning income] but was applied in a case where there wasn’t taxable income being generated for this particular activity.”

Policymakers should keep all these considerations in mind as they craft policies through tax expenditures or as they evaluate existing tax expenditures’ effectiveness in promoting specific policy goals.

Photo by Pgeam via Getty Images.

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