The Economic Impact of Tax Expenditures in the Federal Income Tax Code

November 12, 2012

Tax expenditures are provisions in the U.S. tax code through which individuals and corporations can lower their tax burden by behaving certain ways, reflected at both the individual and corporate levels. The current total tax expenditures in the United States hover around $1 trillion, with over 80 percent accruing to individuals and the remainder to corporations. Tax expenditures alter behaviors. In some cases, these actions can manifest distortive incentive structures; at the holistic level, this damages the economy, say Jeremy Horpedahl and Brandon Pizzola of the Mercatus Center.

The tax expenditure framework benefits the wrong people and encourages "gaming" by those in a position to take advantage. The entire economic system is distorted in terms of where resources are spent, how capital is allocated, how income is distributed, and how lobbying wastes resources and affects the structure of the tax code. These issues impact all the top tax expenditure scenarios.

Some of the largest individual tax expenditures are:

  • Exclusion of employer contribution for medical insurance premiums and medical care.
  • Retirement and pension contribution -- employer contribution into these programs are not included in the employee's deductible income.
  • Deductibility of mortgage interest on owner-occupier homes.
  • State and local taxes -- these reduce an individual's income and ability to pay federal taxes.
  • Lower tax rates for certain capital gains and dividends -- lower rates encourage investment and economic growth.

Some of the largest corporate tax expenditures are:

  • Accelerated depreciation of machinery and equipment.
  • Deferral of income from controlled foreign corporations.
  • Deduction for U.S. production activities.
  • Credit for increasing research activities.
  • Exclusion of interest on public-purpose state and local bonds.

There are several benefits to revamping and simplifying the tax code.

  • Lowering tax rates leads to more robust economic growth.
  • Dismantling the tax expenditure system includes less distortion, a simpler tax code, and less money spent on lobbying and rent-seeking.
  • The cumulative benefits would aid the economy at large.

Source: Jeremy Horpedahl and Brandon Pizzola, "A Trillion Little Subsidies: The Economic Impact of Tax Expenditures in the Federal Income Tax Code," Mercatus Center, October 25, 2012.

 

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