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RPC Must Read November 9, 2011
"What is Tax Reform?": Federal Tax Expenditures
Recent comprehensive tax reform discussions by policymakers and stakeholders have included the topic of federal tax “expenditures”. In the context of tax reform, there is a growing consensus that reducing the amount of federal tax expenditures would broaden the tax base and allow for lower marginal tax rates. According to the Joint Committee on Taxation, tax expenditures include any reductions in the income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers. With that being said, there is no universal technical definition of a tax expenditure. Defining a tax expenditure is often in the eye of the beholder.
Abstractly, tax expenditures are revenue losses from special tax deductions, credits, and other tax benefits. In 2010, the Organization of Economic Cooperation and Development (OECD) estimated 164 tax preferences in the United States tax code. It is estimated that corporate and individual tax expenditures total over $1 trillion dollars. Of this $1 trillion, $900 billion are individual, rather than corporate, tax expenditures. Tax expenditures can take many forms. Tax benefits, deductions, and credits are all provisions in the Internal Revenue Code that limit the tax liability of a taxpayer.
1. Tax Deductions: A deduction is an item or expenditure subtracted from gross income to reduce the amount of income subject to tax. Tax deductions reduce the taxable income of a taxpayer. As a result, their value thus depends on the taxpayer’s marginal tax rate. A taxpayer has the choice of claiming the standard deduction or itemizing deductible expenses.
a. The “standard deduction” is a base amount of income that is not subject to tax. It can only be used if the taxpayer does not choose the “itemized deduction” method. The itemized deduction method includes deductions made up of money spent on goods and services throughout the year. They are specific deductions outlined by the Internal Revenue Service (IRS). In either case (standard or itemized deduction method), taxable income is decreased by the amount of the allowed deduction times the filer’s marginal tax rate (e.s. $5000 deduction at 35% marginal rate is $5000 x .35 = $1750).
b. Tax filers may also claim deductions in addition to the standard deduction or itemized deductions. These include deductions for contributions to Individual Retirement Accounts, alimony payments, certain moving expenses, and interest on student loans among others.
2. Tax Credits: A tax credit is a sum deducted from the total amount a taxpayer owes to a governmental entity. Tax credits reduce a person’s tax liability at least equal to the credit. It is a dollar-for-dollar reduction in the tax payment (rather than a deduction which is based on the marginal tax rate). Credits are subtracted not from taxable income but directly from a person’s tax liability. Tax credit can be refundable or non-refundable.
a. The majority of tax credits are non-refundable. This means taxpayers can only use the credit to reduce or eliminate positive income tax liability. It cannot reduce the amount of income tax owed to less than zero (which would entitle the taxpayer to a payment from the U.S. Treasury).
b. A refundable tax credit does not have the same restriction as a non-refundable credit. Therefore, if the credit exceeds pre-credit tax liability, the tax filer still receives the excess amount as a payment from the U.S. Treasury. There are three major refundable tax credits. They are: the earned income tax credit, the child tax credit, and the small health coverage tax credit.
The major difference between deductions and credits is that deductions only reduce the amount of your income that is taxable, while credits reduce the actual amount of tax owed. The increase of these deductions and credits in the tax code has caused the amount citizens who owe any income tax at all to decline substantially over time. According to the Tax Foundation, the number of people owing no tax liability has grown substantially since 1960 and has now reached nearly 52 million citizens.