‘Tax Expenditures’ Nearly Match Federal Income Tax Collections

Published November 5, 2012

The loopholes known as “tax expenditures” reduce individual and corporate tax obligations by more than $1 trillion each year. But while these tax deductions are hugely popular and fiercely protected, economists disagree on whether they are really a good deal for most Americans.

“A Trillion Little Subsidies: The Economic Impact of Tax Expenditures in the Federal Income Tax Code” is a new Mercatus Center study that looks at the 10 largest tax expenditures for individuals and corporations and weighs the economic impact of each. The study also reviews the intended-versus-actual beneficiaries and outcomes of particular tax expenditures and considers the economic and political implications of eliminating all expenditures in a single swipe.

According to the federal Office of Management and Budget, of the more than $1 trillion in FY2011 federal tax expenditures, 80 percent, or $891 billion, went to individuals, and 20 percent, or $181 billion, to corporations.

Breaks Equal Discretionary Spending

To put this in perspective: FY2011 tax expenditures were nearly equal to all federal income tax collected in that year, or to the entire FY2011 discretionary budget. They were also greater than the annual federal spending on Medicare or Social Security.

Although applied through the tax code, their effect is similar to spending provisions, hence the name tax expenditures: They encourage certain kinds of government-supported behavior by subsidizing it. Because they are part of the tax code, however—reducing revenue from what it otherwise would be, rather than overtly increasing spending—they mask the true size and scope of government.

The paper argues tax expenditures hinder economic growth by distorting individuals’ and corporations’ behavior toward qualifying for tax loopholes rather than making the best economic decisions.

Big Economic Distortions

By distorting behavior, tax expenditures distort the entire economic system by altering spending on goods and services; distorting capital allocation; changing the distribution of income; and encouraging lobbying and rent-seeking to maintain and expand these provisions.

For example, corporations must divert significant resources away from pro-growth activities to the nonproductive—but critical to compete with other U.S. corporations—activity of fighting for more and bigger tax breaks.

Misdirected Benefits

For the largest tax expenditures studied, the stated legislative intent was seldom realized.

The intended economic benefits seldom materialized, and the intended beneficiaries were seldom the greatest beneficiaries. Most tax-expenditure benefits accrue disproportionately to higher-income earners and encourage “gaming” the system by those in a position to take advantage, often resulting in cronyism and the capture of the tax code for private gain.

For example, although the encouragement of home ownership has become the common justification for the home mortgage interest deduction, it does not effectively achieve this goal. Of the 33 percent of taxpayers who itemize deductions, only 20 percent claim the home mortgage deduction. Of those, two-thirds make more than $100,000 a year.

That means individuals and families on the margin who could be motivated to become homeowners by incentives—that is, lower-income individuals and families—are unlikely to use this deduction.

End and Cut

The paper concludes economically optimal tax reform must include two key pieces: Eliminate all tax expenditures and lower marginal tax rates across the board enough to keep from raising taxes.

Eliminating expenditures without simultaneously lowering tax rates amounts to a tax increase on the economy as a whole. This would result in slower economic growth and, thus, lower future tax collections.

The report suggests a one-shot elimination of tax expenditures is more probable than a piecemeal elimination. This is because the former would give all taxpayers an immediately recognizable benefit (such as an increase in individuals’ paychecks or a significant reduction in lobbying and accounting expenses for businesses) to offset later.

The benefits of eliminating tax expenditures include less distortion, a simpler tax code, and less money spent on lobbying and rent-seeking. All these changes would benefit the economy at large, and the nation, the study concludes.

Jeremy Horpedahl ([email protected]) is an assistant professor of economics in the H. W. Siebens School of Business at Buena Vista University in Storm Lake, Iowa, and author of “A Trillion Little Subsidies.”


Internet Info


“A Trillion Little Subsidies: The Economic Impact of Tax Expenditures in the Federal Income Tax Code,” Mercatus Center: http://news.heartland.org/policy-documents/trillion-little-subsidies-economic-impact-tax-expenditures-federal-income-tax-code