A RECONSIDERATION OF TAX EXPENDITURE ANALYSIS 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

May 12, 2008 

JCX-37-08 
i 

CONTENTS

Page

SUMMARY.................................................................................................................................... 1 

I. OVERVIEW OF JCT STAFF TAX EXPENDITURE PROJECT..................................... 2 

A. Original Goals of Tax Expenditure Analysis................................................................ 2 

B. Has the Enterprise Succeeded? ..................................................................................... 4 

C. Why Revisit Tax Expenditure Analysis Now? ............................................................. 7 

D. Proposed New Approach .............................................................................................. 9 

E. Subcategories of Tax Subsidies .................................................................................. 12 

1. Tax Transfers ........................................................................................................ 12 

2. Social Spending .................................................................................................... 12 

3. Business Synthetic Spending ................................................................................ 13 

F. Estimating the Magnitude of Tax Expenditures ......................................................... 14 

G. Outline of Subsequent Work....................................................................................... 16 

II. THE DEVELOPMENT OF TAX EXPENDITURE ANALYSIS.................................... 18 

A. The Tax Expenditure Budget’s Origins and Statutory Basis...................................... 18 

B. The Congressional Budget Act of 1974...................................................................... 20 

C. JCT Staff Implementation of Tax Expenditure Analysis............................................ 22 

D. Treasury Department Analysis: The Shift to a Reference Law Baseline .................. 25 

E. Recent Treasury Department Analyses....................................................................... 28 

III. CRITIQUES OF THE TAX EXPENDITURE CONCEPT.............................................. 29 

A. The Design of the Normal Tax Base........................................................................... 29 

B. The “Normal” Tax as a Tax Reform Agenda ............................................................. 34 

C. Tax “Exceptionalism”................................................................................................. 35 

D. The “Last Penny” Argument....................................................................................... 35 

E. Analysis of the Criticisms........................................................................................... 35 

IV. REVISED TAX EXPENDITURE TAXONOMY............................................................ 39 

A. Introduction................................................................................................................. 39 

B. Tax Subsidies.............................................................................................................. 39 

C. Tax-Induced Structural Distortions............................................................................. 41 

D. Comparison to Treasury Department Approach......................................................... 42 

E. Subcategories of Tax Subsidies .................................................................................. 43 

1. Social Spending .................................................................................................... 44 

2. Business Synthetic Spending ................................................................................ 45 

3. Utility of Tax Subsidy subcategories.................................................................... 46 

F. Miscellaneous Considerations .................................................................................... 47 

V. ECONOMIC CONSIDERATIONS IN TAX EXPENDITURE ANALYSIS.................. 48 

A. Introduction to the Economic Evaluation of Tax Expenditures.................................. 48 

1. Overview............................................................................................................... 48 

2. Equity.................................................................................................................... 50
ii 

3. Efficiency.............................................................................................................. 53 

4. Ease of administration........................................................................................... 56 

B. Theoretical Economic Research on Tax Expenditures ............................................... 58 

C. Evaluating the Design of Tax Expenditures ............................................................... 62 

1. Transparency......................................................................................................... 62 

2. Targeting............................................................................................................... 64 

3. Certainty................................................................................................................ 65 

D. Application of Economic Analysis to Selected Tax Subsidies................................... 68 

1. Refundable earned income credit.......................................................................... 68 

2. Individual retirement accounts.............................................................................. 72 

3. Research and experimentation tax credit .............................................................. 74 

VI. ESTIMATING METHODOLOGY.................................................................................. 78 

A. Recent Tax Expenditure Estimating Methodology..................................................... 78 

B. Tax Expenditure Estimates Generally ........................................................................ 81 

C. New Methodology ...................................................................................................... 83 

1. The baseline and presentation............................................................................... 83 

2. Miscellaneous methodological issues................................................................... 83 

3. Areas for further research and development......................................................... 84 
1 

SUMMARY 

This document,1 prepared by the staff of the Joint Committee on Taxation (the “JCT 

Staff”), reconsiders the utility of the JCT Staff’s current implementation of tax expenditure 

analysis. Tax expenditure analysis can and should serve as an effective and neutral analytical 

tool for policymakers in their consideration of individual tax proposals or larger tax reforms. Its 

efficacy has been undercut substantially, however, by the depth and breadth of the criticisms 

leveled against it. Tax expenditure analysis no longer provides policymakers with credible 

insights into the equity, efficiency, and ease of administration issues raised by a new proposal or 

by present law, because the premise of the analysis (the validity of the “normal” tax base) is not 

universally accepted. Driven off track by seemingly endless debates about what should and 

should not be included in the “normal” tax base, tax expenditure analysis today does not advance 

either of the two goals that inspired its original proponents: clarifying the aggregate size and 

application of government expenditures, and improving the Internal Revenue Code. The JCT 

Staff therefore has begun a project to rethink how best to articulate the principles of tax 

expenditure analysis, in order to improve the doctrine’s utility to policymakers, reemphasize its 

neutrality, and address the concerns raised by many commentators. 

This pamphlet introduces a new paradigm for classifying tax provisions as tax 

expenditures. Our revised classification divides the universe of such provisions into two main 

categories: tax expenditures that can be identified by reference to the general rules of the existing 

Internal Revenue Code (not, as is the current practice, by reference to a hypothetical “normal” 

tax), which we label “Tax Subsidies,” and a new category that we have termed “Tax-Induced 

Structural Distortions.” The two categories together cover much the same ground as does the 

current definition of tax expenditures, and in some cases extend the application of the concept 

further. The revised approach does so, however, without relying on a hypothetical “normal” tax 

to determine what constitutes a tax expenditure, and without holding up that “normal” tax as an 

implicit criticism of present law. The result should be a more principled and neutral approach to 

the issues. 

Section I of this pamphlet presents an overview. It briefly reviews the concept of tax 

expenditure analysis, explains the reasons for revisiting it now, and introduces the new paradigm 

for categorizing tax expenditures. Section II outlines the development of tax expenditure 

analysis and describes how that doctrine is used today by the JCT Staff and by the Treasury 

Department. Section III summarizes commentators’ principal objections to how tax expenditure 

analysis is currently implemented. Section IV responds to those criticisms by describing in detail 

our new taxonomy of tax expenditures. Section V explains the economic considerations that 

underlie tax expenditures and applies that economic thinking to our new paradigm. Finally, 

Section VI reviews some of the issues associated with quantifying tax expenditures under the 

revised definitions. 

 1

 This document may be cited as follows: Joint Committee on Taxation, A Reconsideration of 

Tax Expenditure Analysis (JCX-37-08), May 12, 2008. This document can also be found on our website 

at www.house.gov/jct. 
2 

I. OVERVIEW OF JCT STAFF TAX EXPENDITURE PROJECT 

A. Original Goals of Tax Expenditure Analysis 

In 1967, Assistant Secretary of the Treasury for Tax Policy Stanley Surrey introduced to 

U.S. tax policy discussions the phrase “tax expenditures.” Surrey used the term to refer to 

provisions of the Internal Revenue Code that are deliberate departures from generally accepted 

concepts of net income (usually by way of special exemptions, deductions, credits or exclusions) 

and that affect the private economy in ways that usually are accomplished by direct government 

spending.2 In Surrey’s view: 

The federal income tax system consists really of two parts: one part comprises the 

structural provisions necessary to implement the income tax on individual and 

corporate net income; the second part comprises a system of tax expenditures 

under which Governmental financial assistance programs are carried out through 

special tax provisions rather than through direct Government expenditures. This 

second system is grafted on to the structure of the income tax proper; it has no 

basic relation to that structure and is not necessary to its operation. Instead, the 

system of tax expenditures provides a vast subsidy apparatus that uses the 

mechanics of the income tax as the method of paying the subsidies.3

Surrey believed that a close analysis of tax expenditures could lead to better “expenditure 

control” by the Congress, through a more complete accounting for government expenditures 

regardless of their form. Surrey further anticipated that tax expenditure analysis would be helpful 

in fashioning “tax reform” policies.4

 

Surrey’s “expenditure control” theory rested on his belief that tax expenditures escaped 

the scrutiny applied to actual appropriations programs. Surrey hoped that the regular publication 

of a “tax expenditure budget” would induce Congress to abandon narrowly-constructed tax 

incentives and subsidies.5 He anticipated that, once tax expenditures were identified and clearly 

displayed as government spending substitutes, subsequent dissection would reveal them to be 

poorly targeted or inefficient, when compared either to an actual government spending program, 

 2

 Stanley S. Surrey, Excerpts from remarks before The Money Marketeers on The U.S. Income 

Tax System -- the Need for a Full Accounting, November 15, 1967, in United States Department of the 

Treasury, Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year 

Ended June 30, 1968 (Washington, D.C., Government Printing Office, 1969) at 322. 

3

 Stanley S. Surrey, Pathways to Tax Reform 6 (Cambridge, Mass., Harvard University Press, 

1973). 

4

 Excerpts from remarks before the Money Marketeers, supra; see also Pathways to Tax Reform, 

supra, at 30-49 (describing uses of a tax expenditure budget). 

5

 See Stanley S. Surrey, The Federal Tax System--Current Activities and Future Possibilities, 

(speech before Boston Economic Club, May 15, 1968), in Annual Report of the Secretary of the Treasury 

on the State of the Finances for the fiscal year ended June 30, 1968, supra at 313. 
3 

or (in most cases) when compared to not expending government resources at all. In this way, the 

“expenditure control” agenda would be advanced.6

Surrey also saw tax expenditure analysis as playing a vital role in tax policy debates. In 

particular, Surrey believed that many tax expenditures violated consensus principles of tax 

equity, economic efficiency or ease of administration. Surrey hoped that, by rephrasing “tax 

incentive” proposals as “tax expenditures,” and then by analyzing the equity, efficiency and 

administrative consequences of those proposals as if they were spending requests, policymakers 

would recognize that many such proposals were inconsistent with the goal of a fair, efficient and 

simple income tax system.7

In the forty years since Surrey introduced the term to U.S. tax policy discourse, 

policymakers have relied on tax expenditure analysis to judge the policy implications of 

individual tax proposals, to gauge the overall health of the Federal income tax system, and to 

measure the aggregate governmental resources devoted to particular policies. Since 1974, 

Federal law has required the Congressional Budget Office (“CBO”) and the Treasury 

Department annually to publish detailed lists of tax expenditures. (In light of the traditional 

expertise of the JCT Staff in respect of revenue matters, and a separate statutory requirement that 

Congress rely on JCT Staff estimates when considering the revenue effects of proposed 

legislation,8

 the CBO has always relied on the JCT Staff for the production of this annual tax 

expenditure publication.) Other Federal organizations (e.g., the Congressional Research Service) 

also employ the principles of tax expenditure analysis when analyzing Federal income tax 

policies. 

 6

 Stanley S. Surrey and Paul R. McDaniel, Tax Expenditures 32-37 (Cambridge, Mass., Harvard 

University Press, 1985). 

7

 Id. at 25-27, 69-98. 

8

 P.L. 93-344 §201(g), codified at 2 USC 601(f). 
4 

B. Has the Enterprise Succeeded? 

Surrey’s original hope that tax expenditure analysis would have a salutary effect on 

budget transparency (and through that, on actual budget outlays) has not been realized, for 

several reasons. First, tax laws and appropriations follow completely different paths through 

Congress, and in particular are developed by different substantive committees. As a result, in 

practice one type of legislation does not substitute for the other.9 Second, many tax expenditures 

have vaguely similar distributional effects to those achieved through spending programs, but the 

two delivery systems are so different that in many cases each is a highly imperfect economic 

substitute for the other. Third, as a result of contemporary “pay-as-you-go,” or “PAYGO” 

requirements, policymakers today typically pair tax expenditures against tax revenue-raising 

measures, rather than proposing them as a direct substitute for spending programs. Finally, many 

commentators believe that, as budget and other pressures have made it more difficult to advance 

policies through the appropriations process, policymakers have wholeheartedly embraced tax 

expenditures as a second best means of implementing their policy agendas. 

In fact, Congress’s use of tax expenditures has accelerated over the years. In 1972, for 

example, the JCT Staff’s first description of tax expenditures totaled some 60 items.10 Our 2007 

pamphlet, by contrast, while employing essentially the same methodology as that of our first 

description 35 years earlier, listed 170 tax expenditures.11

The importance of tax expenditures in dollar terms can be seen by comparing actual 

Federal discretionary outlays to the aggregate amount of tax expenditures. Figure 1, below, 

shows estimated budget outlays by spending category for fiscal year 2009. In fiscal year 2009, 

the Federal government projects annual total outlays of more than $3.1 trillion. Of this amount, 

roughly $1.6 trillion will go to mandatory spending programs including Social Security, 

Medicare and Medicaid; $730 billion will go to defense and national security programs; and 

$260 billion will go to service the national debt. This leaves a projected $482 billion for nondefense discretionary spending of all types. 

 9

 See Emil Sunley, Tax Expenditures in the United States: Experience and Practice 155, 166, in 

Hana Pulackova Brixi, Christian M.A. Valenduc, and Zhicheg Li Swift, eds., Tax Expenditures—

Shedding Light on Government Spending Through the Tax System (2004) (“I can recall only one time 

when Congress traded off a tax expenditure [tax deduction for adoption expenses] for a direct spending 

program, and that trade-off was possible only because the tax-writing committees also have jurisdiction 

over welfare and income support.”). 

10 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Calendar Years 1967 

through 1971 (JCS-28-72), October 4, 1972. 

11 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-

2011 (JCS-3-07), September 24, 2007. 
5 

Figure 1.–FY2009 Estimated Budget Outlays by Category

Amounts in Billions of Dollars

Medicaid and SCHIP

$224 B

Net Interest

$260 B

Other Mandatory Spending 

$360 B

Medicare

$408 B

Social Security

$644 B

Non-security Discretionary 

$482 B

Defense and Security

 $730 B

JCT Staff published tax expenditure calculations cannot be compared directly with these 

projected actual expenditures, because our tax expenditure figures calculate the nominal 

revenues forgone by the existence of the rule in question, not the revenues that would be raised 

by repealing the rule; the two are not the same because actual repeal would have behavioral 

consequences that would affect post-repeal revenue collections. Moreover, tax expenditures are 

not additive, due to behavioral and other issues. Nonetheless, an indication of the relative 

magnitude of tax expenditures can be ascertained from the JCT Staff estimates contained in the 

CBO publication Budget Options, which are the revenue estimates.

12 

For fiscal year 2009, implementation of ten of these options developed by CBO, chosen 

for both quantitative importance and the degree to which they match up with the JCT Staff’s 

most recent tax expenditure list, would increase revenue by about $250 billion (without taking 

into account potential interactions between the provisions).13 Some of these options do not 

 12 Congressional Budget Office, Budget Options (February 2007), 

<http://www.cbo.gov/doc.cfm?index=7821>. 

13 Revenue Options 7b, 8a, 10, 13, 15, 18, 23, 28, 35, and 43. These items are, respectively: 

repeal of the mortgage interest deduction and conversion of the mortgage interest deduction to a credit for 

primary residence mortgages under $400,000; elimination of the deductions of state and local taxes; 

limitation on the deductions for charitable giving to amounts exceeding two percent of adjusted gross 
6 

represent full repeal of the underlying tax expenditure; for example, the CBO revenue options 

list includes converting the home mortgage interest deduction to a tax credit at an effective 15 

percent rate for primary residence mortgages below $400,000, but preserves the tax benefits of 

home mortgage interest payments to that extent. Moreover, while these ten options are among 

the larger revenue raisers on the CBO list, these options do not correspond strictly to the ten 

largest tax expenditures contained in our most recent tax expenditure pamphlet. Yet even so, 

they amount to more than half of all government non-defense discretionary spending. Their 

magnitude illustrates the enormous importance of tax expenditures today, relative to actual nondefense discretionary appropriations.14

In sum, there is scant evidence that tax expenditure analysis has succeeded in its first 

mission of “expenditure control.” That does not mean, however, that tax expenditure analysis has 

failed, but rather that its principal utility appears to have been as a tool of tax policy and tax 

distributional analysis. The rhetoric of tax expenditure analysis, and the economic reasoning that 

underlies that rhetoric, in fact can provide a successful framework by which to judge the fairness, 

efficiency and administrative consequences of many “incentive” proposals. Policymakers further 

can look to tax expenditure analysis to provide insight into “base broadening” and similar 

measures. 

For these reasons, as well as the practical points made earlier, we believe it appropriate to 

proceed on the basis that tax expenditure analysis today is most usefully described as primarily a 

tool of tax policy. This pamphlet in turn attempts to reinvigorate the utility of tax expenditure 

analysis in making tax policy decisions, by responding to the criticisms that have been leveled 

against it, and by describing the analytical power of its underlying economic reasoning. 

 

income; inclusion of employer-paid premiums for income-replacement insurance in employees’ taxable 

income; reduction in the tax exclusion for employer-paid health insurance; elimination of the child tax 

credit; repeal of the expensing of exploration and development costs for extractive industries; repeal of 

the deduction for domestic production activities; and elimination of the source rules exception for exports. 

14 We emphasize that these ten CBO options are listed simply to demonstrate the magnitude of 

tax expenditures today, not to suggest in any way that these particular revenue options necessarily 

represent desirable tax policy or should be adopted into law. 
7 

C. Why Revisit Tax Expenditure Analysis Now? 

As currently applied, tax expenditure analysis is less helpful to policymakers in 

fashioning tax policy than might otherwise be the case, because the proponents of tax 

expenditure analysis generally have failed to respond convincingly to the important criticisms 

leveled against it. Tax expenditure analysis has always been controversial, and there is today a 

voluminous literature criticizing its premises and implementation as a tool of tax policy. 

Many tax academics and policy experts have criticized tax expenditure analysis as resting 

on insufficiently rigorous foundations. These critics argue that the ideal “normal” tax system 

from which tax expenditures are identified does not correspond to any generally accepted formal 

definition of net income. Some observers further view tax expenditure analysis, in the form 

currently implemented, as a thinly veiled agenda for a specific form of tax reform. Under this 

view, the normative tax system at the heart of tax expenditure analysis is not simply an analytical 

tool, but is also an aspirational goal of the process. Others have questioned whether tax 

expenditure analysis serves any purpose at all, because the doctrine appears to these critics to rest 

on the unexamined premise that the tax laws should be uniquely “privileged,” through not being 

burdened by the political compromises and policy agendas reflected in appropriations legislation. 

Finally, some critics question the narrow focus on subsidies that are favorable to taxpayers, 

noting that there also are narrowly punitive provisions in the Internal Revenue Code. All these 

criticisms have gone largely unanswered. 

The most important of these criticisms is the objection to the “normal” tax system.15 In 

current tax expenditure analysis, the “normal” tax plays three roles. First, it serves as the 

benchmark against which present law tax provisions are measured to determine whether they 

constitute tax expenditures. Second, the “normal” tax operates, at least in the view of some, as 

an implicit reproach to the current tax system, through being held up as an aspirational but 

achievable superior tax system. Third, the “normal” tax serves as the baseline from which to 

calculate the dollar magnitude of a particular tax expenditure. 

The first two of these roles elevate the importance of the “normal” tax to a level it cannot 

support, because the “normal” tax is largely a commonsense extension (and cleansing) of current 

tax policies, not a rigorous tax framework developed from first principles. As a result, the 

“normal” tax cannot be defended from criticism as a series of ultimately idiosyncratic or 

pragmatic choices. If tax expenditure analysis is to enjoy broad support, it must be seen as 

neutral and principled; unfortunately, the “normal” tax satisfies these requirements only in the 

eyes of those who already believe that the “normal” tax accurately captures their personal ideal 

of a tax system. 

To summarize, tax expenditure analysis can and should serve as an effective and neutral 

analytical tool for policymakers in their consideration of individual tax proposals or larger tax 

reforms. Its efficacy has been undercut substantially, however, by the depth and breadth of the 

criticisms leveled against it. Tax expenditure analysis no longer provides policymakers with 

 15 See, e.g., Boris I. Bittker, Accounting for Federal “Tax Subsidies” in the National Budget, 22 

National Tax Journal 244 (1969). 
8 

credible insights into the equity, efficiency, and ease of administration issues raised by a new 

proposal or by present law, because the premise of the analysis (the validity of the “normal” tax 

base) is not universally accepted. Driven off track by seemingly endless debates about what 

should and should not be included in the “normal” tax base, tax expenditure analysis today does 

not advance either of the two goals that inspired its original proponents: clarifying the aggregate 

size and application of government expenditures, and improving the Internal Revenue Code. The 

JCT Staff therefore has begun a project to rethink how best to articulate the principles of tax 

expenditure analysis, in order to improve the doctrine’s utility to policymakers, reemphasize its 

neutrality, and address the concerns raised by many commentators. 
9 

D. Proposed New Approach 

This pamphlet introduces a new approach to classifying tax provisions as tax 

expenditures. Our revised paradigm attempts in particular to respond to what we believe to be the 

most important consensus objections to the current articulation of tax expenditure analysis. First, 

in many cases, it is not possible to identify in a neutral manner the terms of the “normal” tax to 

which present law should be compared. Second, many observers believe that the “normal” tax 

has been fashioned, not simply to serve as the baseline from which to identify tax expenditures, 

but also to advocate the adoption of that “normal” tax into law, by presenting it as an aspirational 

but achievable tax system that is superior to the current Internal Revenue Code. 

To address these concerns, the revised classification of tax expenditures divides the 

universe of such provisions into two main categories: tax expenditures in a narrow sense (as 

explained below), which we label “Tax Subsidies,” and a new category that we have termed 

“Tax-Induced Structural Distortions.” The two categories together cover much the same ground 

as does the current definition of tax expenditures, and in some cases extends the application of 

the concept further. The revised approach does so, however, without relying on a hypothetical 

“normal” tax to determine what constitutes a tax expenditure, and without holding up that 

“normal” tax as an implicit criticism of present law. The result should be a more principled and 

neutral approach to the issues. 

Our approach to “Tax Subsidies” (that is, tax expenditures in a narrow sense) builds 

loosely on the work of Seymour Fiekowsky and others, by defining a “Tax Subsidy” as a specific 

tax provision that is deliberately inconsistent with an identifiable general rule of the present tax 

law (not a hypothetical “normal” tax), and that collects less revenue than does the general rule. 

(We refer to the converse case, of an exception that deliberately overtaxes compared to the 

general rule, as a “Negative Tax Subsidy.”) In practice, our conception of the compilation of 

general rules that together comprise our baseline for identifying Tax Subsidies corresponds 

closely to the Treasury Department’s “reference tax” baseline in its tax expenditure analyses. 

The Tax Subsidy tax base is constructed by asking what constitutes the general rule, and 

what the exception, under actual present law. Our determination of Tax Subsidies in most cases 

thus is made, not by reference to an alternative and hypothetical “normal” tax chosen by the JCT 

Staff, but rather by reference to the face of the Internal Revenue Code itself (along with its 

legislative history and similar straightforward tools for identifying legislative intent). 

We anticipate that our category of Tax Subsidies will comprise the preponderance of 

items that today are classified as tax expenditures. Some important provisions currently 

identified as tax expenditures, however, cannot easily be described as exceptions to a general 

rule of present law, because the general rule is not clear from the face of the Internal Revenue 

Code. In light of this ambiguity, such a provision cannot properly be classified as a tax 

expenditure (more accurately, a Tax Subsidy) in the proposed narrower sense. If the JCT Staff 

were to attempt to expand the scope of Tax Subsidies to address these important policy questions 

by arbitrarily selecting one taxing pattern or another as the general rule, the result would be the 
10 

same sort of subjective determinations that undermine the utility of a “normal” tax base in the 

current implementation of tax expenditure analysis.16 

As an example, consider the present law’s “deferral” treatment of the earnings of foreign 

corporations owned by U.S. persons. To date, annual JCT Staff tax expenditure pamphlets have 

treated this provision as a tax expenditure, because the “normal” tax originally was defined to 

treat subpart F as the rule, and the deferral of “active” foreign earnings as the exception. This 

provision would not, however, be classified as a Tax Subsidy under our proposed definition, 

because present law can fairly be said to be ambiguous as to what constitutes the general rule for 

taxing foreign earnings.17 

While they may not constitute Tax Subsidies, items like the “deferral” treatment of 

foreign earnings raise important tax policy issues. Moreover, present law’s treatment of these 

provisions can be criticized on strict economic efficiency grounds.18 Tax expenditure analysis as 

currently implemented identifies some of these issues, but does so by reference to the “normal” 

tax baseline. The result is a sterile debate as to the appropriateness of the choice of that base, 

which in turn obscures rather than illuminates the important economic efficiency problems that 

current policies embody. 

Our response to the insufficiencies of an inappropriately narrow definition of tax 

expenditures is to create a second major category of tax expenditures alongside Tax Subsidies, 

which we have labeled “Tax-Induced Structural Distortions.” These we define as structural 

elements of the Internal Revenue Code (not deviations from any clearly identifiable general tax 

rule and thus not Tax Subsidies) that materially affect economic decisions in a manner that 

imposes substantial economic efficiency costs.19 

As one example, the “deferral” treatment of foreign earnings will be classified as a TaxInduced Structural Distortion. Another example is the differential taxation of debt and equity. 

The distinction between debt and equity encourages business firms to leverage their capital 

structures in ways that have large economic efficiency consequences, but the distinction is not a 

tax expenditure (Tax Subsidy) in the narrow sense, because there is no clear consensus as to 

what general rule of tax law, if any, the debt-equity distinction might violate. 

 16 See Victor Thuronyi, Tax Expenditures: A Reassessment, 1988 Duke Law Journal 1155, 1182-

1186 (1988). 

17 See J. Clifton Fleming, Jr. and Robert J. Peroni, Reinvigorating Tax Expenditure Analysis and 

its International Dimension, 27 Virginia Tax Review 101, 196-197 (2008). 

18 Section V.A of this pamphlet explains the concept of economic efficiency in the context of tax 

expenditure analysis. 

19 While tax expenditure analysis can be helpful in identifying equity and ease of administration 

issues as well as efficiency concerns, for reasons developed in Section IV our definition of Tax-Induced 

Structural Distortions looks only to the last of these criteria. 
11 

We recognize that a few items that today are classified as tax expenditures may not fit 

neatly either as Tax Subsidies or as Tax-Induced Structural Distortions. We propose to continue 

to carry those items on our tax expenditure tables to preserve continuity with all of our prior 

work in this area. We will reevaluate this decision periodically, in light of the success (or 

failure) of the new approach proposed here. 

Finally, the JCT Staff’s revised approach to tax expenditure analysis further expands the 

traditional definition by identifying special provisions that increase the tax burden (above what 

the general rule would impose) as “negative” tax expenditures. (As previously noted, we label 

these provisions “Negative Tax Subsidies.”) Limitations directly linked to various positive tax 

expenditures, the alternative minimum tax, and the limitation of itemized deductions are not 

classified as negative tax expenditures but instead are considered reductions in those positive 

expenditures. 
12 

E. Subcategories of Tax Subsidies 

The JCT Staff believes that it would be helpful to policymakers to divide Tax Subsidies 

(i.e., tax expenditures in the narrow sense) into three subcategories. Section IV explains our 

thinking behind these divisions in more detail. 

We propose these subdivisions with some reservations, because plausible arguments can 

be made to categorize many items in more than one subcategory, and we would not wish for 

classification arguments again to rob tax expenditure analysis of its productive power. We 

therefore emphasize that these subcategories are meant only to help policymakers to compare 

Tax Subsidies of like kind to one another. Regardless of the subcategories to which we have 

assigned them, all Tax Subsidies rely on the same fundamental definition. 

The subcategories of Tax Subsidies are as follows: 

1. Tax Transfers 

Tax Transfers generally are payments to persons made without regard to their income tax 

liability, usually because there was no income tax liability to begin with, or because the person’s 

income tax liability was eliminated by another tax subsidy.20 In contrast, Tax Subsidies other 

than Tax Transfers only reduce (or increase, in the case of Negative Tax Subsidies) a taxpayer’s 

income tax liability. 

The subcategory of Tax Transfers today comprises the refundable portions of the earned 

income tax credit, child tax credit and the 2008 rebate. These provisions usually are based on 

perceived need as measured by income. The provisions authorizing these payments are the 

clearest examples of hybrid tax/spending programs, i.e., they are essentially direct government 

spending programs that use the tax system for distribution.21 

2. Social Spending 

This subcategory of Tax Subsidies includes Tax Subsidies that are unrelated to the 

production of business income and Tax Subsidies related to the supply of labor. These Tax 

Subsidies often are intended to subsidize or induce behavior (for example, charitable giving) that 

generally is considered to be unconnected to the production of business income. Examples 

include the itemized deduction for healthcare expenses, Individual Retirement Account (“IRA”) 

deductions (or exclusions, in the case of Roth IRAs), and the nonrefundable portion of the child 

tax credit. This category also includes the portions of the earned income credit, child tax credit 

and 2008 rebate that are not refundable. 

 20 For evaluation purposes, the refundable portion of a tax expenditure is considered separately 

from the nonrefundable portion.

21 Tax Transfers are also among the tax expenditures that are close substitutes for existing direct 

government spending programs. For example, the refundable portion of the earned income credit and 

child tax credit are similar to non-tax-related government programs (both Federal and State and local) that 

address financial need and encourage employment of low-income persons.
13 

In cases where a provision has potentially both business and non-business statutory 

incidence, we classify the provision based on a judgment about the effect and/or the intent of the 

provision. Thus, for example, we treat working-condition fringe benefits, which are excludible 

from employee income (but deductible by businesses), as Tax Subsidies in the Social Spending 

category rather than in the Business Synthetic Spending category (described below) because this 

treatment of fringe benefits is generally viewed by analysts as affecting labor supply more than 

general business decisions.22 By the same token, IRAs, owing to their role in capital 

accumulation, are Tax Subsidies that have a link to Business Synthetic Spending. Nevertheless, 

we classify them as Social Spending, because so much of their design, including their mandatory 

distribution requirements, is geared toward income support for retirement. 

When legislative intent is not readily discernible, the item generally will be classified 

according to whether or not it is linked directly to production of business income. Thus, we will 

classify most education subsidies as Social Spending, while various capital income subsidies will 

be classified as Business Synthetic Spending (or in some cases these items will show up in the 

other first-order category, as Tax-Induced Structural Distortions). 

Owner-occupied housing preferences can rationally be categorized either as Social 

Spending or in the subcategory of Business Synthetic Spending, depending on whether one 

views home ownership as primarily a consumption activity or as a substitute for an incomeproducing investment. On balance, we believe that they are better described here. Doing so 

acknowledges that preferences for owner-occupied housing reflect a social policy agenda that 

transcends the tax law. Moreover, it is more straightforward for non-economists to understand 

the tax treatment of housing as an exception to the general rule for personal expenditures (no 

deduction of interest expense or other costs) than it is to see the homeowner as forgoing the 

rental income that could have been obtained were the housing made available for arm’s-length 

rental. 

3. Business Synthetic Spending 

This category includes Tax Subsidies intended to subsidize or induce behavior directly 

related to the production of business or investment income but excludes any Tax Subsidies 

related to the supply of labor. Examples of Business Synthetic Spending include the section 199 

deduction for income attributable to domestic production activities, the completed contract 

method of accounting rules, various energy subsidies, the last-in-first-out method of accounting 

and the expensing of soil and water conservation payments. 

 22 The legislative and executive branch histories of enactment and implementation of these 

provisions also support this incidence assumption, because this tax treatment of fringe benefits primarily 

was considered to affect decisions about labor supply and other laborer concerns such as health and 

retirement. 
14 

F. Estimating the Magnitude of Tax Expenditures 

The JCT Staff’s current quantification methodologies for tax expenditures are not 

tantamount to revenue estimates, for two critically important reasons. First, our annual tax 

expenditure tables do not take into account the many large interactive effects that would be 

observed if Congress were simultaneously to repeal all the many tax expenditures that appear on 

our tables. Second, by tradition, tax expenditures are calculated on a static basis: that is, the 

behavioral consequences that would follow from repeal are ignored. By contrast, the JCT Staff’s 

actual revenue estimates fully reflect anticipated behavioral effects of the proposal under 

consideration, subject only to the constraint that in the usual case we do not model any 

macroeconomic growth effects from the proposal.23 

While the principal thrust of the JCT Staff’s revised approach to tax expenditure analysis 

is to deemphasize the relevance of the “normal” tax as much as possible, the new approach must 

still define a baseline from which to measure the magnitude of tax expenditures. As previously 

described, current tax expenditure analysis employs the “normal” tax as the baseline from which 

the JCT Staff can calculate the dollar magnitude of a particular tax expenditure. 

By contrast, there is no single objective unit of measurement for determining the 

magnitude of all the provisions that fall within the two-pronged definition of tax expenditures 

recommended here. The revenues forgone by Tax Subsidies can be calculated by reference to 

the general rules of the Internal Revenue Code, but by definition this strategy does not work for 

Tax-Induced Structural Distortions, which are so classified specifically because there is 

ambiguity as to what is the present law general rule and what is the exception. 

On balance, we believe that the most feasible approach, and the one most consonant with 

the original legislative history of the Congressional Budget Act of 1974 is to follow general 

present-law tax rules (what the Treasury Department calls its reference tax base) for Tax 

Subsidies. We will further supplement that information with data for those Tax-Induced 

Structural Distortions that today are analyzed as tax expenditures by applying our current 

definition of the normal tax, as reflected in our recent annual tax expenditure pamphlets, solely

for purposes of this quantification exercise.24 The end result is a bit complex, but has several 

practical benefits. 

First, we believe that the most important benefit of tax expenditure analysis is that it 

provides a useful framework from which to evaluate the equity, efficiency and administrative 

issues raised by a new proposal or present law. For this purpose, the categorization of the rule in 

question (as a Tax Subsidy, a Tax-Induced Structural Distortion, or not a tax expenditure at all) 

is more important than the quantification of the revenue forgone by the provision. Second, 

unless we are to quantify the forgone revenues only of Tax Subsidies, some baseline that is more 

 23 Inside the JCT Revenue Estimating Process, A presentation by the Chief of Staff of the Joint 

Committee on Taxation to the New York State Bar Association, January 29, 2008. Revised January 30, 

2008, <http://www.house.gov/jct/Inside_Revenue_Estimating.pdf>. 

24 Section VI of this pamphlet expands on these points. 
15 

inclusive than present law is needed, and this one has been developed (and modeled) for many 

years. Third, as described above, the quantification of tax expenditures is not, and has never 

been, intended to serve any purpose beyond providing rough rank ordering of the relative 

importance of different tax expenditures; because the quantification of a tax expenditure has 

never been presented as tantamount to a revenue estimate, the use of the “normal” tax as the 

baseline in a limited number of cases does little practical harm. Finally, this approach preserves 

continuity with our quantitative presentations of tax expenditures in prior years, which we 

believe to be helpful to policymakers and researchers alike. 
16 

G. Outline of Subsequent Work 

We envision this pamphlet as the first of several on this topic that we intend to publish in 

the coming months. The next pamphlet will comprise our annual list of tax expenditures, 

reclassified along the lines described in this document, but limited to those items that we 

describe herein as Tax Subsidies. That pamphlet also will discuss some of the specific reasoning 

that led us to classify a particular Tax Subsidy in one subcategory or another. 

The subsequent document will present a preliminary discussion of selected Tax-Induced 

Structural Distortions. That pamphlet will not recommend any particular solutions, but instead 

will attempt to identify critical economic inefficiencies embedded in the current tax system, and 

then to describe the range of possible solutions (as well as their attendant costs). Of necessity, 

both the list of Tax-Induced Structural Distortions that we set out, and our analyses of them, will 

be preliminary in nature, and we envision substantially revising this pamphlet in particular in 

years to come. Subsequent pamphlets will explore important ancillary themes, like the expansion 

of tax expenditure analysis to excise taxes. 

While we hope that our efforts to reduce the relevance of the idiosyncratic “normal” tax 

are viewed as responsive to the most serious criticisms of current tax expenditure practice, we 

acknowledge that no effort along the lines of a tax expenditure analysis can ever be entirely 

value-free. The unavoidable problem is that, by definition, tax expenditure analysis requires 

comparing actual rules to some hypothetical, whether that hypothetical is entirely exogenous to 

existing law, as in the case of the “normal” tax, or is inferred from circumstantial evidence and 

presented as a general rule in the law today, as advocated in our revised approach. 

In this regard, we recognize that our specific implementation of tax expenditure analysis 

is firmly wedded to the view that the current Internal Revenue Code is at heart an income tax, 

because we employ that perspective when we attempt to identify what are the Code’s general 

rules, and what the exceptions thereto.25 We believe that this approach is consistent with the 

language and history of the Code, as well as with the understanding of policymakers today. It of 

course is possible that subsequent policymakers may embrace a consumption tax as the 

fundamental starting point for a future Internal Revenue Code, at which point we would need to 

revisit many of the conclusions reached in the series of documents that we envision publishing 

over the next several months. 

We welcome comments and suggestions on the contents of this pamphlet as well as the 

overall project. 

 25 For an interesting examination of how tax expenditure analysis might change in a 

consumption tax environment, see Robert Carroll, David Joulfaian, and James Mackie, Income versus 

Consumption Tax Baselines for Tax Expenditures, Paper presented at NBER Conference on Tax 

Expenditures, March 2008. 
17 

Figure 2.−Comparison Chart of Tax Expenditure 

Methodologies

Tax Subsidies

Deviations from a clearly 

identifiable general rule of

present tax law, and collects 

less revenue than general 

rule; provisions that collect 

more revenue than the 

general rule will be labeled 

“negative tax subsidies.”

Tax-Induced Structural Distortions

Structural elements of present tax law 

that materially affect economic 

decisions in a manner that imposes 

substantial economic efficiency cost.

Tax Transfers

E.g., Refundable portion 

of the earned income 

credit and child tax credit.

Social spending

E.g., IRAs, fringe benefits, 

mortgage interest deduction.

Business Synthetic 

Spending

E.g.., Section 199 deduction, 

energy subsidies, R&E credit

Tax Expenditures Under Existing 

Methodology:

Current methodology includes only positive 

tax expenditures identified as referenced to 

the concept of “normal law.”

Historical Continuity

Tax expenditures under 

the existing methodology 

that do not fit into one of 

the other categories, but 

will be continued to be 

carried for reasons of 

historical comparisons.

Other Tax Provisions:

Current methodology excludes negative tax 

expenditures and other tax provisions not 

identified as expenditures as referenced to 

the concept of “normal law.”

Tax Expenditures Under New 

Methodology
18 

II. THE DEVELOPMENT OF TAX EXPENDITURE ANALYSIS 

A. The Tax Expenditure Budget’s Origins and Statutory Basis 

The first analysis of “tax expenditures” appeared in the Treasury Department’s annual 

financial report for the 1968 fiscal year.26 That report, prepared under the guidance of Assistant 

Secretary for Tax Policy Stanley Surrey, implemented Surrey’s earlier call for a “tax expenditure 

budget” that would encourage “expenditure control” and facilitate “tax reform.”27 Surrey hoped 

that a formal identification of tax expenditures as substitutes for direct spending would lead to 

more rigorous analysis of those provisions, revealing them to be poorly targeted or inefficient 

when compared either to actual government spending or (in most cases) to no spending at all.28 

Surrey further believed that an examination of tax expenditures as if they were spending requests 

would demonstrate that many of these provisions are inconsistent with the goal of an equitable, 

efficient and simple income tax system. The 1968 Treasury Report therefore sought to identify 

“the major respects in which the current income tax bases deviate from widely accepted 

definitions of income and standards of business accounting and from the generally accepted 

structure of an income tax” and to provide “estimates of the amount by which each of these 

deviations reduces revenues.”29 

The 1968 Treasury Report did not include a comprehensive description of the definitions 

and standards, or the “generally accepted structure of an income tax,” that served as its baseline 

for the identification of tax expenditures. In fact, the only features that the 1968 Treasury Report 

explicitly included in the “accepted structure” of an income tax are the personal exemptions and 

graduated rates for individuals and the existence of a separate corporate tax. 

 26 United States Department of the Treasury, Annual Report of the Secretary of the Treasury on 

the State of the Finances for the Fiscal Year Ended June 30, 1968, (Washington, D.C., Government 

Printing Office, 1969) (herein, the “1968 Treasury Report”). For its reports on the 1972 and 1974 fiscal 

years, the Treasury Department collaborated with the JCT Staff. 

27 Stanley S. Surrey, Excerpts from remarks before The Money Marketeers on The U.S. Income 

Tax System -- the Need for a Full Accounting, November 15, 1967, in the 1968 Treasury Report, supra at 

322; see also Pathways to Tax Reform, supra, at 30-49 (describing uses of a tax expenditure budget). 

28 Surrey, The Federal Tax System--Current Activities and Future Possibilities (speech before 

Boston Economic Club, May 15, 1968), in the 1968 Treasury Report, supra at 313 (“I doubt that any of 

these special tax treatments could stand the scrutiny of careful program analysis, and I doubt that if these 

were direct expenditure programs we would tolerate for very long the inefficiencies that such program 

analysis would reveal.”). 

29 1968 Treasury Report, supra at 327. Consistent with Surrey’s goal of expenditure control, the 

1968 and later Treasury Reports presented tax expenditures in the same functional categories under which 

direct expenditures are classified in the Federal budget. 
19 

Surrey later conceded that the early Treasury Reports had relied in part on the HaigSimons definition of personal income30 as “the algebraic sum of (1) the market value of rights 

exercised in consumption and (2) the change in the value of the store of property rights between 

the beginning and end of the period in question.”31 This definition, however, provides only a 

general framework for analysis. As numerous critics have pointed out, the Haig-Simons 

definition says nothing about most of the structural issues that must be decided under any income 

tax law, such as the rate structure, the proper taxpaying unit and the proper accounting period. 

The meaning of the term “consumption” is also debatable; there is no strong consensus, for 

example, as to how items such as gifts, charitable contributions and medical expenses should be 

treated under this standard. Other features of the Haig-Simons definition, such as the inclusion 

of imputed income from owner-occupied housing, pose significant administrative obstacles.32 

Surrey therefore refined the Haig-Simons definition by incorporating what he described 

as “widely accepted” definitions and standards and “generally accepted” structural features. 

Thus, he treated certain items, such as the failure to tax imputed rent from owner-occupied 

homes, as part of the normal tax baseline “where the case for their inclusion in the income base 

stands on relatively technical or theoretical tax arguments.”33 His baseline included the personal 

exemptions and graduated rates for individuals, on the grounds that those features were “part of 

the structure of an income tax based on ability to pay.”34 He also included a separate corporate 

income tax in the baseline on the grounds that U.S. tax policy had accepted the concept, 

notwithstanding that strong arguments could be made that integrated taxation of corporations and 

shareholders would better implement the Haig-Simons definition. Numerous other structural 

issues were revealed only through his choices for the list of tax expenditures.35 

 30 Responding to criticism from Boris Bittker, Surrey initially denied that the Haig-Simons 

definition of income had served as the model for the Treasury tax expenditure project. See Stanley S. 

Surrey and William F. Hellmuth, The Tax Expenditure Budget -- Response to Professor Bittker, 22 

National Tax Journal 528, 531 (1969). In later writings, however, Surrey was much more explicit about 

the use of Haig-Simons as the “normative tax” on which his tax expenditure analysis was based: “Tax 

expenditure analysis, as applied to a particular tax, requires an understanding of the normative structure of 

that tax in order to determine whether a provision is a part of the structural or the tax expenditure 

component. In the U.S. analysis of income tax expenditures, the normative concept of net income is 

based on the Schanz-Haig-Simons economic definition of income . . . .” Stanley S. Surrey and Paul R. 

McDaniel, Tax Expenditures, supra at 3. 

31 Henry C. Simons, Personal Income Taxation (Chicago, University of Chicago Press, 1938).

32 See Thuronyi, supra at 1165. 

33 1968 Treasury Report, supra at 329. 

34 1968 Treasury Report, supra at 329. 

35 Some items were omitted from the list for practical reasons, such as the perceived difficulty of 

estimating the magnitude of the subsidy (e.g., accelerated depreciation) or the relatively small size of the 

subsidy. 
20 

B. The Congressional Budget Act of 1974 

Congress soon embraced Surrey’s concept of tax expenditure analysis in the 

Congressional Budget Act of 1974 (herein, the “Budget Act”).36 Consistent with Surrey’s vision 

of expenditure control, the House and Senate Budget Committees (created by the Budget Act) 

were charged with the duty “to request and evaluate continuing studies of tax expenditures, to 

devise methods of coordinating tax expenditures, policies, and programs with direct budget 

outlays, and to report the results of such studies” to the respective chamber of Congress on a 

recurring basis.37 To assist in that effort, the CBO (also created by the Budget Act) was required 

to produce an annual tax expenditure budget,38 and the Executive Branch was required to include 

a tax expenditure budget in the annual President’s Budget transmittal to Congress.39 

The Budget Act defines tax expenditures as “those revenue losses attributable to 

provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from 

gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax 

liability; and the term ‘tax expenditure budget’ means an enumeration of such tax 

expenditures.”40 Although the Budget Act does not define the baseline to be used in identifying 

tax expenditures, the legislative history states that Congress assumed the use of a “normal” tax 

baseline.41 The legislative history does not, however, describe the components of this “normal” 

 36 P.L. 93-344. 

37 P.L. 93-344 §101(c) and §102(a). These sections amended House and Senate rule, 

respectively. The current rules relating to the duties of the budget committees are clause 4(b)(6) of Rule 

X of the Rules of the House of Representatives, September 14, 2007 

<http://www.rules.house.gov/ruleprec/110th.pdf> and clause 1(e)(2)(C) of Rule XXV of the Standing 

Rules of the Senate, September 14, 2007 <http://rules.senate.gov/senaterules/Rules091407.pdf>. 

38 The CBO is required to provide an annual report to Congress on “the levels of tax expenditures 

under existing law, taking into account projected economic factors and any changes in such levels based 

on proposals in the budget submitted by the President for such fiscal year.” P.L. 93-344 §202(f)(1)(B). 

The Budget Act required that the report accompanying the first concurrent budget resolution allocate tax 

expenditures among major functional categories. P.L. 93-344 §301(d)(6). The report to accompany any 

bill or resolution reported from committee providing new or increased tax expenditures must contain a 

statement detailing how these will affect the levels of tax expenditures under existing law and for the 

following five fiscal years. P.L. 93-344 §308(a)(2) and §308(c)(3). 

39 The Budget Act amended the Budget and Accounting Act of 1921(P.L. 67-13) to require this. 

P.L. 93-344 §601. 

40 P.L. 93-344 §3(a)(3) currently codified to 2 USC 622.3. 

41 Committee on Government Operations, United States Senate, Congressional Budget and 

Impoundment Control Act of 1974, Public Law 93-344, Legislative History S. 1541-H.R. 7130, 

(Washington, D.C., U.S. Government Printing Office, December 1974). The original Senate provision 

defined tax expenditures as “those revenue losses attributable to provisions of the Federal tax laws which 

allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a 

preferential rate of tax, or a deferral of tax liability representing a deviation from the normal tax structure 

for individuals and corporations.” S1541. The final statutory language ended this definition after the 
21 

structure.42 In the absence of explicit guidance, the JCT Staff traditionally interpreted the 

“normal” tax in a manner consistent with Surrey’s original approach. The Treasury Department, 

however, has interpreted the same language to permit some significant departures. 

 

word “liability,” as noted above. The accompanying Conference Report stated, however, that this 

shortening of the definition was a simplification that intended no change in meaning. Senate Conference 

Report NO. 93-924 to accompany H.R. 7130, Congressional Budget and Impoundment Control Act of 

1974, June 12, 1974, p. 50. 

42 Legislative History, supra at 1676. 
22 

C. JCT Staff Implementation of Tax Expenditure Analysis 

In light of the traditional expertise of the JCT Staff in respect of revenue matters, and a 

separate statutory requirement that Congress rely on JCT Staff estimates when considering the 

revenue effects of proposed legislation,43 the CBO has always relied on the JCT Staff for the 

production of its annual tax expenditure publication. Since 1975,44 the JCT Staff reports have 

always included a description of the features of the normal tax baseline used to identify and 

measure tax expenditures.45 Although the number of provisions listed as tax expenditures has 

grown from 70 in 1975 to 170 in 2007, the general contours of the normal tax baseline used by 

the JCT Staff have remained largely unchanged and are similar in essential respects to Surrey’s 

original concept. The growth in the number of identified tax expenditures is attributable 

primarily to changes in law, as well as increased scrutiny of the Internal Revenue Code over 

time. 

As explained in the JCT Staff’s 2007 report, the determination of whether a provision is a 

tax expenditure is made on the basis of a concept of income that is larger in scope than “income” 

as defined under general U.S. income tax principles.46 Under the JCT Staff methodology 

employed to date, the “normal” tax structure includes separate components for individuals and 

corporations. 

The JCT Staff definition of the “normal” structure of the individual income tax includes 

the following major elements: one personal exemption for each taxpayer and one for each 

dependent, the standard deduction, the existing tax rate schedule, and deductions for investment 

and employee business expenses. The JCT Staff views the personal exemptions and the standard 

deduction as defining a zero-rate bracket that is a part of normal tax law. An itemized deduction 

that is not directly incurred in the production of taxable income is classified as a tax expenditure, 

but only to the extent that it, when added to a taxpayer’s other itemized deductions, exceeds the 

standard deduction. Most other tax benefits to individual taxpayers are classified as tax 

 43 P.L. 93-344 §201(g), codified at 2 USC 601(f). 

44 The JCT Staff issued its first report on tax expenditures in 1972. Joint Committee on 

Taxation, Estimates of Federal Tax Expenditures, October 4, 1972 (JCS-28-72). This report was issued at 

least in part in response to Congressional requests made in the conference report to the Revenue Act of 

1971. Senate Amendment No. 74 to the Revenue Act of 1971 would have required the inclusion in the 

budget of estimates of “losses in revenue” from provisions of the Federal income tax laws and also 

estimate of indirect expenditures through the operation of the Federal tax laws. The Senate receded from 

its amendment in conference, as the Treasury Department indicated its willingness to supply the desired 

information to the relevant tax committees as requested. Conference Report No. 92-708 to accompany 

H.R. 10947, Revenue Act of 1971. The actual tax expenditure estimates included in this report were 

supplied by the Office of Tax Analysis of the Department of the Treasury. 

45 Joint Committee on Taxation, Estimates of Federal Tax Expenditures, July 8, 1975 (JCS-11-

75). 

46 Joint Committee on Taxation, Estimates of Federal Tax Expenditures, Sept. 24, 2007 (JCS-3-

07), available at < http://www.house.gov/jct/s-3-07.pdf>. 
23 

expenditures, except for certain items that are included in the baseline for reasons of ease of 

administration: 

• The imputed income that individuals receive from the use of owner-occupied 

homes and durable goods is not classified as a tax expenditure, because it is 

administratively difficult to measure this imputed income for tax purposes. 

• Capital gains are treated as taxable in full in the year realized through sale, 

exchange, gift or transfer at death. Thus, the deferral of tax until realization is 

not classified as a tax expenditure (as the Haig-Simons income definition might 

suggest). However, reduced rates of tax, further deferrals of tax (beyond the year 

of realization) and exclusions of certain capital gains are classified as tax 

expenditures. 

• The “normal” tax base also does not provide for any indexing of the basis of 

capital assets for inflation, with the result that the income tax is levied on 

nominal gains as opposed to real gains in asset values. 

Tax provisions that provide treatment less favorable than “normal” income tax law 

(commonly referred to as “negative tax expenditures”) have not been identified as such in JCT 

Staff tax expenditure reports, because listing those items was viewed as not required by the 

statutory definition of a tax expenditure. The individual alternative minimum tax and the passive 

activity loss rules are not viewed either as a part of “normal” income tax law or as separate, 

negative tax expenditures. Instead, they are viewed as provisions that reduce the magnitude of 

the tax expenditures to which they apply. 

With regard to business income, “normal” income tax law is assumed to require the 

accrual method of accounting, the standard of “economic performance” (to test whether 

liabilities are deductible) and the general concept of the matching of income and expenses. In 

general, tax provisions that do not satisfy all three standards are viewed as tax expenditures. The 

normal income tax law is assumed, however, to provide for the carryback and carryforward of 

net operating losses, and the general limits on the number of years that such losses may be 

carried back or forward are also treated as part of the “normal” law on the basis of administrative 

convenience and compliance concerns. 

The tax treatment of capital costs is acknowledged to be one of the most difficult areas in 

which to identify either the normal tax rule or tax expenditures, given the variety of alternative 

cost recovery methods available depending on the nature of the costs and the status of the 

taxpayer. Traditionally, the JCT Staff has classified as tax expenditures any cost recovery 

allowances that are more favorable than those provided under the alternative depreciation 

system, which provides for straight-line recovery over tax lives that are longer than those 

permitted under the accelerated system. For reasons of administration, the normal tax system 

does not take into account the effects of inflation on tax depreciation. 

Finally, the existence of a separate corporate income tax is treated as a feature of the 

“normal” tax law, but the lower rates for small businesses are treated as tax expenditures because 

they are intended to provide tax benefits to small business and, unlike the graduated individual 
24 

income tax rates, are unrelated to concerns about ability to pay. Notwithstanding the general 

treatment of corporations as separate from their owners, the earnings of foreign subsidiaries of 

U.S. taxpayers are treated as currently includible by those U.S. owners. Special tax rules for 

passthrough entities (i.e., the absence of entity-level taxation) are not classified as tax 

expenditures, on the basis that those tax benefits are available to any entity that chooses to 

organize itself and operate in the required manner. For nonprofits, tax-exempt status is not 

classified as a tax expenditure because the nonbusiness activities of those organizations generally 

must predominate and their unrelated business activities are subject to tax. 
25 

D. Treasury Department Analysis: The Shift to a Reference Law Baseline 

While the JCT Staff presentation of tax expenditures has largely remained constant, the 

Department of Treasury’s analysis has changed significantly over time. Early reports prepared 

during the Ford and Carter Administrations continued the use of the “normal” tax baseline. 

During those years, the lists of tax expenditures produced by the Treasury Department were very 

similar to those produced by the JCT Staff, likely reflecting their common origin. As early as 

1976, however, the Treasury Department acknowledged the arbitrariness of accepting certain 

features of the tax system as part of the “normal” tax structure, and noted that features of the 

normal tax structure should not be immune from scrutiny simply because they are not classified 

as tax expenditures. According to the 1976 report, many such features themselves have 

significant effects on economic activity and income distribution and could be replaced with 

budget outlays (or other policy instruments) or eliminated.47 

The Reagan Administration viewed the concept of tax expenditures with more skepticism 

than its predecessors. It preferred the term “tax subsidies,” as it viewed most special tax 

provisions as more analogous to subsidies for particular activities than to direct government 

spending.48 In addition, the Reagan Administration shifted to what it viewed as a more objective 

baseline. Thus, beginning in 1983, the Treasury Department’s Special Analysis of tax 

expenditures sought to identify those provisions of the Internal Revenue Code that constitute 

basic structural features of the income tax and those that provide a special exception to the 

structural rules. Under this approach, a “tax expenditure” is a provision that satisfies two 

conditions: First, the provision is “special” in that it applies to a sufficiently narrow class of 

transactions or taxpayers to permit the specification of a program objective that could be 

assigned to an existing agency other than the IRS and be administered with appropriated funds.49 

Second, there must be a “general” rule to which the “special” provision is a clear exception. 

This definition relies heavily on the word “special” in the definition of tax expenditure provided 

in the Budget Act (“those revenue losses attributable to provisions of the Federal tax laws which 

allow a special exclusion, exemption, or deduction from gross income or which provide a special 

credit, a preferential rate of tax, or a deferral of tax liability”). The general, structural rules of the 

Internal Revenue Code became known as the “reference tax law” baseline. 

 47 Special Analysis, Budget of the United States, Fiscal Year 1976. In this regard, the report 

explicitly recognized the following elements as part of the “normal” tax structure: (i) the progressive rate 

schedules for individuals, (ii) personal exemptions and the minimum standard deduction, (iii) separate 

rate schedules for filing status, (iv) deduction of business expenses, (v) exclusion of unrealized capital 

gains and losses, (vi) exclusion of imputed income from owner-occupied housing and other durable 

assets, (vii) exclusion of gifts and bequests, (viii) exclusion of the value of government services received 

in kind (e.g., food stamps or Medicare), (ix) foreign tax credits, (x) treatment of corporations as separate 

taxpaying entities, and (xi) the deferred taxation of earnings of foreign corporations. 

48 The 1983 budget also expressed the view that the term “tax expenditure” implied that the 

government has control over all resources. 

49 This condition represented a version of the substitutability criterion suggested by Seymour 

Fiekowsky. See Fiekowsky, The Relation of Tax Expenditures to the Distribution of the ‘Fiscal Burden,’

2 Canadian Taxation 211, 215 (1980). 
26 

The reference tax law included the following components: 50 definition of a taxpaying 

unit, tax rate schedules, and general accounting rules for determining income subject to tax. 

Taxpaying units overlap in the “normal” and reference tax structures with one major exception. 

The reference tax law treats controlled foreign corporations as separate taxable entities whose 

income is not subject to U.S. tax until distributed to U.S. taxpayers. Thus, no tax expenditure 

arises from the deferral of tax on foreign earnings of controlled foreign corporations, because 

U.S. taxpayers generally are not taxed on accrued, but unrealized income. Separate rate 

schedules for different taxpayers are part of reference law, such that lower rates for the first 

several thousand dollars of corporate income do not give rise to tax expenditures under reference 

law as they do under “normal” law.51 General accounting rules determine that income subject to 

tax is gross income less costs of earning that income under reference law. 

Reference law excludes gifts, defined as receipts of money or property that are not 

consideration in an exchange. This definition encompasses transfer payments, which are deemed 

gifts from the Federal government, even though “normal” law regards cash transfer payments as 

gross income. Depreciation under the reference tax law adopts the existing general accelerated 

depreciation rules as the baseline, thus they generate no tax expenditures. In contrast, “normal” 

law defines the difference between an approximation of economic depreciation and accelerated 

depreciation as a tax expenditure. In all other major respects, reference law and “normal” law 

are equivalent.52

The Reagan Administration used the “reference law” approach exclusively for the 1983 

and 1984 fiscal years. As a result, its tax expenditure lists did not fully correspond to the lists 

provided by the JCT Staff or by the CBO. Beginning in 1985, however, the Treasury 

Department provided lists of tax expenditures with respect to both its new reference tax law 

baseline and its historic normal tax baseline.53 

Essentially, the Treasury Department’s list of tax expenditures was split into two 

categories, a presentation that continues today. The first consists of deviations from the 

reference law baseline. The second category consists of more general deviations from a 

 50 This discussion draws heavily on Special Analyses, Budget of the United States Government, 

1985, “Special Analysis G - Tax Expenditures.” 

51 Capital gains rates currently do not generate tax expenditures under reference law as they are 

structured as a maximum separate rate schedule. In 1985, the Code accomplished favorable treatment of 

capital gains via an exclusion, and thus such treatment gave rise to a tax expenditure even under reference 

law. 

52 In 1990, the Treasury Department expanded the scope of the tax expenditure budget to include 

special and preferential provisions of the federal estate and gift tax laws. This addition was made possible 

by the use of a reference tax baseline, as no generally accepted normative tax structure exists for transfer 

taxes. This presentation ceased with the Fiscal Year 2003 budget, however, due to Bush Administration 

concerns over the lack of a generally accepted baseline and because the estate tax had been repealed by 

the Economic Growth and Tax Relief Reconciliation Act of 2001. 

53 Special Analysis, Budget of the United States, Fiscal Year 1985. 
27 

comprehensive normative base. Items in the second group are not treated as “tax expenditures” 

as such, but comprise a list of provisions subject to consideration as part of a more general 

reform of the existing income tax. The Treasury Department also uses a different classification 

of those provisions that can be considered a part of the normal base of both the individual and 

business income tax law. 

In general, the JCT Staff methodology involves a broader definition of the normal income 

tax base, so that the JCT Staff list of tax expenditures includes some provisions that are not 

contained in the Treasury list. The cash method of accounting by certain businesses is one 

example. The Treasury Department considers the cash method of accounting for certain 

businesses to be part of normal income tax law, while the JCT Staff methodology treats it as a 

departure from normal income tax law that constitutes a tax expenditure. 
28 

E. Recent Treasury Department Analyses 

The Bush Administration, in its FY2003 budget, expressed renewed concern with the 

degree of arbitrariness in the tax expenditure baseline, stating that “the meaningfulness of tax 

expenditure estimates is uncertain and that the ‘tax expenditure’ presentation can be improved by 

consideration of alternative or additional tax bases.”54 The effort to improve the tax expenditure 

presentation focused on three aspects: first, the definition of an income tax or standard against 

which tax expenditures are identified; second, estimating “negative” tax expenditures, i.e., 

provisions that cause a taxpayer to pay more tax than would be consistent with the baseline 

income tax; and third, estimating tax expenditures relative to a hypothetical consumption tax, as 

well as relative to an income tax. 

The FY2004 budget implemented changes in each of the three areas outlined above. It 

changed the way accelerated depreciation was accounted for in the baseline income tax and 

added an estimate of the tax expenditure associated with net imputed rental income from owneroccupied housing.55 It also included estimates of the negative tax expenditure associated with 

the multiple taxation of corporate income. Significantly, it also began reporting tax expenditures 

relative to a consumption tax baseline. 

 54 Analytical Perspectives, Budget of the United States, Fiscal Year 2003, Chapter 6. 

55 For consistency, the tax expenditure list should not include both the exclusion of imputed 

rental income and the deduction for mortgage interest as the latter is a cost of earning the former and 

therefore rightly deducted if the former is included in income. 
29 

III. CRITIQUES OF THE TAX EXPENDITURE CONCEPT 

A. The Design of the Normal Tax Base 

In current tax expenditure analysis, the “normal” tax base serves (at a minimum) as the 

measuring rod by which to judge whether particular tax provisions constitute tax expenditures, 

and also the baseline from which the JCT Staff calculates the revenues forgone by particular tax 

expenditures. As explained in Section II, this baseline has remained largely unchanged over the 

past 40 years, and therefore today is similar in essential respects to Surrey’s original concept. 

In 1969, Professor Boris Bittker provided the foundation for much of the criticism that 

would follow by examining the subjective nature of Surrey’s “normal” tax.56 As Bittker 

observed, “any system of income taxation is an aggregation of decisions about a host of 

structural issues that the Haig-Simons definition does not even purport to settle.”57 For example, 

the Haig-Simons definition provides no guidance on the rate structure, the proper taxpaying unit, 

the relationship between a corporation’s income and its shareholders’ tax liability, or the proper 

accounting period. According to Bittker, Surrey’s silent incorporation of his own judgments on 

these structural elements into his “accepted concept of net income” succeeded in “bringing some 

issues to the fore only to conceal others.”58 Provisions that deviated from Surrey’s “normal” tax, 

such as the investment credit, were classified as tax expenditures, while “a rate reduction 

concentrated on high bracket taxpayers” escaped that “pejorative classification” because the rate 

structure was treated as inherent in the “normal” tax.59 Other items that Bittker cited as 

debatable choices for inclusion in the “normal” income tax included the Internal Revenue Code’s 

nonrecognition provisions (such as the treatment of like-kind exchanges and corporate 

reorganizations), straight-line depreciation for buildings (which can exceed the decline in market 

value) and the foreign tax credit (while the deduction of nonbusiness state and local taxes was 

treated as a tax expenditure). Bittker concluded that no set of tax expenditures derived from such 

a subjective baseline could achieve sufficient consensus to warrant inclusion in a national 

budget.60 

 56 Boris I. Bittker, Accounting for Federal “Tax Subsidies” in the National Budget, 22 National 

Tax Journal 244 (1969). 

57 Bittker, supra at 260. 

58 Id. 

59 Bittker, supra at 261. Subsequent critics have made essentially the same point. See also

Thuronyi, supra at 1166 (“Surrey’s normative tax reflected his vision of what the U.S. income tax should 

look like, given the constraints of politics. By incorporating ‘generally accepted’ concepts, though, 

Surrey endeavored to shield this subjective vision behind the authority of a consensus of experts.”). 

60 Despite his concerns about the logical consistency of Surrey’s argument, Bittker nevertheless 

felt that the Treasury’s tax expenditure budget was “a promising exploration of [the] territory,” which 

might serve as a starting point for more “comprehensive estimates.” Id. at 260. 
30 

Since the publication of Bittker’s essay, many other observers, representing a wide range 

of political and policy perspectives, have echoed his criticism of the “normal” tax base as a 

subjective compilation of judgments without a rigorous formal basis. Despite nearly uniform 

agreement on this point, however, no consensus has emerged on an alternative approach. 

In 1980, Seymour Fiekowsky, then Assistant Director of the Treasury Department’s 

Office of Tax Analysis, observed that “from the outset critics have perceived that the compilers 

of tax expenditure budgets are not as interested in more reliable accounting of the size of the uses 

side of the budget as they are in perpetuating the confusion between expenditure and tax 

structural issues in order to ‘reform’ the tax system.”61 Fiekowsky argued instead for a more 

rigorous examination of the extent to which a tax provision could be replaced with a direct 

expenditure. He proposed a distinction between “tax subsidy programs,” such as the section 103 

exemption for interest on state and municipal bonds, and “tax policy, or tax-structural, issues,” 

such as the capital gains preference and tax depreciation rules. To identify “tax subsidies,” he 

proposed two criteria: (1) in the absence of the particular provision, existing tax law provides a 

general rule for determining tax liability, and (2) it is possible to formulate an expenditure 

program administrable by a cognizant government agency that would achieve the same objective 

at equal, higher or lower budgetary cost. A tax expenditure budget would include only items that 

met both tests, i.e., “tax subsidies,” and these would be evaluated using conventional cost and 

effectiveness criteria. 

Fiekowsky’s category of “tax policy” or “tax-structural issues” included items that had 

important tax policy consequences but that were not “tax subsidies,” either because there was no 

clear general rule to which they were an exception, or because it was not feasible to envision a 

spending program that would substitute for the tax rule. For example, neither the preferential 

treatment of capital gains nor accelerated depreciation methods constituted tax subsidies in 

Fiekowsky’s view, but for different reasons. The capital gains preference would meet the first leg 

of the definition because, in its absence, capital gains and losses would be taxable as items of 

ordinary income, but not the second leg, because it would be unrealistic to imagine replacing the 

capital gains preference with an expenditure program. On the other hand, the Internal Revenue 

Code arguably contains no general tax depreciation rule that would apply in the absence of the 

accelerated depreciation provisions. 

Fiekowsky argued that both of these items can be evaluated only with reference to 

“superior tax structural rules, i.e., other feasible rules to define the tax base and specify the 

taxable unit and rates of tax, that impose less economic welfare loss or more nearly achieve the 

goal of horizontal equity while raising the necessary revenue.” In his view, tax expenditure 

analysis was not an appropriate context in which to make those tax policy choices.62 

 61 See generally Fiekowsky, supra at 213. 

62 In the same year, Michael McIntyre proposed a similarly limited approach under which tax 

expenditure analysis would apply only to tax provisions that were spending equivalents. To identify “tax 

expenditures,” however, he proposed the less rigorous test that there be “a bare assertion that the tax rule 

under examination promotes a spending goal.” McIntyre observed that tax analysts cannot always 

distinguish goals associated with raising revenue from goals associated with spending, since tax policy is 
31 

Other critics have argued that the definition of a tax expenditure should focus on the first 

of Surrey’s goals – expenditure control – as a way to address their concerns regarding Surrey’s 

normative baseline. In 1988, Professor Victor Thuronyi acknowledged the utility of the tax 

expenditure concept,63 but argued that, by defining tax expenditures as departures from a 

normative tax, Surrey had “tried to cover all tax reform questions with the tax expenditure 

umbrella.”64 Thuronyi proposed instead a category of “substitutable tax provisions,” defined to 

include any tax provision that can be replaced with a non-tax-based federal program that fulfills 

the tax provision’s purposes at least as effectively as does the provision itself. Thuronyi believed 

that identification of these provisions would help policymakers treat tax and spending provisions 

alike for budget-making purposes and encourage replacement of tax provisions with direct 

spending programs where the latter would be more efficient. This approach, he argued, “does 

not rely on the idea of a normative tax, and thus avoids attack from those who disagree with a 

particular normative tax or, more generally, with the approach of defining tax expenditures as a 

departure from a normative tax.”65 

In 1992, Professors Douglas A. Kahn and Jeffrey S. Lehman argued forcefully that the 

idea of a normative tax base to which existing law should be compared “presumes that some of 

us should be deemed to know the answers better than others.”66 They pointed out that a range of 

views exist on the ideal nature of an income tax (including that it should instead be a 

consumption tax), and argued that the choice among the various alternatives is “a contestable, 

contingent, political decision.”67 To assist in that regard, they argued for less restrictive analyses 

of tax law provisions that depart from a variety of different conceptions of the appropriate tax 

base. 

Ten years later, Bruce Bartlett argued in a similar vein that traditional tax expenditure 

analysis, and its “implicit assumption that there is some ideal tax system against which to judge 

tax preferences,” institutionalizes a particular view of tax policy that makes it difficult to make 

 

a tool of both social and economic policy. He argued that his approach could accommodate an analysis of 

an argument according to both tax policy and spending policy criteria. Tax expenditure analysis would 

address only the latter criteria, and would say nothing about the suitability of a tax rule for promoting tax 

policy goals. Michael J. McIntyre, A Solution to the Problem of Defining a Tax Expenditure, 14 

University of California Davis Law Review 78 (1980). 

63 Thuronyi, supra at 1205 (“Ever since Stanley Surrey created the tax expenditure concept, it 

has proven extremely useful in alerting policymakers that the tax system provides subsidies.”). 

64 Id. at 1181. 

65 Id. at 1187. Thuronyi also supported retention of Surrey’s traditional definition of tax 

expenditures but, in recognition of its inherently subjective nature, he viewed it as a means of identifying 

“tax-based subsidies” that would be evaluated using criteria other than equivalence to a spending 

program. 

66 Douglas A. Kahn and Jeffrey S. Lehman, Tax Expenditure Budgets: A Critical View, 54 Tax 

Notes 1661, 1665 (1992). 

67 Id. 
32 

positive reforms.68 Bartlett, who advocated replacement of the income tax with a consumption 

tax, supported what he viewed as the Bush Administration’s move to “downgrade and revise the 

tax expenditures budget.” He viewed this step as helpful in laying the groundwork for 

fundamental tax reform, observing that the Haig-Simons income base of traditional tax 

expenditure analysis “reinforces the supposed superiority of an income base and is a barrier to 

adoption of a consumption-based system.”69

In 2003, Leonard Burman observed that “[t]here is clearly an ideological element to the 

[tax expenditure analysis] debate about tax bases. People who favor an income tax also tend to 

favor the current method of measuring and displaying tax expenditures. Those who would prefer 

heavier reliance on consumption taxes would favor defining the normal tax as a broad-based 

consumption tax. Given that the actual income tax is a hybrid system containing many elements 

of income and consumption taxation, there is no objective way to resolve this dispute.” Burman 

argued that it would be better to resolve the debate about income versus consumption tax outside 

the context of tax expenditure analysis. Once that issue was resolved, he suggested, the 

measurement and analysis of tax expenditures against the appropriate baseline would be helpful 

in making the tax system as neutral as possible.70

Still other critics have responded by proposing wholly different theories of tax 

expenditure analysis. Professor Daniel Shaviro, writing in 2004, observed that the tax 

expenditure debate had gone “off the rails,” not in its aim of identifying “special” provisions, but 

in doing so “through the identification of a supposedly canonical, yet in practice under-theorized 

and rightly controversial, official definition of the ‘normative income tax base.’”71 Shaviro 

argued that the debate over the defensibility of the normative base was misdirected and too 

narrowly focused, and argued instead for an approach to tax expenditure analysis that would be 

more flexible and varied in its groupings. Shaviro restated the definition of tax expenditures as 

“mainly allocative rules that, as a formal matter, are found within the (ostensibly mainly 

distributional) tax system.”72 Shaviro hoped that by acknowledging reasonable disagreements 

 68 Bruce Bartlett, The End of Tax Expenditures as We Know Them?, 92 Tax Notes 413, 419 

(2001). 

69 Id. at 421. 

70 See Leonard E. Burman, Is the Tax Expenditure Concept Still Relevant, 56 National Tax 

Journal 613, 618 (2003). While Burman saw the issue of defining the normal tax as an income tax or a 

consumption tax as the most contentious point of debate, he also maintained that resolution of this 

question was not critical to the utility of tax expenditure analysis, because even those who favor a 

consumption tax could find useful information in the “normal” income tax expenditure budget. Burman’s 

theory was that tax expenditure analysis’s use of the “normal” income tax base provided at least a crude 

measure of the nonneutralities that existed among different kinds of saving and investment under the 

existing hybrid tax system. 

71 Shaviro, supra at 199. 

72 Shaviro, supra at 188. This definition draws on Richard Musgrave’s distinction between the 

allocative and distributional branches of the fiscal system. See Richard Musgrave, The Theory of Public 

Finance, A Study in Political Economy (1959). 
33 

with respect to the underlying distributional aims of any given tax system or tax base, it would be 

possible to focus the debate on the allocative effects (i.e., the effect on the “amount, use, and 

character of all assets in society”) of particular provisions. This approach, he believed, would 

facilitate a more effective evaluation of those allocative provisions than the traditional focus on 

spending equivalence. 

More recently, Professors David A. Weisbach and Jacob Nussim have observed that 

“[t]here is no such thing as a normative tax base. The simultaneous need for a definition and the 

lack of grounding for any particular definition make the tax expenditure budget problematic.”73 

They argue instead for a theory of tax expenditures that focuses on institutional design, rather 

than tax policy. Under their approach, “it is entirely irrelevant whether some piece of 

governmental policy complies with independent tax norms.” Rather, they suggest that tax 

expenditure analysis should determine the best way to implement a government program – 

through a direct spending program or through a tax program – starting from the premise that such 

a program will exist. 

 73 David A. Weisbach and Jacob Nussim, The Integration of Tax and Spending Programs, 113 

Yale Law Journal 955, 976 (2004). 
34 

B. The “Normal” Tax as a Tax Reform Agenda 

Closely related to the criticism that the “normal” tax is not rigorously specified is the 

charge that the proponents of tax expenditure analysis use that tool to promote its “normal” tax 

as the goal of a tax reform agenda. Under this view, the “normal” tax does not simply serve as 

the baseline from which to identify tax expenditures, but also is consciously presented as an 

aspirational but achievable tax system that is superior to the current Internal Revenue Code, and 

that therefore should be enacted into law. 

Critics who see the adoption of the “normal” tax as the goal of tax expenditure analysis 

are thus inclined to see any tax expenditure analysis as a politically charged process. In this 

vein, Surrey’s insistence that his goal was merely expenditure control is dismissed as 

disingenuous. According to Professor Shaviro: 

Tax reform, defined as broadening the base of the income tax so that high-income 

taxpayers would pay more, had long been a personal cause. For Surrey, the tax 

expenditure budget was a tool of tax policy, not just budget policy. It was meant 

to serve as a hit list, identifying tax provisions that should be repealed and either 

disappear altogether or else reappear as direct spending, and not just placed on par 

with direct spending whenever budgetary balance was evaluated.74

Similar criticism has been directed toward proponents of alternative baselines. For 

example, Professor Linda Sugin has suggested that the Reagan Treasury Department 

manipulated tax expenditure analysis by changing from a “normal” tax base to a reference tax 

law baseline (as outlined above) in order to skew the tax expenditure budget in favor of social 

spending while embedding business incentives into the tax’s normal structure.75 

 74 Shaviro, supra at 201; see also Fiekowsky, supra at 213 (“Indeed, from the outset critics have 

perceived that the compilers of tax expenditure budgets are not as interested in more reliable accounting 

of the size of the uses side of the budget as they are in perpetuating the confusion between expenditure 

and tax structural issues in order to ‘reform’ the tax system.”). 

75 See Linda Sugin, Tax Expenditure Analysis and Constitutional Decisions, 50 Hastings Law 

Journal 407, 425 (1998-1999). Sugin, who acknowledges that tax expenditure analysis “provides relevant 

information” and is “well suited” to legislatures, is concerned about the potential judicial application of 

tax expenditure analysis to cases involving the equal protection or establishment clause, “because of the 

theoretical impossibility of [tax expenditures’] definition.” Id. at 419. 
35 

C. Tax “Exceptionalism” 

A third line of criticism is the argument that tax expenditure analysis embodies “tax 

exceptionalism,” that is, an unrealistic insistence on “keeping the tax laws clean of tax preference 

provisions henceforth and forever.”76 This criticism has more typically been directed toward 

advocates of a “comprehensive” income tax base, who are viewed as seeking to treat the tax 

system as “separate from the rest of government,”77 and spending programs in particular, in order 

to keep it free of tax subsidies or preferences. By implication, however, any analysis that seeks 

to identify and evaluate tax subsidies or preferences is susceptible to a similar charge. 

Professors Weisbach and Nussim, for example, argue that tax exceptionalism is a 

mistake. In their view, the tax system should not be privileged, rather it should be seen simply as 

another political tool, and the decision to implement a nontax program through the tax system 

should be “solely a matter of institutional design.”78 

D. The “Last Penny” Argument 

Finally, some critics have suggested that tax expenditure analysis is based on the “sinister 

premise .... [that one should] think of all income as virtual state property, and forbearance to tax 

away every last penny of it as itself a tax expenditure.”79 The argument has also been phrased in 

terms of tax expenditure analysis serving an agenda of “egalitarianism,” by which apparently is 

meant using the tax system to level the wealth of all members of society.80 

E. Analysis of the Criticisms 

The proponents of traditional tax expenditure analysis have failed to respond 

convincingly to the criticisms of the “normal” tax as underspecified and (whether consciously so 

designed or not) as an implicit goal of a tax reform agenda. In current tax expenditure analysis, 

the “normal” tax plays three roles. First, it serves as the benchmark against which present law 

 76 See Kyle Logue, If Taxpayers Can’t be Fooled, Maybe Congress Can: A Public Choice 

Perspective on the Tax Transition Debate, 67 University of Chicago Law Review 1507, 1525 (2000). 

77 See Weisbach and Nussim, supra at 968. Logue, who originated the term “tax exceptionalism” 

used it to criticize Daniel Shaviro on this basis. See Logue, supra at 1525. 

78 Weisbach and Nussin, supra at 957. 

79 Charles Fried, Whose Money Is It?, Washington Post, January 1, 1995, page C-7. Cited in 

Shaviro, supra at 187; see also Joint Economic Committee Study, Tax Expenditures: A Review and 

Analysis 1 (1999) (noting that the tax expenditure concept relies on an expansive definition of income; as 

a result, “provisions that shield components of this broad definition of income are viewed as depriving the 

government of its rightful revenues; these lost revenues are regarded as properly belonging to the federal 

government.”). 

80 Bartlett, supra at 419 (“[A]dvocates of the tax expenditure concept prefer to argue their case as 

a matter of principle. Yet a closer examination of their arguments suggests that egalitarianism, rather than 

good tax policy, is the true motive.”). 
36 

tax provisions are measured to determine whether they constitute tax expenditures. Second, the 

“normal” tax operates, at least in the view of some, as an implicit reproach to the current tax 

system, through being held up as an achievable and superior alternative tax system. Third, the 

“normal” tax serves as the baseline from which to calculate the dollar magnitude of a particular 

tax expenditure. 

The first two of these roles elevate the importance of the “normal” tax to a level it cannot 

support, because the “normal” tax is largely a commonsense extension (and cleansing) of current 

tax policies, not a rigorous tax framework developed from first principles. As a result, the 

“normal” tax cannot be defended from criticism as a series of ultimately idiosyncratic or 

pragmatic choices. If tax expenditure analysis is to enjoy broad support, it must be seen as 

neutral and principled; unfortunately, the “normal” tax satisfies these requirements only in the 

eyes of those who already believe that the “normal” tax accurately captures their personal ideal 

of a tax system. 

In part, the large body of criticism on these points can be explained as an academic 

preference for logically rigorous presentations derived from objective first principles. As 

summarized above, many academic writers have concluded that a “normal” tax base that cannot 

be specified in an objective manner simply represents the personal tastes of the proponent, and 

therefore cannot form the basis for separating core principles from exceptions.81 

More fundamentally, however, the depth and breadth of the criticism can be seen as 

evidence that, in contrast to the prevailing view 40 years ago, there no longer is a near-universal 

consensus view as to the ideal tax system. Much academic work since the time Surrey first 

published his proposal for tax expenditure analysis has been devoted to arguing for the 

superiority of a consumption tax system over an income tax. Other academic writers have 

developed the argument that the current tax law hews much less closely to income tax ideals than 

was once commonly supposed, and further have sought to demonstrate that consumption taxes 

and income taxes are not (or can be designed so as not to be) as different in their economic and 

distributive effects as they might at first appear. Finally, other academic observers have argued 

 81 Bittker, for example, preferred a “more limited accounting” that would confine itself to 

estimating the cost of departures from the Haig-Simons definition, without attempting to account for the 

cost of structural provisions (such as the joint return, rate schedules, taxable periods and tax exemptions) 

for which that definition provides no normative model. Bittker, supra at 260-261. Bittker argued that 

“such calculations could provide information that would be helpful in applying our political, economic 

and ethical criteria in making policy judgments about the income tax system.” He further believed that 

these estimates would “help to show whether the departures of existing law are skewed in a particular 

direction, and whether some departures counterbalance rather than reinforce others--matters of much 

importance for the person who acknowledges that some departures are unavoidable, but who wants 

nevertheless to approach as closely as possible to the Haig-Simons ideal.” Id. at 261. 
37 

that a practical income tax can never come close to satisfying income tax ideals, and in the 

resulting world of “second best” choices, that unachievable ideal can be a misleading goal.82 

Whether these criticisms are correct is less important for this purpose than is the 

observation that they are prevalent. Tax expenditure analysis is useful to policymakers only if its 

conclusions are widely agreed to be neutral, in both a political and an economic sense.83 The 

breadth and depth of the criticism of the present “normal” tax base suggests that such agreement, 

if it ever existed, cannot be obtained in the current environment. In light of these realities, the 

JCT Staff believes that it is appropriate to revisit our tax expenditure methodology, in order to 

refashion it in a manner that will generally be viewed as more neutral and more principled than 

the current implementation. 

There also is merit to the argument that tax expenditure analysis reflects tax 

“exceptionalism” – the belief that the tax system ordinarily ought not to be burdened with the 

sort of ad hoc political compromises reflected on the face of much spending legislation. In the 

view of the JCT Staff, however, that “exceptionalism” is largely justified. 

Unlike most spending programs, the tax system affects every individual and every 

economic transaction. The same is not true of most spending legislation. Because virtually every 

adult American must wrestle with the Internal Revenue Code, and because our system ultimately 

relies on self-assessment, it is important to reduce the compliance burden and to reinforce the 

view that the tax system is equitable. A taxpayer who reads 87 pages of instructions for a tax 

return84 that detail a host of special exemptions, credits, and deductions incurs substantial 

compliance costs (in time or money), and may come away from the experience with the belief 

that the tax system contains numerous special provisions that are available to others, but not to 

him. Both the mistakes that may result and the perception of a system riddled with special 

provisions undercut in an important way the success of the self-assessment system.85 For these 

reasons, the JCT Staff believes that there is merit in a presumption in favor of a tax system that is 

as simple and as easy to administer as possible. 

 82 See Diane Lim Rogers, Federal Income Tax Policy: Issues of Distribution and Equity, in W. 

Bartley Hildreth and James A. Richardson, eds., Handbook on Taxation 586 (1998) (summarizing the 

shifts in academic thinking about tax design between the 1960s and 1980s). 

83 Cf. Thomas Neubig, The Current Role of the Tax Expenditure Budget 239, 243, in Neil Bruce, 

ed., U.S. Policymaking, in Tax Expenditures and Government Policy (1988) (“Since its original 

development, the purpose of the tax expenditure budget, the appropriate conceptual baseline, and the 

measurement of tax expenditures, have become questions without consensus resolution. Without such 

resolution, differences in and unresolved questions about the tax expenditure budget have become excuses 

for ignoring or minimizing its role in the budget.”). 

84 The general instructions for IRS Form 1040 in 2007 were 87 pages long. 

85 See Robert V. Beaudry, The Flat Rate Tax: Is It a Viable Solution to the Crisis Facing the 

Internal Revenue Code?, 9 Oklahoma City University Law Review 219, 250 (1984), quoted in Edward A. 

Zelinsky, Efficiency and Income Taxes: The Rehabilitation of Tax Incentives, 64 Texas Law Review 973, 

1027 at fn. 106 (1985-1986). 
38 

Finally, the JCT Staff believes that the “last penny” argument is wholly without merit. In 

a recent article, Professors J. Clifton Fleming, Jr. and Robert J. Peroni point out that this 

argument makes sense only if tax expenditure analysis “can be fairly understood as asserting that 

Congress has a normative obligation to adopt a generally applicable income tax and that 100% is 

the normatively correct rate for such tax.”86 Tax expenditure analysis does not, however, require 

the enactment of an income tax, and does not prescribe any particular level of income taxation as 

normatively correct.87 Moreover, tax expenditure analysis is agnostic as to the extent to which 

any income tax system is progressive: today’s implementation of tax expenditure analysis, for 

example, treats individual marginal tax rates that are lower than the maximum marginal rate (at 

whatever rates they happen to be from year to year) as part of the “normal” tax base, not as tax 

expenditures.

 86 J. Clifton Fleming, Jr. and Robert J. Peroni, Reinvigorating Tax Expenditure Analysis and Its 

International Dimension, 27 Virginia Tax Review 101, 156 (2008); see also, Thuronyi, supra at 1178 

(“This criticism, of course, misses the point. Tax expenditure analysis does not assert that the federal 

government has a right to tax away everyone’s income. Rather, it asserts that the government taxes to the 

extent of the normative tax, but gives back a substantial amount of this tax revenue through various taxbased spending programs.”). 

87 Id. 
39 

IV. REVISED TAX EXPENDITURE TAXONOMY88

A. Introduction 

This Section IV introduces a new approach to classifying tax provisions as tax 

expenditures. Our revised paradigm attempts in particular to respond to what we believe to be the 

most important consensus objections to the current articulation of tax expenditure analysis, as 

summarized in Section III. First, in many cases, it is not possible to identify in a neutral manner 

the terms of the “normal” tax to which present law should be compared. Second, many observers 

believe that the “normal” tax has been fashioned, not simply to serve as the baseline from which 

to identify tax expenditures, but also to advocate the adoption of that “normal” tax into law, by 

presenting it as a realistic goal of a tax reform agenda. 

To address these concerns, the revised classification of tax expenditures divides the 

universe of such provisions into two main categories: tax expenditures in a narrow sense, which 

we label “Tax Subsidies,” and a new category that we have termed “Tax-Induced Structural 

Distortions.” The two categories together cover much the same ground as does the current 

definition of tax expenditures, and in some cases extend the application of the concept further. 

The revised approach does so, however, without relying on a hypothetical “normal” tax to 

determine what constitutes a tax expenditure, and without holding up that “normal” tax as an 

implicit criticism of present law. The result should be a more principled and neutral approach to 

the issues. 

B. Tax Subsidies 

Our approach to “Tax Subsidies” (that is, tax expenditures in a narrow sense) builds 

loosely on the work of Seymour Fiekowsky and others, by defining a Tax Subsidy as a specific 

tax provision that is deliberately inconsistent with an identifiable general rule of the present tax 

law (not a hypothetical “normal” tax), and that collects less revenue than does the general rule.89 

(We refer to the converse case, of an exception that deliberately overtaxes compared to the 

general rule, as a “Negative Tax Subsidy.”) In practice, our conception of the compilation of 

general rules that together comprise our baseline for identifying Tax Subsidies corresponds 

closely to the “reference tax” baseline that the Treasury Department uses in its tax expenditure 

analyses. 

The Tax Subsidy paradigm is constructed by asking what constitutes the general rule, and 

what the exception, under actual present law. Our determination of Tax Subsidies in most cases 

thus is made, not by reference to an alternative and hypothetical normal tax chosen by the JCT 

 88 This Section IV is an expanded version of the summary of our new approach presented in 

Section I. 

89 Fiekowsky, supra, at 215; see also OMB, The Budget of the United States Government, Fiscal 

Year 1983 -- Special Analyses G-5 (1982); Thuronyi, supra,,at 1187 (advocating a two-step classification 

scheme that (1) identifies a provision’s significant purposes and (2) determines whether a nontax program 

can serve those purposes at least as well). 
40 

Staff, but rather by reference to the face of the Internal Revenue Code itself (along with its 

legislative history and similar straightforward tools for identifying legislative intent). 

This definition does not require the kinds of normative judgments that go into the 

construct of the current “normal” tax, but it is nonetheless not automatic in application. First, 

there will be occasional uncertainty as to whether there is a clear general rule of current tax law. 

Second, the system itself is at risk of producing different results through different names for 

economically similar preferences. 

For example, the Treasury Department, in its comparable implementation of a 

“reference” tax base, does not list capital gains as a tax expenditure, because the capital gains 

preference is implemented as a different tax rate. In 1985, by contrast, the Internal Revenue 

Code provided preferential treatment for capital gains through an exclusion; the Treasury 

Department treated the exclusion as giving rise to a tax expenditure even under its “reference” 

base. The JCT Staff will be mindful of the importance of continuity from one period to the next 

as it develops the detailed implementation of the concept of Tax Subsidies in the future. 

Fiekowsky and others would go further than we propose to do, by classifying a tax 

provision as what we call a Tax Subsidy only if that provision could be replaced by a direct 

expenditure program in a reasonably administrable manner. The Treasury Department also has 

adopted this “spending substitute” leg to its definition; we understand, however, that the 

Treasury Department does not currently exclude any prospective tax expenditure on the grounds 

that a spending program could not be designed as an effective substitute. 

In practice, many Tax Subsidies will satisfy this second test as well, but in the end we 

believe it better not to add this second test to our definition, for two reasons. First, in some cases 

the test will lead to new and often fruitless debates about whether a hypothetical spending 

program could be designed to accomplish the same distributional effects as does a particular tax 

provision. Second, as explained earlier, our experience has shown that tax expenditure analysis 

has been most successful when applied as a tool of tax policy, rather than budget transparency. In 

our view, the ”spending substitute” leg of the Fiekowsky definition points too much in the 

direction of the second agenda, by requiring that a Tax Subsidy be convertible into a 

straightforward spending substitute.90

Some important provisions currently identified as tax expenditures cannot easily be 

described as exceptions to a general rule of present law, because the general rule is not clear 

from the face of the Internal Revenue Code. In light of this ambiguity, such a provision cannot 

properly be classified as a tax expenditure (more accurately, a Tax Subsidy) in the proposed 

narrower sense. Instead, we propose a second category, described below, for those provisions. 

 90 In Section VI we discuss outlay equivalence, which is a byproduct of this spending test. 
41 

C. Tax-Induced Structural Distortions 

As indicated above, some important provisions currently identified as tax expenditures 

cannot easily be described as exceptions to a general rule of present law, because the general rule 

is not clear from the face of the Internal Revenue Code. Those provisions therefore cannot 

properly be classified as Tax Subsidies in the narrower sense described above. If the JCT Staff 

were to attempt to expand the scope of Tax Subsidies to address these important policy questions 

by arbitrarily selecting one taxing pattern or another as the general rule, the result would be the 

same sort of subjective determinations that undermine the utility of a “normal” tax base in the 

current implementation of tax expenditure analysis.91 

The opportunity for taxpayers to elect to defer inclusion, for income tax purposes, of 

certain “active” earnings of foreign corporations owned by U.S. persons is one example of a 

provision that today is treated as a tax expenditure, but that would not be classified as a Tax 

Subsidy under our proposed definition, because present law is ambiguous as to what constitutes 

the general rule for taxing foreign earnings.92 

Items like the deferral treatment of foreign earnings raise important tax policy issues. 

Moreover, present law’s treatment of these provisions can be criticized on strict economic 

efficiency grounds.93 Tax expenditure analysis as currently implemented identifies some of these 

issues, but does so by reference to a “normal” tax baseline. The result is a sterile debate as to the 

appropriateness of the choice of that base, which in turn obscures rather than illuminates the 

important economic efficiency problems that current policies embody. 

Our response to the insufficiencies of an inappropriately narrow definition of tax 

expenditures is to create a second major category of tax expenditures alongside Tax Subsidies, 

which we have labeled “Tax-Induced Structural Distortions.” These we define as structural 

elements of the Internal Revenue Code (not deviations from any clearly identifiable general tax 

rule and thus not Tax Subsidies in our classification) that materially affect economic decisions in 

a manner that imposes substantial efficiency costs. 

The “deferral” of certain foreign earnings thus is one example of a Tax-Induced 

Structural Distortion. Another example is the differential taxation of debt and equity. The 

distinction between debt and equity is a Tax-Induced Structural Distortion, because it encourages 

business firms to leverage their capital structures, but it is not a Tax Subsidy (a tax expenditure 

in the narrower sense), because there is no clear consensus as to what general rule of tax law, if 

any, the debt-equity distinction might violate. 

We identify and present Tax-Induced Structural Distortions by considering their 

economic efficiency costs, not by invoking any normative tax system. For example, we analyze 

 91 See Thuronyi, supra, at 1182-1186. 

92 See Fleming and Peroni, supra at 196-197.

93 Section V.A. below discusses the concept of economic efficiency. 
42 

the current deferral tax treatment of the earnings of foreign subsidiaries as raising two important 

efficiency concerns: (i) U.S. firms may have an incentive under present law not to repatriate 

“active” foreign earnings to the United States;94 and (ii) deferral also implies a conditionally 

different tax rate on foreign active business income than the rate that applies to domestic income, 

and this difference may affect the type and location of business investment when compared 

either to a wholly domestic enterprise, or to a wholly foreign one. 

One possible solution to these efficiency concerns is to adopt a territorial tax regime; 

another is the first solution’s polar opposite, that is, to adopt a “full inclusion” tax regime. (Other 

hybrid solutions may also exist.) Each solution in turn raises issues of interest to policymakers. 

Our tax expenditure presentation of this and similar cases, however, will not prejudge the issue 

(as current tax expenditure analysis arguably does), by holding up one solution or the other as the 

“normal” tax system. 

While tax expenditure analysis can be helpful in identifying efficiency, equity, and ease 

of administration issues, as well as the design issues discussed in Section V, our definition of 

Tax-Induced Structural Distortions looks only to the substantive criterion of efficiency. There 

are at least three reasons for this decision. First, efficiency is an inherently more neutral 

construct than is equity (and possibly simplicity), and our overriding objective in rethinking tax 

expenditures is to move to a system that most observers can accept as neutral and principled. 

Second, most tax expenditures that are particularly troubling for equity (or other) reasons will be 

described as Tax Subsidies. Finally, most of the important structural ambiguities in the Internal 

Revenue Code today relate to the taxation of capital income (that is, business or investment 

income); efficiency goals loom largest in this context. 

D. Comparison to Treasury Department Approach 

It is instructive to compare the two-pronged definition outlined above to the Treasury 

Department’s current two-layer approach to tax expenditure analysis. The Treasury Department 

employs two concentric tax bases: a “normal” tax that is similar to that currently employed by 

the JCT Staff, and a “reference” tax base that (like our proposed tax base for identifying Tax 

Subsidies) constitutes a compilation of the general rules of the Internal Revenue Code and that 

can be visualized as a subset of the normal tax base.95

The Tax Subsidy component of the two-pronged approach advocated here is determined 

in a manner generally similar to the Treasury Department’s reliance on its reference tax base, 

except that the definition proposed here does not add an incremental judgment (albeit one that 

has not figured heavily into the current construction of the Treasury Department’s list) as to 

whether a spending program could substitute for the tax provision in question. The definition of 

a “Tax-Induced Structural Distortion,” by contrast, is very different from our understanding of 

 94 A taxpayer whose foreign tax credit position leaves it vulnerable to U.S. residual taxation may 

refrain from repatriating income back to the United States. 

95 Office of Management and Budget, Analytical Perspective, Budget of the United States 

Government, Fiscal Year 2009 at 297. 
43 

what the Treasury Department does today, because it does not invoke a “normal” tax base at 

all.96 Instead, our definition of “Tax-Induced Structural Distortions” relies entirely on an 

objective inquiry into efficiency considerations. The two categories that of our proposed 

definition of tax expenditures thus are intended to be as transparent and objective as possible. 

E. Subcategories of Tax Subsidies 

The JCT Staff believes that it would be helpful to policymakers to divide Tax Subsidies 

(i.e., tax expenditures in the narrow sense) into three subcategories. We propose these 

subdivisions with some reservations, because plausible arguments can be made to categorize 

many items in more than one subcategory, and we would not wish for classification arguments 

again to rob tax expenditure analysis of its productive power. We therefore emphasize that these 

subcategories are meant only to help policymakers to compare Tax Subsidies of like kind to one 

another; regardless of the subcategories to which we have assigned them, all Tax Subsidies rely 

on the same fundamental definition. 

As a starting point, we have assumed that the following definitional provisions are in 

accordance with the general rules of current law and therefore are not Tax Subsidies:97 (i) the 

personal exemption and standard deduction, because these items generally are offered to all 

taxpayers; (ii) filing status options, because these options are deemed to reflect an attempt to 

achieve parity across heterogeneous taxpayer units; and (iii) the nominal tax rate structure, which 

reflects a societal preference about how tax liability should vary by taxable income.98 

 96 In contrast to Fiekowsky, we view Tax-Induced Structural Distortions as firmly part of tax 

expenditure analysis, because the same economic reasoning and design parameters apply to them as apply 

to Tax Subsidies. 

97 As discussed earlier, one of Boris Bittker’s criticisms of Stanley Surrey’s approach was that 

the decision about what definitional items constituted tax expenditures, including the choice of rates and 

filing units, seemed subjective. While it is true that judgments are necessary in any tax expenditure 

analysis, the JCT Staff attempts here to identify rationales such as universality (the personal exemption 

and standard deduction), equity (filing status), and pragmatism (the rate structure itself) for identifying 

certain items as general rules rather than as Tax Subsidies. Specifically with respect to the rate structure, 

one difficulty in treating the rates themselves as tax expenditures stems from the decision about what the 

“general” rate would be (Zero? The top marginal rate? Some average rate that results in revenue 

neutrality? A uniform rate that maximizes revenue, or maximizes efficiency, or maximizes equity?). 

Attempting to present whatever negative or positive tax expenditures would result from treating the rate 

structure itself as a tax expenditure is also difficult in the context of a more comprehensive tax 

expenditure analysis that relies largely (with the exception of tax credits) on the effective marginal rates 

faced by taxpayers under present law to value tax expenditures. An interesting alternative presentation 

that treats part of the rate structure as a tax expenditure can be found in Rosanne Altshuler and Robert D. 

Dietz, Reconsidering Tax Expenditure Estimation: Challenges and Reforms, Paper presented at NBER 

Conference on Tax Expenditures, March 2008. 

98 Because the personal exemption is phased out (“PEP”) on the basis of a definition of gross 

income, a concept that is almost as general as taxable income, this phase-out also is treated as reflecting a 

societal preference about progressivity; thus PEP (like the nominal tax rate structure) is not treated as a 

negative tax expenditure. 
44 

Limitations directly linked to various Tax Subsidies, the alternative minimum tax, and the phaseout of itemized deductions are not classified as negative tax expenditures but instead are 

considered reductions in tax expenditures 

The subcategories of Tax Subsidies (including two examples of Negative Tax Subsidies 

presented in the third subcategory) are as follows: 

1. Tax Transfers 

A Tax Transfer is a payment made to a person without regard to the person’s income tax 

liability, because there was no income tax liability to begin with, or because the person’s income 

tax liability was eliminated by another Tax Subsidy.99 Unlike Tax Transfers, other Tax 

Subsidies only reduce (or increase, in the case of Negative Tax Subsidies) a taxpayer’s income 

tax liability. 

The subcategory of Tax Transfers today includes the refundable portions of the earned 

income tax credit, child tax credit, and the Recovery Rebates as enacted in the Economic 

Stimulus Act of 2008. These provisions usually are based on perceived need as measured by 

income. The provisions authorizing these payments are the clearest examples of hybrid 

tax/spending programs, i.e., they are essentially direct government spending programs that use 

the tax system for distribution.100 

2. Social Spending 

This subcategory of Tax Subsidies includes Tax Subsidies that are unrelated to the 

production of business income, and Tax Subsidies related to the supply of labor. These Tax 

Subsidies often are intended to subsidize or induce behavior (for example, charitable giving) that 

generally is considered to be unconnected to the production of business income. Examples 

include the itemized deduction for medical and dental expenses, IRA deductions (or exclusions, 

in the case of Roth IRAs), and the nonrefundable portion of the child tax credit. This category 

also includes the portions of the earned income credit, child tax credit, and 2008 rebate that are 

not refundable. 

In cases where a provision has potentially both business and non-business statutory 

incidence, we classify the provision based on a judgment about the effect and/or the intent of the 

 99 For evaluation purposes, the refundable portion of a tax expenditure is considered separately 

from the nonrefundable portion. 

100 Tax Transfers are also among the tax expenditures that are close substitutes for existing direct 

government spending programs. For example, the refundable portion of the earned income credit and 

child tax credit are similar to non-tax-related government programs (both Federal and State and local) that 

address financial need and encourage employment of low-income persons. The Tax Transfer category is 

not intended to be the exclusive listing of provisions targeted as financial relief for, or employment of, 

low-income persons, as other nonrefundable provisions may have the same or overlapping goals, but 

means-tested refundability is a clear demarcation for preventing Tax Transfers from being overinclusive 

as a category. 
45 

provision. Thus, for example, we treat working-condition fringe benefits, which are excludible 

from employee income (but deductible by businesses), as Tax Subsidies in the Social Spending 

category rather than in the Business Synthetic Spending category, described below, because this 

treatment of fringe benefits is generally viewed by analysts as affecting labor supply more than 

general business decisions.101 By the same token, IRAs, owing to their role in capital 

accumulation, are Tax Subsidies that have a link to Business Synthetic Spending. Nevertheless, 

we classify them as Social Spending, because so much of their design, including their mandatory 

distribution requirements, is geared toward income support for retirement. 

When legislative intent is not readily discernible, an item that appears to qualify for more 

that one category will be classified according to whether or not it is linked directly to production 

of business income. Thus, we will classify most education subsidies as Social Spending, while 

various capital income subsidies will be classified as Business Synthetic Spending (or in some 

cases these items will be placed in the other first-order category, Tax-Induced Structural 

Distortions). 

Owner-occupied housing preferences can rationally be categorized either as Social 

Spending or in the subcategory of Business Synthetic Spending, depending on whether one 

views home ownership as primarily a consumption activity or a substitute for an incomeproducing investment. On balance, we believe that these housing preferences are better described 

as Social Spending. Doing so acknowledges that preferences for owner-occupied housing reflect 

a social policy agenda that transcends the tax law. Moreover, it is more straightforward for noneconomists to understand the tax treatment of housing as an exception to the general rule for 

personal expenditures (no deduction of interest expense or other costs) than it is to see the 

homeowner as forgoing the rental income that could have been obtained were the housing made 

available for arm’s-length rental. 

3. Business Synthetic Spending 

This category includes Tax Subsidies intended to subsidize or induce behavior directly 

related to the production of business or investment income (but excludes any Tax Subsidies 

related to the supply of labor). Examples of Business Synthetic Spending include the section 199 

deduction for income attributable to domestic production activities, the completed contract 

method of accounting rules, various energy subsidies, the last-in-first-out method of accounting, 

and the expensing of soil and water conservation payments. 

Negative Tax Subsidies are those special provisions of the law that increase the normal 

tax burden above what the general rules would impose. Two examples of Negative Business 

Synthetic Spending items are the two-percent floor on the deductibility of itemized investment 

expenses, and the disallowance of a deduction for employee remuneration in excess of $1 

million. 

 101 The legislative and executive branch histories of enactment and implementation of these 

provisions also support this incidence assumption, because this tax treatment of fringe benefits primarily 

was considered to affect decisions about labor supply and other laborer concerns such as health and 

retirement. 
46 

4. Utility of Tax Subsidy subcategories 

We hope that our division of Tax Subsidies into the above three subcategories will 

facilitate consensus on the principles that are relevant to the evaluation of a particular Tax 

Subsidy. All tax subsidies raise questions of equity, efficiency and ease of administration. The 

three subcategories can be useful, however, to suggest that these factors may have different 

weights across the different subcategories. 

For example, targeting and incentive effects are likely to be most important in the 

evaluation of a Tax Transfer intended to aid low-income persons. Effects on income distribution 

may be less important, however, to the evaluation of a Social Spending provision than is its 

efficacy in achieving a specific societal goal. For an item in the Business Synthetic Spending 

subcategory, concerns regarding certainty and economic efficiency may be more relevant than 

for items in the other two subcategories. Tradeoffs among competing goals are a necessity in the 

design of any tax provision. The subcategories of Tax Subsidies are intended simply to assist in 

making and understanding these tradeoffs. 
47 

F. Miscellaneous Considerations 

The above discussion arguably overstates the practical differences among the different 

definitions of tax expenditures. The Treasury Department, for example, lists some 152 items as 

tax expenditures under its “reference tax” baseline. In the Treasury Department’s analysis, 

employing the “normal” tax as the baseline adds only nine additional items.102 While the JCT 

Staff’s list of tax expenditures historically has included more items than has the Treasury 

Department’s, we nonetheless anticipate that our category of Tax Subsidies will comprise the 

preponderance of items that today are classified as tax expenditures. 

We recognize that a few items that today are classified as tax expenditures may not fit 

neatly either as Tax Subsidies or as Tax-Induced Structural Distortions. We propose to continue 

to carry those items on our tax expenditure tables to preserve continuity with all of our prior 

work in this area. We will reevaluate this decision periodically, in light of the success (or 

failure) of the new approach proposed here. 

Finally, the JCT Staff’s revised approach to tax expenditure analysis further expands the 

traditional definition by identifying special provisions that increase the tax burden (above what 

the general rule would impose) as “negative” tax expenditures. (As previously noted, we label 

these provisions “Negative Tax Subsidies.”) Limitations directly linked to various positive tax 

expenditures, the alternative minimum tax, and the limitation on itemized deductions are not 

classified as negative tax expenditures but instead are considered reductions in those positive 

expenditures.103

 102 These additional items include: certain accelerated depreciation deductions, the current 

expensing of research and experimentation expenditures, and the “deferral” of active income earned by 

foreign subsidiaries of U.S. taxpayers. 

103 The limitation on itemized deductions, also known as the “Pease” limitation after former 

Representative Donald Pease, is allocated on a pro rata basis for quantitative presentation. 
48 

V. ECONOMIC CONSIDERATIONS IN TAX EXPENDITURE ANALYSIS 

A. Introduction to the Economic Evaluation of Tax Expenditures 

1. Overview 

Analysts generally apply three principal economic criteria when judging the merits of any 

tax system: Does that tax system increase or decrease equity across taxpayers? Does it increase 

or decrease economic efficiency (that is, the extent to which market decisions are free of 

distortions introduced by the tax)? And can that tax system be easily administered? Tax 

expenditure analysis can apply these same criteria to evaluate the efficacy of any proposed tax 

expenditure, which reflects the status of a tax expenditure as both an exception to a general rule 

of tax law and as part of the fabric of the overall tax system. 

The next several subsections therefore explain how economists use the terms “equity,” 

“efficiency” and “ease of administration,” and the application of these terms to tax expenditure 

analysis.104 These concepts may sound subjective, but in fact economists have made a great deal 

of progress over the last several decades in expressing them in objective terms. By providing 

relatively robust answers to the questions suggested above, tax expenditure analysis can offer 

useful insights to policymakers called on to decide, for example, whether a proposed new tax 

expenditure is worth the revenue cost.105

The ultimate goal of economic analysis is to provide guidance to policymakers in order to 

improve welfare – that is, the overall well-being of the members of a society. As a first-order 

approximation, economists often use wealth (or income, or sometimes consumption) as a proxy 

 104 See The Structure and Reform of Direct Taxation: Report of a Committee Chaired by 

Professor J. E. Meade (George Allen and Unwin, London, 1978); James Banks and Peter A. Diamond, 

The Base for Direct Taxation (March 20, 2008), MIT Department of Economics Working Paper No. 08-

11. These are not the only goals that might explain tax expenditures. The Meade Report and Banks and 

Diamond expand these categories by including international and transition goals, but the categories 

presented here are inclusive enough to cover a variety of aims. In addition, efficiency may also include 

concerns about competitiveness (a justification often offered for the foreign earned income exclusion 

under section 911) or national security (the income tax exclusion for certain military benefits), while 

equity concerns may include tax expenditures justified on the basis of common (or even international) law 

or treaties. 

105 The issues of equity, efficiency and ease of administration are equally relevant when applied 

to the non-tax mechanisms generally available to policymakers to intervene in the economy by 

subsidizing (or penalizing) one activity above others: direct spending and mandates (i.e., regulation). In 

many cases, there may be only minor differences in the equity or efficiency analysis of a proposed 

subsidy couched alternatively as direct spending or as a tax expenditure. (The relative ease of 

administration may, however, differ materially between the two.) Because the issues are the same, 

regardless of the type of intervention, policy analysts generally recommend that all three mechanisms 

(direct spending, tax expenditure and, where relevant, regulation) be considered before adopting one 

approach over the others. The nature of the legislative process, however, does not readily permit such 

comparisons always to be made. 
49 

for welfare, but they fully realize that this is an imperfect measure.106 Given a fixed revenue 

constraint (i.e., a need for a fixed amount of tax revenues), analysts usually will conclude that a 

system that is more equitable in distributing the burden of taxation, more efficient (or less 

distorting) with respect to economic decision making, and easier to administer will result in 

increased welfare, including through increased productivity and increased wealth. Economists 

usually believe that the ordinary operations of the marketplace do a better job of allocating 

resources and opportunities than does a more regulated system. They accordingly believe that 

competitive markets are likely to improve welfare, by maximizing economic efficiency and 

productivity. 

As a very general matter, therefore, economists ordinarily are skeptical about the value of 

tax expenditures and begin with the presumption that in most cases tax expenditures will 

diminish economic efficiency.107 Economists recognize, however, that the welfare of society 

encompasses more than efficiency goals. As a result, if the tax expenditure has other redeeming 

attributes, then on balance it may enhance welfare. For example, a tax expenditure that 

diminishes economic efficiency may improve equity (or some other societal value) in ways such 

that the overall welfare of society is enhanced, notwithstanding the detriments to efficiency.108 

Ultimately, such decisions can only be resolved through the political process, because that is the 

vehicle that resolves competing and otherwise incomparable preferences of a society. 

To take a well-known example, the Federal income tax today contains several large 

subsidies (incentives) for home ownership. Most economists would agree that these tax subsidies 

are welfare-diminishing. The tax expenditures can be described as introducing inequality of 

after-tax treatment between otherwise similarly-situated home owners and home renters. The 

incentives can also be seen as introducing inequities in another sense, by virtue of what Stanley 

Surrey called their “upside down” design – that is, the fact that these tax expenditures, by being 

structured as tax deductions, give proportionately greater government subsidies to taxpayers with 

higher incomes (because the value of a tax deduction is determined by the taxpayer’s marginal 

tax rate). Housing tax subsidies can also be viewed as inefficient, in at least three respects. First, 

they encourage private capital to be diverted into the housing sector from other investments that 

would have been made in a world without such incentives, thereby raising the cost of capital for 

the rest of the economy. Second, the revenues forgone by providing these tax subsidies must be 

made up by raising marginal tax rates, and those higher tax rates by themselves introduce 

 106 Critics sometimes mistakenly argue that economists, by using wealth as a first-order proxy for 

welfare, ignore public goods like environmental protection. In fact, economists recognize that wealth 

should include measures of assets like the environment. Such assets will be inefficiently priced 

(undervalued) in market transactions and may justify government intervention to correct such mispricing. 

Economists have suggested ways to deal with these “externalities,” some of which are discussed in more 

detail below. 

107 Subsection V.A.3, below, briefly discusses the application of the theory of the second best in 

this context. 

108 Some tax expenditures, like savings incentives, may actually increase economic efficiency, by 

mitigating structural distortions inherent in an income tax, as described below. 
50 

distortions in behavior. Finally, current law’s housing incentives certainly add significant 

complexity to our tax system. 

Nonetheless, the political process has concluded that subsidizing home ownership is 

desirable. This conclusion can be explained as reflecting factors other than efficiency – for 

example, “externalities” such as the possible advantages to society of having its citizens feel 

more “invested” in their communities, and committed to the larger political system, that might 

stem from home ownership. Moreover, a simple application of tax expenditure analysis along the 

lines summarized above might be criticized in this context (when one is reviewing a 

longstanding tax expenditure) for assuming a world where decisions had not been distorted for 

many decades by these incentives; the technical analysis of what to do with those tax 

expenditures in light of that past history, or in light (in this case) of the market dislocations that 

this sector of the economy currently is suffering, might be completely different from the analysis 

that would be applied to a completely new proposed tax expenditure. 

To conclude this example, tax expenditure analysis can shed helpful light on the costs (in 

the broad sense, including, as noted above, environmental costs and similar externalities) of tax 

subsidies associated with owner-occupied housing, or can propose ways of rethinking the 

subsidies that might reduce their costs (for example, the replacement of housing-related tax 

deductions with tax credits). The ultimate decision as to the net societal welfare to be gained by 

subsidizing home ownership, however, can only be resolved through the political process. 

The remainder of this Subsection V.A. amplifies the above themes, by describing in more 

detail the principal economic criteria used to evaluate tax systems or tax expenditures: equity, 

efficiency and ease of administration. These are the criteria by which economists would argue 

that the desirability of most tax expenditures should be judged. 

Subsection V.B. is a higher-level presentation that grounds the economic considerations 

of tax expenditure analysis in contemporary economic research literature. This subsection 

requires some background in academic economics. 

Subsection V.C. then poses and answers a related but slightly different question: once a 

decision has been reached to implement a tax expenditure, how can that expenditure be designed 

so as to minimize its equity, efficiency, and administrative deficiencies? This subsection 

introduces three analytical criteria to help with that design question: transparency, targeting and 

certainty. 

Finally, Subsection V.D. applies the principles developed in Subsections V.A. and V.B. 

to this pamphlet’s new paradigm for categorizing tax expenditures. 

2. Equity 

Equity denotes a concept of fairness, particularly as relates to the distribution of wealth or 

the burden of taxation.109 Equity includes the notions of horizontal and vertical equity. 

 109 Another concept of equity relates to the choice of business organizational form. That is, tax 

provisions should treat businesses in different organizational forms the same. See Roger H. Gordon and 
51 

Horizontal equity is the idea that taxpayers who are similarly situated with respect to their ability 

to pay taxes should pay similar amounts of tax. That is, "taxes should bear similarly upon all 

people in similar circumstances."110 Vertical equity suggests that taxpayers with different 

abilities to pay should be treated differently, or those with a greater ability to pay should pay 

more.111 Together, these two ways of looking at equity suggest that "the ideal tax base should 

be equivalent to whatever is determined to be the appropriate measure of ability to pay."112 In 

practice, of course, difficulties arise in determining when taxpayers are similarly situated—that 

is, what constitutes the correct measure of ability to pay. 

The concept of vertical equity by itself does not answer the question of whether the tax 

system should be used to reduce income inequality in society. A “proportional” income tax – a 

flat tax imposed at a single specified rate on taxable income – would, for example, collect five 

times as much revenue from a taxpayer with $100,000 of taxable income as from one with 

$20,000, and to that extent would honor the principle of vertical equity. That flat income tax 

would also leave intact the pre-tax inequality in income between the two taxpayers (because the 

after-tax incomes of each would still be in a ratio of 5:1). 

In reality, the Federal income tax has always been used to address income inequality in 

society, through its “progressive” rate structure. Economists define a progressive tax as one in 

which the average tax rate rises with income.113 An average income tax rate is the taxpayer's 

total income tax liability divided by his total income. Mechanically, this is accomplished by 

applying higher marginal tax rates as incomes increase. A marginal income tax rate is the rate of 

tax imposed on an additional, or marginal, dollar of income earned by the taxpayer.114 

 

Jeffrey K. MacKie-Mason, Tax Distortions to the Choice of Organizational Form, 55 Journal of Public 

Economics 279-306 (1994). 

110 Henry Simons, Federal Tax Reform 8 (University of Chicago Press, 1950). 

111 Richard Musgrave, The Theory of Public Finance (McGraw Hill, 1959). 

112 Diane Lim Rogers, Federal Income Tax Policy: Issues of Distribution and Equity 579-607, in 

Handbook on Taxation, eds. W. Bartley Hildreth & James A. Richardson (Marcel Dekker, Inc., 1999). 

An alternative view of equity suggests that taxes should be paid in proportion to the benefits 

received. See Adam Smith, Wealth of Nations (1776). The property tax may also embody this concept of 

equity in which the taxpayer gets what he pays for and pays for what he gets. There are efficiency 

advantages as well to this construction of equity. See James R. Hines, Jr. What is Benefit Taxation?, 75 

Journal of Public Economics 483-492 (2000). 

113 Louis Kaplow, Taxation and Redistribution: Some Clarifications, 60 Tax Law Review 58 

(2007). 

114 Statutory tax rates in the Code are marginal tax rates. While the current Federal tax system 

has both rising marginal and rising average tax rate rates, a tax may be progressive, even if marginal rates 

are declining at higher levels of income. 
52 

For example, if a hypothetical income tax imposed a tax rate of 20 percent on the first 

$50,000 of taxable income, 30 percent on the next $50,000 of income, and 40 percent on all 

income beyond that, then a taxpayer who had precisely $50,000 of taxable income would have 

an average tax rate of 20 percent (because the taxpayer’s tax bill would be $10,000), but would 

face a marginal tax rate on his next dollar of income of 30 percent. Similarly, a taxpayer who 

earned $100,000 in taxable income would pay tax at an average rate of 25 percent (not 30 

percent, because the first $50,000 of income was taxed at only 20 percent), and would face a

marginal tax rate on her next dollar of income of 40 percent. 

While any particular level of progressivity is a matter for society to judge, economic 

analysis can provide measures of progressivity to inform this political process. One way to 

measure progressivity is to measure the difference between pre-tax and after-tax income 

inequality. One common tool that public policy economists have employed to measure income 

inequality (whether pre-tax or after-tax) is the “Gini coefficient.” The Gini coefficient 

summarizes the characteristics of how society’s aggregate income is distributed among its 

members in a single number. This measure equals 1.0 when all income in an economy is 

attributable to one taxpayer (that is, the system is as unequal as possible), and 0.0 when all 

income is equally distributed among the members of the society. The Gini coefficient by itself, 

however, does not provide information about the equity of the tax system.115 

Tax expenditures interact with the notion of equity in various ways. Some tax 

expenditures may be designed to provide a better measure of what Congress deems to be the 

correct measure of “ability to pay,” and thereby improve horizontal equity. For example, the 

deduction for medical expenses in excess of 7.5 percent of adjusted gross income may reflect a 

determination that two taxpayers with the same gross income are not similarly situated if one has 

high medical expenses and the other does not. 

Tax expenditure design also can have a significant effect on vertical equity. For example, 

tax expenditures formulated as deductions will generally reduce the progressivity of the tax 

system, by reducing average tax rates more for higher marginal rate taxpayers than for lower 

marginal rate taxpayers. (This is what Stanley Surrey termed the “upside down” subsidy effect of 

tax expenditures structured as deductions.) In contrast, tax expenditures structured as credits 

would generally increase the progressivity of the tax system. A credit will create uniform 

incentives and provide uniform benefits to all individuals if it is structured as a refundable 

credit.116 Gini coefficients and similar tools can be used to compare the after-tax income 

inequality (i.e. tax progressivity) consequences of complex trade-offs among different packages 

of tax expenditures and/or tax revenue raising provisions. 

 115 See Michael J. Graetz, Paint-by-Numbers Tax Lawmaking, 95 Columbia Law Review 609, 

620-624 (1995), for a more detailed discussion of uses of the Gini coefficient to evaluate tax laws. For 

example, a tax system may be judged by comparing pre-tax and post-tax Ginis. Changes in tax laws may 

be assessed by comparing post-tax Ginis before and after a tax change. 

116 Lily L. Batchelder, Fred T. Goldberg, Jr., Peter R. Orszag, Efficiency and Tax Incentives: The 

Case for Refundable Tax Credits, 59 Stanford Law Review 52-57 (2006). 
53 

3. Efficiency 

To an economist, the “efficiency” of a tax does not relate to the ease with which it is 

collected. Instead, a tax system is more “efficient” if it does not distort, or if it actually improves, 

the economic decisions that individuals and businesses make. A tax system is perfectly efficient 

if individuals and firms make the same decisions in the presence of the tax as they would if the 

tax did not exist, subject only to the fact that they are less wealthy by virtue of paying the tax. 

(That is, even an efficient tax that is not immediately returned to the taxpayer in the form of 

government services reduces a taxpayer’s wealth – otherwise it would not be a tax.) 

No practical tax system can be wholly efficient, because distortions in behavior will 

follow whenever the taxpayer’s actions can determine the base on which he is taxed.117 For 

example, confronted with an income tax cost to working more and earning more money, some 

taxpayers will choose (untaxed) leisure instead. The result, to an economist, is a distortion, 

because the taxpayer has chosen, in light of the imposition of taxes on his wages, to work less 

than he would in a world without such taxes.118 These non-neutralities can cause taxpayers to 

 117 Joel Slemrod, Which is the Simplest Tax System of Them All? 355, in Henry J. Aaron and 

William G. Gale, eds., Economic Effects of Fundamental Tax Reform (Brookings Institution 1996). Thus, 

the usual example of a perfectly efficient tax is a “poll” tax, i.e., one imposed at the same rate on every 

individual, regardless of wealth or other distinguishing feature. Such a tax cannot be avoided, and 

therefore does not change behavior. It is also plainly inequitable, and in the United States at least suffers 

from Constitutional infirmities. 

118 As described in the text below, it is well known among economists that any income tax—even 

an "ideal" income tax — introduces two important economic inefficiencies. First, an income tax, like any 

tax measured by effort or output (including a consumption tax), distorts an individual's decisions with 

respect to how to divide his time between labor and leisure. Second, an income tax distorts an individual's 

choice as to whether to consume his after-tax earnings currently, or to postpone that consumption for the 

future. (This second distortion follows from the fact that an income tax generally taxes the returns earned 

by the individual from investing his after-tax earnings pending his future consumption of them.) 

Economists also have developed what is referred to as the "theory of the second best." As applied 

to taxation, this important theory argues that, where a tax (like an income tax) itself creates economic 

inefficiencies, actions to partially correct those inefficiencies (in some cases, but not others, for example) 

may actually compound the problem, not mitigate it. Instead, the theory argues, the total economic effects 

of the tax system before the proposed correction must be compared to the total effects afterwards. 

The theory of the second best has direct relevance to the examination of tax expenditures, because 

it implies that a particular tax expenditure might not be as detrimental from an economic efficiency 

perspective as might at first appear to be the case (or, theoretically, might actually improve matters). For 

example, when Congress provides investment incentives for some types of capital investment but not 

others, that legislation will distort the allocation of capital, when compared to an income tax that treated 

all capital investment identically, but might possibly reduce the income tax's aggregate distorting effects 

on savings. Such legislation thus might (or might not) lead to a net welfare gain. 

In the practical context of considering pending legislation, however, analysts (including the JCT 

Staff) tend not to emphasize the relevance of the theory of the second best, for several reasons. First, most 

tax expenditures on their face introduce new and very narrow incremental inefficiencies on top of the 
54 

make decisions that result in an inefficient use of their own and the economy's resources. By 

reducing taxpayer welfare, these distortions diminish the performance of the economy, and the 

welfare of society as a whole.119 

Economists use the term “deadweight loss” as a synonym for the distortions in economic 

decision-making caused by taxes. Thus, the “deadweight loss” of a tax is the welfare cost to 

society of the tax, beyond the actual cash payments made to the government, that are attributable 

to hours not worked, investments not made, or the like, because of the tax burden that would be 

imposed on those affirmative acts. 

No practical tax, whether a consumption tax or an income tax, can avoid the deadweight 

loss associated with distorting taxpayers’ preferences for how they would divide their time 

between work and leisure in the absence of taxes. In addition, an income tax, by taxing both 

wage income and any return on the wage-earner’s after-tax savings, decreases the present value 

of future consumption compared to present consumption. This in turn creates a bias against 

saving. (On the other hand, by taxing investment returns from savings, income taxes can have 

lower marginal and average tax rates than an otherwise comparable consumption tax, which may 

have compliance or other economic advantages.) 

Distortions to the decision to save rather than to spend thus are an inevitable consequence 

of choosing an income tax. It follows that many savings incentives should be classified as tax 

expenditures, in the sense that they are exceptions to the general income tax rule, but at the same 

time these tax expenditures may actually increase economic efficiency. 

Importantly for tax expenditure analysis, the concept of deadweight loss also includes the 

welfare costs to society of affirmative decisions to change behavior (whether of consumption, or 

investment, or other acts), to avoid or reduce tax burdens. That is, tax expenditures may create 

distortions (deadweight loss) by influencing the allocation of resources. 

 

systemic inefficiencies of an income tax, and it is highly likely that a more sophisticated analysis would 

lead to the conclusion that these highly targeted provisions in fact lead to an increase, rather than a 

mitigation, of existing systemic inefficiencies. Second, it can be argued that the practical goal in general 

of economic analysis of income tax proposals, in the absence of some conscious decision to the contrary, 

should be to preserve the known systemic inefficiencies of the income tax, and measured from this 

baseline (as opposed to the ideal of a perfectly efficient world), the theory of the second best has less 

relevance. Finally, it is much easier to determine the direct distortion of a new provision than its indirect 

effects on pre-existing distortions. As a consequence, most policy analysts addressing practical legislative 

proposals invoke second-best considerations only when the effects are clear. 

119 An additional consideration for efficiency is the extent to which a tax system promotes overall 

economic growth. See Richard Abel Musgrave and Peggy B. Musgrave, Public Finance in Theory and 

Practice (Fifth ed., McGraw Hill, February 1989). Designing a tax system that encouraged economic 

growth was one of the primary objectives of the Treasury Department’s study of fundamental tax reform 

in 1984. See Treasury Department, Office of the Secretary, Tax Reform for Fairness, Simplicity, and 

Economic Growth: The Treasury Department Report to the President, Vol 1: Overview (1984). If capital 

is allocated more efficiently across sectors of the economy, the result will be more productive investment 

and growth will accelerate. 
55 

Thus, imagine that a taxpayer on a limited budget today prefers peanut butter to cream 

cheese, and a subsidy then is created for production of the latter through the adoption of tax 

expenditures aimed at cheese makers. In light of the now-lower subsidized price of cream 

cheese, the taxpayer (and others like her) may choose to switch some of her peanut butter 

consumption to cream cheese. Proponents of the cheese tax expenditure would point to the surge 

in cream cheese production and consumption as demonstrating that an untapped need had been 

filled, but economists apprised of the facts would conclude that the concomitant decline in 

peanut butter consumption told a sadder story of deadweight loss, in which peanut butter fanciers 

distorted their pretax preferences to reduce their tax liabilities. 

As another, and weightier, example, income from investments in corporate equity 

generally is subject to a corporate-level tax when earned and to individual-level tax when 

distributed, while interest from certain State and local securities is exempt from tax. This creates 

a bias against corporate equity investment and a bias in favor of investment in State and local 

debt securities. Such non-neutralities may distort investor decisions, thereby reducing the 

efficiency of capital markets in allocating capital to its most highly valued uses. Similarly, the 

exclusion of employer-provided health benefits from taxable income may lead employees to 

consume more health care and less other goods than they otherwise would. 

Progressive tax structures may increase vertical equity, but they also increase the 

distorting effect of taxes on the work-leisure decision, by imposing ever-greater tax burdens as 

taxpayers earn more money. In general, as marginal tax rates become higher, the deadweight 

losses (the distorting effects of taxes) imposed on society increase, because the higher marginal 

rates impel stronger taxpayer reactions. As a result, in designing a tax system or a tax 

expenditure there frequently is a direct tradeoff between equity and efficiency goals. 

For a fixed government revenue constraint (that is, for a fixed amount of taxes that need 

to be raised), the introduction of tax expenditures necessitates higher marginal rates to raise the 

same amount of revenue. As a result, and in addition to whatever direct effects they may have, 

tax expenditures will amplify the distortions attributable to imposing higher marginal tax rates. 

It is important to remember both these direct and indirect consequences when measuring the 

deadweight loss attributable to a tax expenditure. 

Some taxes may actually improve economic efficiency if they correct a market 

“externality.” Externalities are factors (positive or negative) that are not traded in any market or 

that influence any party not involved in a particular economic transaction. The best-known 

example of an externality is environmental degradation, which causes a real decline in all of 

society’s welfare, but which, in the absence of some mandate (regulation) or tax might not be 

reflected in the economic calculus of the parties causing that degradation. In response, 

economists might propose a “Pigouvian” tax, named for economist Arthur Pigou, who developed 

the concept of economic externalities.120 In this case, a tax actually improves economic 

efficiency, by assuring that private marginal costs of an activity will equal (after consideration of 

 120 Arthur C. Pigou, A Study in Public Finance (Third Edition, Macmillan, 1947). 
56 

the Pigouvian tax) society’s marginal costs. To improve efficiency, not only must the externality 

exist, but also the tax must effectively discourage the targeted activity. 

Just as there are Pigouvian taxes in the real world, so too there can be Pigouvian tax 

expenditures – that is, tax expenditures that, by compensating for an externality, actually 

improve economic efficiency. For example, one rationale for the research and experimentation 

credit is that a private firm may find it difficult to capture the full benefits from its research and 

prevent its competitors from using such benefits. Thus the firm will conduct too little research 

and experimentation relative to the full benefits such activity would provide to society as a 

whole. If this is so, then a Pigouvian subsidy in the form of a tax expenditure for such research 

is compatible with optimal resource allocation.121 

4. Ease of administration 

One of the common complaints about the current income tax system is that it is difficult 

to administer and extremely complex. The complexity leads to the use of resources to learn the 

rules of the tax and to prepare returns for the collection of the tax. Individuals, businesses, and 

the government all use resources in the process of collecting the tax revenue. Researchers have 

estimated the compliance burden at between $90 billion122 and $265 billion per year.123 

Expenditures by the government show up in the staffing and budget requirements. For fiscal year 

2008, the Internal Revenue Service had a budget of more than $10.8 billion, with over 91,000 

full-time equivalent employees.124 During fiscal year 2007, the IRS processed 235 million 

returns.125 The IRS also processed 1.8 billion information returns in the course of its 

document-matching program.126 These information returns relate to items such as wage, 

dividend, and interest receipts and are matched against individual income tax returns to identify 

income reporting discrepancies, unsubstantiated deductions, and nonfiling of returns. There were 

 121 See William J. Baumol, On Taxation and the Control of Externalities, 62 American Economic 

Review 307-322 (1972). A similar argument can be made for addressing negative externalities, such as 

pollution, with negative tax expenditures. In this case individuals may not fully incorporate the 

environmental costs they impose on society by certain activities, and thus indulge in them too much. A 

negative tax expenditure that raised the private cost of such activities to reflect the full social cost could 

enhance economic efficiency. 

122 John L. Guyton, Adam K. Korobow, Peter S. Lee, and Eric J. Toder, The Effects of Tax 

Software and Paid Preparers on Compliance Costs, 58 National Tax Journal 439-448 (September 2005). 

123 Scott J. Moody, Wendy P. Warcholik, and Scott A. Hodge, The Rising Cost of Complying 

with the Federal Income Tax, Tax Foundation, Special Report No. 138, December 2005. 

124 Internal Revenue Service, The Budget in Brief, Fiscal Year 2009 at 6. 

125 IRS Data Book, Fiscal Year 2007 (Pub. 55B), March 2008, Table 2 (hereinafter, “IRS Data 

Book”). 

126 IRS Data Book, Table 14. 
57 

over 179 million income, estate, gift, and partnership returns filed in 2006. The IRS examined 

1.5 million of those returns, for an audit rate of 0.86 percent.127

Tax expenditures generally contribute to the compliance burden of the income tax. Some 

have suggested that not only do they make the tax system more complex because they require 

distinctions between subsidized and unsubsidized activities, but also they raise compliance costs, 

IRS costs of administration, and rates of noncompliance.128 To the extent that individuals and 

businesses must devote resources to tracking tax-preferred activities due to tax expenditures, this 

raises compliance costs. Refining tax expenditures by better targeting them to their intended 

beneficiaries may have the unintended consequence of also increasing complexity.129 Tax 

expenditures also increase the length of instructions and the time required to complete tax 

returns. 

Some tax expenditures, however, particularly exclusions, may simplify administration of 

the tax system. For example, the exclusion from taxable income of de minimis working 

condition fringe benefits (e.g. employer-provided coffee) simplifies administration of the income 

tax. 

 127 IRS Data Book, Table 9. 

128 Eric Toder, Tax Expenditures and Tax Reform: Issues and Analysis, in Proceedings of the 

National Tax Association Ninety-Eighth Annual Conference (2005) at 475. 

129 For a detailed discussion of these issues in the health context, see Janet Holtzblatt, The 

Challenges of Implementing Health Reform through the Tax System, Paper presented at the conference on 

Taxes and Health Insurance: Analysis and Policies, organized by the Tax Policy Center and the American 

Tax Policy Institute at Brookings Institution, February 29, 2008. 
58 

B. Theoretical Economic Research on Tax Expenditures 

Some results from theoretical economic analyses of income taxes and tax expenditures 

have implications for the analysis of how tax expenditures fare in meeting the substantive goals 

of equity, efficiency, and ease of administration.130 This research often is referred to as “optimal 

income tax” and “optimal tax expenditure” literature. This brief discussion emphasizes some of 

the consensus results of this theoretical research. This summary of the theoretical literature does 

not attempt to survey the important applied research on either the income tax or on tax 

expenditures, because of the volume of such studies and the difficulty in finding consensus 

results that would be useful at this stage of our reexamination of tax expenditures.131 

Optimal income tax theory suggests that provided that equity and revenue generation 

issues are identical, one income tax structure is preferable to another income tax structure if it 

minimizes (1) potential negative labor supply response;132 and (2) the number of tax brackets. 

Optimal income tax theory also favors the imposition of transparent non-increasing tax rates over 

large ranges of income. With respect to this last result, these theoretical studies suggest that, 

again, if equity and revenue issues are somehow ameliorated, generally it would be better to have 

 130 F. P. Ramsey, A Contribution to the Theory of Taxation, Economic Journal 47-61 (March 

1927); James A. Mirrlees, An Exploration in the Theory of Optimum Taxation, 38 The Review of 

Economic Studies 175-208 (1971); A. B. Atkinson & J. E. Stiglitz, The Design of Tax Structure: Direct 

versus Indirect Taxation, 6 Journal of Public Economics 55-75 (1976). These theoretical studies broadly 

have focused on commodity and individual income taxes because at the theoretical level there is little 

justification for separate business or corporate income taxes once an individual income tax has been 

established. 

131 The empirical research on tax expenditures largely focuses on specific questions about tax 

expenditures (e.g., the particular tax and income elasticities, substitutability or complementarity between 

the tax-subsidized activity and direct government provision), while our focus here is more general. 

Indicative of this applied research are the many empirical studies of specific tax expenditures, some 

recent (Altshuler and Dietz, supra) and some not so recent (e.g., L. C. Fitch, Taxing Municipal Bond 

Income (1950)). In particular, the tax treatment of charitable giving and tax-exempt charities (given great 

momentum by The Commission on Private Philanthropy and Public Needs, Research Papers, 5 Volumes, 

published by the Department of the Treasury (1977) and many studies over a long period of time by 

others, e.g., Burton A. Weisbrod, The Nonprofit Economy, Harvard University Press, Cambridge, MA, 

(1980), as well as earlier econometric studies, e.g., Michael K. Taussig, Economic Aspects of the Personal 

Income Tax Treatment of Charitable Contributions, 20 National Tax Journal 1-19 (1967); Martin S. 

Feldstein and Charles T. Clotfelter, Tax Incentives and Charitable Contributions in the United States: A 

Microeconomic Analysis, 5 Journal of Public Economics 1-26 (1976), and issues related to Federalism 

(particularly the tax treatment of interest from municipal bonds) have received empirical attention over 

the years (e.g., D.J. Ott and A.H. Meltzer, eds., Federal Tax Treatment of State and Local Securities

(Washington, D.C., The Brookings Institution, 1963); Roger H. Gordon and Joel Slemrod, A General 

Equilibrium Simulation Study of Subsidies of Municipal Expenditures, 38 Journal of Finance, AFA Papers 

and Proceedings 585-594 (1983).) In addition, these two items, charitable giving and municipal bonds, 

were and are often used as examples in the general discussion of tax expenditures. 

132 This result affirms the similar efficiency result discussed above in subsection V.A.3. 
59 

a tax rate structure composed of decreasing tax rates as income rises.133 In practice, of course, 

the goals of equity and revenue generation make this unobtainable. Also, all else being equal, 

optimal income tax studies suggest that income that is less responsive to taxation should bear a 

relatively higher tax burden.134 

Economic studies of optimal tax expenditures focus on many questions that bear on the 

issues of efficiency and equity.135 One such example is the nature of the activity that is being 

encouraged; this literature analyzes how private activity interacts with the form in which the 

government provides the encouragement in question (direct government provision of the good or 

service, tax expenditures, or other forms of both governmental intervention, such as regulation, 

 133 The efficiency principle that it is better to have non-increasing marginal rates as income rises 

applies to the generation of business and labor income, and not to the treatment of expenses not directly 

related to the generation of this income. For example, a taxpayer’s ability to deduct (rather than claim as 

a credit, or not obtain a tax preference at all) various Social Spending tax expenditures, such as the 

charitable contribution deduction, can be described as moderating the progressivity of the effective rate 

structure. Nonetheless, optimal tax theory would hold that this reduction in progressivity cannot be 

justified on the basis of the efficiency principle described in the text, because the rate reduction is 

achieved by non-business or non-labor related expenses and not solely as a result of the generation of 

more income. The fact that a moderation or decrease in marginal rates is achieved through the non-workrelated expense deduction side muddles in a classic second-best sense the justification for the application 

of the non-increasing marginal rate principle. 

134 This optimality of the inverse relationship between tax rates and behavioral elasticity also 

applies to commodity and consumption taxes. 

135 The mathematical exploration of the general theoretical properties of tax expenditures 

logically followed from the interest in optimal taxation. Feldstein presented a theoretical model of 

charitable giving that was augmented by a stylized representation showing that the present law income tax 

deduction was economically efficient. Martin Feldstein, A Contribution to the Theory of Tax 

Expenditures: The Case of Charitable Giving, in Henry J. Aaron & Michael J. Boskin, eds., The 

Economics of Taxation, Essays in Honor of Joseph Pechman (Washington, D.C., The Brookings 

Institution, 1980) at 99-122. Driessen questioned this result, and Feldstein responded in defense of his 

result. See Patrick A. Driessen, A Qualification Concerning the Efficiency of Tax Expenditure, 33 Journal 

of Public Economics 125-131 (June 1987); Martin Feldstein, The Efficiency of Tax Expenditures: Reply, 

33 Journal of Public Economics 133-136 (June 1987). For extensions of this theoretical research focused 

primarily on the tax expenditure for charitable giving, see Russell D. Roberts, A Positive Model of Private 

Charity and Public Transfers, 92 Journal of Political Economy 136-148 (1984); Theodore Bergstrom et 

al., On the Private Provision of Public Goods, 29 Journal of Public Economics 25-49 (Feb. 1986); and 

James Andreoni, Impure Altruism and Donation to Public Goods: A Theory of Warm Glow Giving, 100 

Economic Journal 464-477 (June 1990). Saez updated the earlier research and generalized the results to 

extend beyond charitable giving. See Emmanuel Saez, The Optimal Treatment of Tax Expenditures, 88 

Journal of Public Economics 2657-2684 (2004). 

Some optimal income tax studies consider both income and other taxes including consumption 

and wealth taxes, e.g., Atkinson and Stiglitz (1980). Even within a framework restricted to income tax, 

the consideration of the differential treatment of capital and income can be explored. See Banks and 

Diamond, supra, provide a recent summary of results on this differentiation). The JCT Staff approach, 

following the narrow direction of the Budget Act, currently is restricted to the income tax. 
60 

mandates, or delegation). Sometimes direct government provision of a good or service and a tax 

expenditure may be very similar, as with the direct government provision of Temporary 

Assistance for Needy Families and a tax expenditure like the refundable earned income credit 

(both have work constraints and involve cash remission, although there are differences in 

eligibility and other areas).136 

Other tax expenditure issues concern the substantive goals of general tax policy that were 

noted previously.137 For example, as subsidy instruments, tax credits are generally preferable to 

tax deductions on equity grounds.138 Efficiency concerns alone suggest that the preferred 

subsidy rate is only by chance likely to be the same as the marginal income tax rate faced by a 

taxpayer; as a result the tax expenditure subsidy rate should not be linked to income but rather to 

something else such as specific consumption. Revenue generation concerns favor a tax system 

that limits the cost of subsidies and minimizes savings, investment, and labor supply distortions. 

Also, tax subsidies should be greater when targeted at more responsive positive behaviors,139 

and interactions with direct government spending and/or tax expenditure-induced behavior 

should be considered. 

Thus in evaluating a tax expenditure, among the issues that one should consider are the 

societal preferences for the subsidized activity,140 the substitutable or complementary 

relationship of direct government provision and other government policy options with the tax 

expenditure, the responsiveness of the favored activity to subsidy, the responsiveness of labor 

supply to any increases in marginal tax rates necessitated by the existence of the tax 

expenditure, the relative efficiency of private provision of the activity that the government seeks 

to encourage, including targeting and fundraising costs, the overall effects that the tax 

expenditure has on the societal preferences for income distribution, any participation benefits 

(“warm glow”) or costs (e.g., learning and compliance, envy) to the taxpayer of undertaking or 

others’ undertaking the subsidized behavior linked to the tax expenditure,141 and the interaction 

 136 The earned income credit is discussed in detail in Section V.D. 

137 There are also some theoretical studies of tax and tax expenditure design, including Martin 

Feldstein, On the Theory of Tax Reform, 6 Journal of Public Economics 77-104 (July 1976). 

138 Therefore unless an expense is directly connected to the generation of business or labor 

income, for equity reasons it generally should be formulated as a credit rather than a deduction. In this 

regard, although Saez, supra, finds that the ideal subsidy a priori should not be linked to the income tax 

rate structure, he also finds that this linkage seems to detract surprisingly little from overall efficiency. 

The potential harm from linkage is limited largely because his area of focus, what we term Social 

Spending in this pamphlet, represents a relatively small part of overall economic activity, at least within 

the stylized model that Saez sets up. 

139 The targeting of tax subsidies to behaviors most susceptible to change is analogous to the 

Ramsey rule of inverse taxation. See Ramsey, supra. 

140 The propriety of the mechanisms for determining societal preferences, which are subjects of 

public choice and other schools of research, are beyond the limited scope of this inquiry. 

141 J. Andreoni, supra. 
61 

of the tax expenditure with other private and government programs (including other tax 

expenditures).142

 142 Saez, supra, mathematically presents many of these and other results. 
62 

C. Evaluating the Design of Tax Expenditures 

1. Overview 

The previous two subsections addressed the substantive question of when, or whether, a 

tax expenditure might improve social welfare, as measured through the economic principles of 

equity, efficiency and ease of administration. Economic analysis also can help, however, to 

improve the design of any tax expenditure, regardless of its substantive merits in the eyes of 

economists. 

Economists have developed a number of consensus principles that can help policymakers 

in designing a proposed tax expenditure. These principles take into account both the popular and 

academic analyses of tax expenditures over the years, including the variety of approaches taken 

in the study and presentation of tax expenditures. These design principles generally can be seen 

as applications of the substantive goals of equity, efficiency, and ease of administration 

presented in Section V.A. above. 

Adherence to these design principles generally does not rely on any particular normative 

view about an income tax. Regardless of whether a particular income tax norm can achieve 

consensus, it is likely that those interested in the betterment of an income tax would agree that 

these non-exclusive general attributes presented below would be desirable in any tax 

expenditure.143 Even when a provision has consensus support for its substantive aim, design 

problems may erode its value, as when a provision that society agrees should aid one group or 

encourage one type of behavior instead significantly compensates another group or encourages 

another type of behavior. Thus, to the extent that a tax expenditure has been created in an effort 

to achieve some combination of substantive goals, all parties likely would prefer that this tax 

expenditure be transparent in its application, that it be targeted narrowly to those taxpayers or 

activities that are the object of the expenditure, and that taxpayers will enjoy certainty in 

realizing the tax advantages through which the expenditure’s goals are to be achieved. 

2. Transparency 

Transparency in the tax expenditure context refers to many design and measurement 

issues that affect both government oversight and taxpayer acceptance and usage of a tax 

expenditure. Perhaps the most commonly cited transparency concern is the degree to which the 

revenue costs of a tax expenditure are identifiable and publicized, and the identity of the 

provision’s beneficiaries is clear. In addition, it is important for the potential benefits and 

possibly non-governmental costs of a provision to be ascertainable. A complex tax expenditure 

also can affect the use or “take-up” of the provision, and increase compliance costs associated 

 143 Of course, someone who is opposed to any income tax, or any kind of tax, may not find these 

principles compelling. 
63 

with the provision. Similarly, obscure or interacting phase-outs may undermine both a 

provision’s intent and taxpayer confidence.144 

The transparency of a tax expenditure to a taxpayer is enhanced by consistency in content 

and availability, the absence of confusing alternatives, and recurring taxpayer participation. For 

example, Congress first enacted the Hope Credit more than a decade ago. While that provision 

has been relatively consistent in content, the Hope Credit has at least one close substitute (the 

Lifetime Learning Credit) and another potential substitute (the tuition and fees deduction.)145 

The Hope Credit also requires a potential user to learn about eligible expenses, whether a student 

is or can be claimed as a dependent, and how the credit interacts with other higher education 

financial programs. In addition, Hope Credit participation is likely to be cyclical or 

discontinuous for taxpayers – for example, the Hope Credit may require a parent’s or student’s 

attention for as little as one or two tax return years and then never again affect that taxpayer. By 

contrast, the home mortgage interest deduction typically is relevant for a continuous and longterm period, once a taxpayer purchases his first primary residence. 

Transparency also is affected by issues of framing and advertising. Framing includes tax 

expenditure design issues such as the naming of a provision, Internal Revenue Code and tax form 

placement, and possible cross-referencing among forms. Naming a provision may seem 

mundane, but taxpayers and others may have a different reaction to something called, for 

example, the Earned Income Credit rather than the Earned Income Tax Credit, or it may be a 

surprise to some taxpayers that section 199, the deduction for “domestic production activities,” 

applies to certain income from services. Even with the pervasive use of tax software and paid 

return preparers, taxpayers often need to educate themselves about the existence of various 

provisions and the mechanics of how to claim them. Public and private advertising and 

promotion therefore increase tax transparency for taxpayers. While the outreach programs of the 

Internal Revenue Service are important, the advertising of the Hope Credit by educational 

institutions likely has contributed to the take-up of that credit in the same way that a vigorous 

publicity campaign undertaken by private financial entities may have increased Individual 

Retirement Account participation in the last 25 years. 

In some cases transparency of costs and benefits for participants may conflict with 

another important goal – taxpayer confidentiality. For example, full identification of who uses 

 144 See Thomas A. Barthold, Thomas Koerner, & John F. Navratil, Effective Marginal Tax Rates 

Under the Federal Individual Income Tax: Death by One Thousand Pin Pricks?, 51 National Tax Journal 

at 563 (1998) and Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and 

Recommendations for Simplification, Pursuant to Section 8022(3)B) of the Internal Revenue Code of 

1986 (JCS-3-01), April 2001 at 88. 

145 An evaluation of the Hope Credit should be conducted in conjunction with an assessment of 

the Lifetime Credit and the tuition and fees deduction, as these provisions significantly interact. There are 

many other tax expenditures that also should be examined as part of a subgroup of tax expenditures that 

are substitutes and complements, and the grouping of tax expenditures by Federal outlay type, which we 

intend to continue in tandem with the new broad classifications described in Section IV, facilitates the 

recognition of these interactions. 
64 

what tax expenditure might have the positive effect of clearly identifying persons or businesses 

that are not taking advantage of tax benefits, but such identification could compromise both 

individual privacy or (in the case of businesses) confidential trade information. 

3. Targeting 

Targeting issues often are related to revenue concerns and the substantive goals of equity, 

efficiency, and ease of administration. Having decided to provide a certain subsidy, it is desirable 

to implement that subsidy by benefiting the intended parties with as little economic distortion 

and for as little cost in terms of forgone revenue as possible. These concerns are not limited to 

the specific tax expenditure provision under examination or even other governmental policies, 

but also include secondary consequences that may be broadly distributed. Examples of marginal, 

or “last dollar,” targeting include the use of thresholds (e.g., the 7.5 percent itemization threshold 

for medical and dental expenses) or the focus on increments above certain historic baselines (the 

research and experimentation credit.) While some limitations, such as historical and other 

threshold tests, may aid in targeting, others (e.g., the financial plan limitations under expired 

section 965) may be worse than no limitation because they may give the impression but not the 

reality of effective targeting.146

One important and common targeting issue is when to use a deduction rather than a credit 

to deliver a tax expenditure. While as discussed in the prior section a credit generally is 

theoretically preferable to a deduction, a deduction in not necessarily inconsistent with good 

targeting. A deduction may be appropriate, for example, when the expense is directly related to 

the production of income, and some might argue that something like charitable giving is not 

entirely voluntary and therefore should be fashioned as a deduction.147 However, it often is at 

least theoretically possible to design a tax credit that creates just as much overall incentive or 

relief as a deduction and that also avoids some equity issues caused by use of a deduction, 

although it is difficult in practice to design credit phase-outs that do not create high effective 

marginal tax rates. 

Because of economic and demographic changes, targeting often requires adjustments that 

may create complexity and uncertainty. For example, the filtering function of the 7.5 percent 

threshold for itemizing medical and dental expenses contemplated by policymakers at the time of 

its enactment may take on a different meaning as the U.S. age structure changes and preferences 

and the need for health care spending change. Also, once a tax expenditure has been enacted, 

inertia, precedence, and interest group behavior may make repeal or scaling back difficult, even 

 146 Negative Tax Subsidies also can be targeted imperfectly. For example, it is questionable how 

effective the $1 million limit on executive compensation under Code section 162(m) is, as corporations 

appear to have responded by altering their methods of compensating executives in ways that do not seem 

to have greatly affected the targeted firms, investors, or executives. See Steven Balsam and David Ryan, 

Limiting Executive Compensation: The Case of CEOs Hired after the Imposition of 162(m), Journal of 

Accounting, Auditing and Finance, September 2007. 

147 This is an argument by W. D. Andrews, Personal Deductions in an Ideal Income Tax, 86 

Harvard Law Review 309-385 (1972). 
65 

if the original tax expenditure targeting rationale is impeached.148 Additionally, electivity may 

cause tax expenditure targeting issues. 

For example, at the time of initial enactment of the first IRA provisions, it was very 

difficult to predict how many taxpayers would take up the new program, in the absence of 

relevant prior experience. Aside from novelty, it is likely that exogenous changes (such as the 

advertising campaigns that financial institutions mounted when IRAs first were introduced) will 

affect electivity in ways that are difficult to foresee.149 

4. Certainty 

Much attention recently has been focused on the pattern of short-term extensions of a 

large number of tax expenditures in a single “extenders” package. In practice, it can involve 

extending an expiring tax expenditure or blocking administrative action.150 Many tax 

 148 For example, part of the rationale for the additional deduction for the aged was relief for what 

has historically been a low-income demographic group (measured by gross, taxable, or disposable 

income.) While as a group the aged’s relative income standing has improved in recent decades, this 

longstanding tax expenditure has not been modified or repealed. Also, when an income tax structure is 

first imposed, a tax expenditure created at the outset may have faced less of a revenue or other test than 

subsequently enacted tax expenditures because incremental change tends to attract more scrutiny – this 

evolutionary institutional factor may be one reason to believe that not all current tax expenditures, given 

the timing and other difference surrounding their placement in the Internal Revenue Code, faced the same 

level and type of attention. 

149 In addition to the targeting issues raised by electivity, what could be termed secondary 

electivity often creates horizontal equity or business entity equity issues. If primary electivity is the 

decision to undertake an activity, such as investing or making a charitable contribution, then secondary 

electivity is the choice permitted in the Code that a person makes of how to treat the investment or 

charitable contribution for income tax purposes. Secondary electivity raises equity issues because it 

allows persons undertaking the same activity to obtain different tax results. Thus one business 

depreciates a capital purchase using the straight-line method while another business elects to expense 

under section 179, or one person itemizes a charitable deduction while another person chooses to take the 

standard deduction, or a U.S. investor may choose between operating overseas as a branch or controlled 

foreign corporation and thereby affect eligibility for deferral. Note that secondary electivity often 

involves a tax expenditure. This electivity, valued by taxpayers for the flexibility it permits, intentionally 

produces varied tax results. The Code sometimes attempts to ameliorate equity issues associated with 

secondary electivity by enforcing symmetry with respect to business or investment transaction (e.g., gain 

deferred in the disposition of an asset may result in downward basis adjustment of a replacement asset), 

but this remedy is often ad hoc and does not necessarily rectify the inequity arising from the secondary 

electivity. It is sometimes difficult to determine when secondary electivity is occurring because of the 

simultaneity of primary and secondary electivity. For example, some charitable giving and some 

investment might not occur in the absence, respectively, of the opportunity to itemize deductions and 

section 179 expensing, and thus it may not be possible to always isolate the equity effects of secondary 

electivity. 

150 For example, Congress temporarily blocked implementation of certain research and 

development allocation rules, used to calculate foreign tax credits, multiple times in the 1970s and 1980s. 
66 

expenditures that have been extended for short periods of time are relatively new.151 Short-term 

sunsets are understandable for new provisions lacking a basis for evaluation, and even older 

provisions are likely to need revisiting from time to time. In fact, one of the complaints about 

tax expenditures is that tax expenditures are not reconsidered enough, which cuts against the goal 

of certainty; this example demonstrates how some of the tax expenditure goals, substantive and 

design, can interact. 

Some tax expenditures that are extended for short periods also may be perceived by 

some of those affected as “too big to expire” or at least expire for very long, and thus taxpayers 

may not be affected much by a short sunset period for those provisions, whereas taxpayer 

uncertainty about short sunsets for newer provisions may be warranted. Both pro- and antitaxpayer retroactivity also reduce certainty, as do temporary tax reductions (or increases), tax 

holidays, tax amnesties, and sporadic enforcement of tax laws. 

One indirect form of uncertainty is the fact that the value of a tax expenditure, 

particularly a deduction or exemption, changes whenever the general tax rates change, and also 

can change when other tax expenditures that interact with the first expenditure change. This type 

of uncertainty cannot be avoided unless Congress adjusts a wide range tax expenditures to hold 

taxpayers harmless every time general income tax rates change. The value of other items may 

change for exogenous reasons, for example, the value of the last-in-first-out method of 

accounting is affected by general and specific price changes. Finally, taxpayers may invite 

uncertainty by taking tax return positions that are either opposed, or at least not acquiesced in, by 

the Internal Revenue Service. 

In summary, in addition to measuring how well tax expenditures fulfill the substantive 

goals of equity, efficiency, and ease of administration, all tax expenditures can be evaluated 

using the design criteria of transparency, targeting, and certainty.

152 Just as the effects on 

substantive tax system goals of undertaking certain tax expenditures may conflict (e.g., what is 

equitable may not be efficient)153 or complement each other (e.g., equity can sometimes enhance 

 

Also, some longer term expirations or sunsets are related to parliamentary rules concerning revenue 

effects outside of the traditional five- or ten-year budget period. 

151 The research and experimentation credit is a notable exception. 

152 The Congressional Research Service (“CRS”) comprehensively examines tax expenditures 

using the normative law approach. Congressional Research Service, Tax Expenditures: Compendium of 

Background Material on Individual Provisions, prepared for the Committee on the Budget, 109th 

Congress, 2nd Session, S. Per. 109-072 (December 2006). The substantive and design criteria presented 

here are noted in some of the CRS descriptions of individual tax expenditures, but not in a formalized 

manner. The criteria discussed here are the foundation for our revised approach to tax expenditures 

described in Section IV above, and may be useful as a companion, along with the CRS publication, to 

applied research on tax expenditures. 

153 An important treatise on the interaction of these two aspirations for an income tax system is 

Arthur M. Okun, Equality and Efficiency: The Big Tradeoff (Washington, D.C., The Brookings 

Institution, 1975). 
67 

efficiency), some of these desirable design characteristics of tax expenditures may also conflict 

or complement each other, and the substantive and design goals may also interact. As an 

example, the attributes that make a tax expenditure understandable and straightforward may 

inhibit attainment of other goals embodied in the Code, as when narrow targeting leads to a lack 

of transparency. 
68 

D. Application of Economic Analysis to Selected Tax Subsidies 

This Subsection presents some selected examples of how the economic reasoning 

developed earlier in Section V can be applied to some examples of Tax Subsidies. 

1. Refundable earned income credit 

The Earned Income Credit (“EIC”) is intended to subsidize the work effort of lowincome families. We classify the refundable portion of the EIC as a Tax Transfer. Because the 

EIC is designed as an income support program (in addition to rewarding work effort), the two 

principal substantive evaluation issues of equity and ease of administration play major roles in 

assessing its effects. 

As can be seen in the figure below, the EIC provides a credit for each additional earned 

dollar up to a maximum dollar amount, with the credit phased out for each dollar of earned 

income or adjusted gross income above a phase-out threshold. The credit rate, maximum 

income, beginning of the phase-out, and the phase-out rate depend on whether the taxpayer has 

no qualifying children, one qualifying child, or two or more qualifying children. 

Figure 3.–2004 Value of the EIC by Income and Number 

of Qualifying Children 

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000

No Children One Child Two or more Children

While not all of the EIC is received by taxpayers as a refund, a substantial majority of the 

revenue cost is categorized as refundable (88 percent of the EIC claimed on 2004 returns was 

refunded after the nonrefundable portion was exhausted by offsetting income and self-
69 

employment taxes.)154 The table below shows that the income distribution of the EIC is 

concentrated among low-income taxpayers, and could be considered a substitute for direct 

spending welfare programs. 

Table 1.–Distribution by Income Class of the Earned Income Credit 

at 2006 Rates and 2006 Income Levels1 

[money amounts in millions of dollars, returns in thousands] 

Income Class2

 Earned Income Returns Credit Amount3

Below $10,000 5,747 $6,650 

$10,000 to $20,000 6,407 16,349 

$20,000 to $30,000 4,808 11,353 

$30,000 to $40,000 4,067 6,446 

$40,000 to $50,000 1,815 1,987 

$50,000 to $75,000 534 475 

$75,000 to $100,000 9 5 

$100,000 to $200,000 3 5 

$200,000 and over 0 0 

 TOTAL 23,391 43,270 

1 Excludes individuals who are dependents of other taxpayers and taxpayers with negative income. 

2 The income concept used to place tax returns into classes is adjusted gross income (AGI) plus: 

 (a) tax-exempt interest, (b) employer contributions for health plans and life insurance, (c) employer share 

 of FICA tax, (d) workers' compensation, (e) nontaxable Social Security benefits, (f) insurance value of 

 Medicare benefits, (g) alternative minimum tax preference items, and (h) excluded income of U.S. citizens 

 living abroad. 

3

 Excludes individuals who are dependents of other taxpayers and taxpayers with negative income. 

As indicated earlier, because the EIC is a Tax Transfer, its efficacy can be determined 

principally by reference to the two substantive criteria of equity and ease of administration. In 

terms of the design criteria, the EIC appears to be relatively targeted, transparent, and certain in 

its application when compared to other Tax Subsidies. 

With regard to equity, the EIC benefits the lower portion of the income distribution as 

shown above. As with any program that provides income support, and particularly in the case of 

a program such as the EIC which attempts to reward work effort, it is important to measure over 

 154 Internal Revenue Service, Statistics of Income Bulletin, Winter 2006-2007 (Washington, D.C. 

2006). The portion that is refundable has varied over time as the liability otherwise owed by taxpayers has 

adjusted to changes in the rest of the income and self employment tax systems. 
70 

time the income mobility of current and prior participants. That is, is the EIC a catalyst or a 

deterrent to income mobility? One mobility measure would be the number of recipients moving 

out of eligibility due to an increase in earnings. A good result would be fewer people qualifying 

for the EIC over time because of an improvement in their employment and income situations. 

One study found that as many as 50 percent of EIC claimants receive the EIC for only short 

periods of time lasting one to three years.155 While these results are not causal, the short tenure of 

those claiming the EIC, combined with the high participation rates, suggests that the program is 

reaching a fairly mobile population in terms of income. 

The combination of the high dollar value of the credit (the maximum credit in 2007 was 

$4,716), the high phase-out rates (about 20 percent for taxpayers with two or more qualifying 

children), and the earned income requirement also means that the EIC is likely to have a number 

of effects on the supply of labor that might have long-term equity and efficiency ramifications. In 

this regard, researchers have found that the EIC has a variety of effects on labor supply.156 

The narrowly targeted design of the EIC contributes to these equity effects. Initially the 

EIC was targeted only toward low-income workers with children, but it was expanded beginning 

in 1994 to include all low-income workers. A measure of the effectiveness of the EIC in 

reaching its targeted beneficiaries is the participation rate in the program. The credit appears to 

be fairly effective in reaching targeted beneficiaries, with some studies finding the participation 

rates for families with children ranging between 80 percent157 and 92 percent.158 These 

participation rates compare favorably with participation rates for other direct spending subsidies. 

 155 Tim A. Dowd, Distinguishing Between Short-Term and Long-Term Recipients of the Earned 

Income Tax Credit, 58 National Tax Journal 807-828 (December 2005). Dowd also finds that there is 

broad usage of the EIC. For taxpayers who have a child at some point over a 15-year period, or are under 

the age of 65, the probability of claiming the EIC at least once is 28 percent. 

156 Researchers have looked at the labor supply effects of the credit. Nada Eissa and Jeffrey 

Liebman, Labor Supply Response to the Earned Income Tax Credit, 111 Quarterly Journal of Economics 

605-637 (1996) and V. Joseph Hotz, Charles H. Mullin, and John Karl Scholz, The Earned Income Tax 

Credit and Labor Market Participation of Families on Welfare, Unpublished Working Paper, March, 

2005, found that the EIC expansions of 1987 and 1994 increased labor force participation. Other studies 

have found that the EIC does not affect hours of work very much. Maria Cancian and Arik Levinson, 

Labor Supply and Participation Effects of the Earned income Tax Credit: Evidence from the National 

Survey of America’s Families and Wisconsin’s Supplemental Benefit for Families with Three Children, 

Unpublished Working Paper, September 2003; Eissa and Liebman, supra. Still, other researchers have 

found that the EIC reduces labor force participation for married taxpayers. Nada Eissa and Hilary Hoynes, 

Taxes and the Labor Market Participation of Married Couples: The Earned Income Tax Credit, 88 

Journal of Public Economics 1931-1958 (August 2004). 

157 John Karl Scholz, The Earned Income Tax Credit: Participation, Compliance and Antipoverty 

Effectiveness, 47 National Tax Journal 63-87 (March 1994).

158 Marsha Blumenthal, Brian Erard, and Chih Chin Ho, Participation and Compliance with the 

Earned Income Tax Credit, 58 National Tax Journal 189-214 (June 2005). 
71 

One study, for example, found that food stamps, arguably targeted at a similar population, had a 

participation rate of 54 percent.159 

There is a significant degree of noncompliance, however, with the EIC requirements, 

resulting in claims by non-targeted individuals. In a recent study, the General Accountability 

Office found that up to 80 percent of the recipients of the advance EIC were non-compliant.160 

Moreover, for the program as a whole, the IRS found that for tax year 1999 as many as 32 

percent of EIC claims were erroneous.161 The high non-compliance rates reduce the degree to 

which the EIC is effective at delivering benefits only to the targeted population of working poor 

families. 

In response to the high non-compliance rate, Congress has attempted to target the credit 

more effectively by increasing the administrative requirements and changing the eligibility 

requirements.162 These efforts, however, affect the extent to which the EIC meets the second 

substantive goal of ease of administration. While some of the non-compliance may be due to 

fraud, the complex nature of the eligibility rules contributes to taxpayer confusion and noncompliance.163 Studies have shown that the high non-compliance rates are indicative of the 

complex eligibility requirements for the EIC,164 and this complexity reduces the extent to which 

the EIC is a transparent program from an administrative perspective. 

On the other hand, the revenue cost of the earned income credit (“EIC”) is relatively 

transparent compared with other tax subsidies. The credit is entered directly on individual tax 

forms and has limited substitutability with other tax expenditures, and the provision’s relative 

complexity is somewhat tempered by its long tenure in the Internal Revenue Code and the 

Internal Revenue Service’s outreach program for employees and employers. For knowledgeable, 

qualifying taxpayers, the EIC is essentially certain. Taxpayers and firms expect that the EIC will 

be available every year because it has been a part of the income tax system since 1975. 

However, low-income and first-time filers may not be aware of, or in some cases may 

 159 Department of Agriculture, Food and Nutrition Service, Explaining Changes in Food Stamp 

Program Participation Rates (Washington, D.C., September 2004).

160 Government Accountability Office, Advance Earned Income Tax Credit, Low Use and Small 

Dollars Paid Impede IRS’s Efforts to Reduce High Noncompliance (Washington, D.C., August 2007). 

161 Internal Revenue Service, Compliance Estimates for Earned Income Tax Credit Claimed on 

1999 Returns (Washington, D.C., February 2002). 

162 For example, in the Personal Responsibility and Welfare Relief Act of 1996, Congress 

required taxpayers to use Social Security Numbers for each claimed child; in the Economic Growth and 

Tax Relief Reconciliation Act of 2001, Congress streamlined some of the rules regarding qualifying 

income and children. 

163 Lindsay H. Rubel, Complexity, Regressivity, and Income Disparity: Self-defeating Aspects of 

the Earned Income Tax Credit (Washington and Lee University, School of Law, 2006). 

164 Janet Holtzblatt, and Janet McCubbin, Issues Affecting Low-Income Filers, in Henry J. Aaron 

and Joel Slemrod, eds, The Crisis in Tax Administration (Brookings Institution Press, 2004). 
72 

overestimate, the high effective marginal tax rates associated with the EIC’s phase-out. This 

confusion about the credit reduces its certainty for taxpayers. 

Finally, the EIC program’s structure also is of interest to the extent that it can provide 

information about the merit of using the tax system (and employers) to partially or fully deliver 

government benefits to employees. Some researchers have argued that because of the lower EIC 

administrative costs and the higher participation rates for the EIC that, relative to other direct 

spending transfer programs, the EIC should be expanded beyond its current target population.165

2. Individual retirement accounts 

The principal purpose of the IRA provisions is to help ensure adequate income for 

retirees, and thus we classify IRAs as Social Spending (while acknowledging that their role in 

capital accumulation means that they share some attributes of other items that we classify as 

Business Synthetic Spending). The IRA provisions attempt to meet this goal of retiree income 

assurance in two ways: (i) IRAs provide a vehicle to which employees can roll over employersponsored pension assets upon separation from service; and (ii) IRAs provide those without an 

employer plan, or those who participate in an employer plan that provides limited benefits, with 

a retirement savings opportunity. The choice was made in providing IRAs that, because of the 

difficulty in ascertaining the retirement assets of a heterogeneous mix of taxpayers, the provision 

would be targeted with relatively modest caps on contributions and with income-related 

limitations. Over the years, however, other IRA programs (such as the Roth IRA) have been 

added to the Internal Revenue Code as a need for flexibility was perceived. The current IRA 

provisions contain many complex rules pertaining to contributions and withdrawals. Depending 

upon the type of IRA and the taxpayer’s current circumstances, a taxpayer may at any one time 

be affected by an IRA’s potential deductibility, deferral of taxation on inside-build-up, 

exemption, and a number of other Internal Revenue Code features. 

As noted in Section IV, for an item in the Social Spending subcategory, efficacy in 

achieving a specified societal goal may be more important than its effects on equity or efficiency. 

In fact, both the IRA deduction and the Roth IRA exemption appear to be relatively inequitable, 

because their tax benefits are linked to a taxpayer’s marginal tax rate. This inequity could be 

mitigated by converting the deduction into a credit.166 However, another potential source of 

inequity may be the difficulty in identifying a worker’s accumulated pension assets, with the 

result that eligibility for the IRA provisions cannot be related directly to the level of those assets. 

The actual extent of any inequity is difficult to determine, due to the connection between the tax 

treatment of the contribution to an IRA and the eventual distribution: for example, a taxpayer 

may obtain a deduction while facing a marginal tax rate of X% at time of contribution and then 

pay tax at a rate of Y% upon distribution (with the distribution including any investment gain). 

The tax treatments are reversed for contributions to and distributions from a Roth IRA. This 

connection between tax treatment of contribution and distribution requires that the equity of the 

 165 Dennis J. Ventry, Welfare By Any Other Name: Tax Transfers and the EITC, 56 American 

University Law Review (2007). 

166 Batchelder, Goldberg and Orszag, supra. 
73 

provision be evaluated taking account of a longer period of time, perhaps with a present-value 

measure of equity. 

The design goals of transparency and certainty are perhaps more relevant, however, in 

determining the extent to which IRAs achieve their societal goal of enhancing retirement income. 

In assessing transparency, participation (as measured by deductible contributions to IRAs) is 

easily gauged because of the tax form entry on Forms 1040 and 1040A, but nondeductible and 

Roth IRA participation is less transparent because taxpayers are not required to make a direct 

entry identifying Roth IRA participation on basic tax forms (although participants in 

nondeductible IRAs are required to complete supplementary Form 8606).167 There may also be 

interactions between IRAs and other tax expenditures that are close substitutes, including defined 

contribution plans such as section 401(k) programs sponsored by employers. Calculations of 

IRA revenue costs, particularly on a present-value basis, are complicated by the necessity of 

tracking or predicting both IRA contributions and distributions, with time and taxpayer 

characteristics (including marginal tax rates) varying over the life of an IRA. The analysis 

further is complicated by the availability of Roth IRAs, and the opportunity (limited by taxpayer 

income level) of taxpayers to convert from traditional IRAs to Roth IRAs. 

IRAs also entail a significant element of uncertainty, i.e., a taxpayer’s uncertainty, noted 

above, about his marginal tax rate at the time of potential distribution. The difference between a 

taxpayer’s tax rate at time of contribution and distribution or early withdrawal is a key factor in 

choosing among the IRA options for taxpayers who are eligible for more than one type of IRA. 

IRAs appear, however, to fare well in terms of ease of administration, a substantive goal 

that is important to all subcategories of Tax Subsidies. IRAs appear to have minimal fraud and 

compliance issues, although the complexity of the mandatory distribution and early withdrawal 

rules noted above may offer opportunities for tax evasion. 

Broader evaluation issues include the interaction of IRAs with other retirement tax 

expenditures. For example, the equity implications of IRAs discussed above may look different 

when one takes account of the effects of the Saver’s Credit.168 Other questions related to the 

substantive Social Spending goals of IRAs include whether, given society’s continued desire to 

 167 A similar distinction occurs with respect to distributions − a normal distribution from a Roth 

IRA will not show up on any tax return form. However, there is information reporting on all IRA 

contributions and distributions, and Form 8606 is required for non-deductible IRA contributions. For 

compliance purposes the IRS thus can use Form 8606 and information returns as well as Form 1040 or 

1040A, and for research purposes the information returns easily can be linked to tax returns. This 

characterization of the connection between lines on Forms 1040 and 1040A, other tax forms and 

information returns, and the role of such information in compliance and research also generally applies to 

other exemptions such as the foreign earned income exclusion or the exclusion of fellowship and 

scholarship income, while the exemption for tax-exempt interest is required to be listed on the Forms 

1040s and 1040A. 

168 For example one study of the Saver’s Credit found that nonrefundability inhibited its effect. 

See Gary Koenig and Robert Harvey, Utilization of the Saver’s Credit: An Analysis of the First Year, 58 

National Tax Journal 787-806 (2005). 
74 

ensure adequate retiree income, the IRA method of encouraging retirement saving are as 

imperative in 2008, with the current proliferation of employee participation in such plans and the 

decline of defined benefit plan participation, as IRAs were when they were introduced en masse 

in the 1980s, a time when defined benefit plan usage was relatively more prevalent. Thus, one 

could test whether IRAs, in their current form or perhaps legislatively enhanced for the future by 

use of tax credits and other tools, are necessary to ensure retirement income security if the 

ongoing decline in defined benefit participation is viewed with alarm. 

3. Research and experimentation tax credit 

The research and experimentation (“R&E”) tax credit, which expired at the end of 2007, 

is a multifaceted Tax Subsidy that is intended to increase general social welfare by encouraging 

businesses to perform research. Its rationale thus is economic efficiency. We classify the R&E 

credit as a Business Synthetic Spending item because it is elected by businesses and aimed at a 

type of spending, research and experimentation expenses, that when targeted correctly improves 

general social welfare. 

One fundamental question about the R&E credit relates to the externality rationale for its 

existence, that is, whether in a Pigouvian fashion the credit increases social welfare by inducing 

important research that otherwise would not occur. In this regard, consideration of other tax and 

outlay effects is necessary for evaluation of the R&E credit’s effect on efficiency.169

As indicated by Tables 2 and 3, the R&E credit is used by businesses of varying size and 

industrial focus. These tables show that a heterogeneous mix of firms claim the credit, although 

the dollar amount of the credit is more narrowly distributed. 

 169 See Zvi Griliches, The Search for R&D Spillovers, 94 Scandinavian Journal of Economics 

(1992); M. Ishaq Nadiri, Innovations and Technological Spillovers, National Bureau of Economic 

Research, Working Paper No. 4423 (1993); Bronwyn Hall, The Private and Social Returns to Research 

and Development, in Bruce Smith and Claude Barfield, eds., Technology, R&D and the Economy

(Washington, D.C., Brookings Institution Press 1996) at 1-14. These papers suggest that the rate of return 

to privately funded research expenditures is high compared to that in physical capital and the social rate 

of return exceeds the private rate of return. Griliches concludes, “in spite of [many] difficulties, there has 

been a significant number of reasonably well-done studies all pointing in the same direction: R&D 

spillovers are present, their magnitude may be quite large, and social rates of return remain significantly 

above private rates.” Griliches, supra, at S43. Charles I. Jones and John C. Williams, Measuring the 

Social Return to R&D, 113 Quarterly Journal of Economics at 1120 (1998), also conclude that “advanced 

economics like the United States substantially under invest in R&D.” 
75 

Table 2.–Percentage Distribution of Corporations Claiming Research Tax 

Credit and Percentage of Credit Claimed by Sector, 2005 

Industry 

Percent of 

Corporations 

Claiming Credit 

Percent of 

Total 

R & E Credit 

Manufacturing 50.7 71.2 

Professional, Scientific, and Technical 

Services 25.3 10.2 

Information 6.7 9.8 

Wholesale Trade 6.2 3.1 

Finance and Insurance 1.5 1.9 

Holding Companies 2.4 1.5 

Retail Trade 0.9 0.7 

Health Care and Social Services 1.0 0.4 

Utilities 0.2 0.3 

Transportation and Warehousing 0.9 0.2 

Administrative and Support and Waste 

Management and Remediation Services 2.4 0.2 

Agriculture, Forestry, Fishing, and Hunting 1.0 0.2 

Mining 0.1 (1) 

Real Estate and Rental and Leasing 0.1 (1) 

Construction 0.2 (1) 

Other Services 0.2 (1) 

Arts, Entertainment, and Recreation (2) (2) 

Educational Services (2) (2) 

Accommodation and Food Services (2) (2) 

Not Allocable (2) (2) 

Wholesale and Retail Trade not Allocable (2) (2) 

1 Less than 0.1 percent.

2

 Data undisclosed to protect taxpayer confidentiality. 

Source: Joint Committee on Taxation staff calculations from Internal Revenue Service, Statistics of Income data. 
76 

Table 3.–Percentage Distribution of Corporations Claiming Research Tax 

Credit and of Credit Claimed by Corporation Size, 2005 

Asset Size ($) Percent of Firms 

Claiming Credit 

Percent of 

Credit Claimed 

0 1.4 0.7 

1 to 99,999 10.1 0.1 

100,000 to 249,999 5.2 0.1 

250,000 to 499,999 3.8 0.2 

500,000 to 999,999 8.1 0.4 

1,000,000 to 9,999,999 37.5 5.4 

10,000,000 to 49,999,999 18.7 6.4 

50,000,000 + 15.3 86.6 

Note: Totals may not add to 100 percent due to rounding. 

Source: Joint Committee on Taxation staff calculations from Internal Revenue Service, Statistics of Income data. 

The R&E credit has several variants. The three primary versions broadly target crossindustrial research activity and are provided on an incremental basis. Another narrower credit 

focuses on research undertaken by energy research consortia and is calculated as a percentage of 

base expenditures. Finally, a credit is available for amounts paid to certain universities and 

nonprofit scientific research organizations for basic research that advances scientific knowledge 

but does not have a specific commercial objective.170 

The R&E credit is a good example of a provision in which targeting creates complexity. 

The complexity arises from requirements to identify qualified expenditures and to track these 

expenditures over time. Taxpayers must also make the calculation for each variant of the credit 

to determine which provides the greatest tax benefit. The provision’s complexity, however, may 

be relatively less burdensome by virtue of the sophistication of typical research credit claimants 

compared with EIC or IRA users. The credit’s incremental targeting is designed to encourage 

taxpayer response similar to that provided by a conventional credit but at a substantially reduced 

revenue cost and, in that respect, enhance efficiency. On the other hand, the nonrefundability of 

 170 A full discussion of this and other issues, including the connection of the R&E credit to 

externalities, can be found in Joint Committee on Taxation, Description of Revenue Provisions Contained 

in the President’s Fiscal Year 2009 Budget Proposal, March 2008 (JCS-1-08). 
77 

the credit disadvantages some potentially important start-up businesses that lack sufficient tax 

liability to fully use the credit.171 

Although the R&E credit currently is not applicable because of its expiration, it has been 

extended many times since its introduction.172 One of the continuing issues related to the R&E 

credit concerns uncertainty, as the credit has been extended for short periods of varying duration 

numerous times over the past two decades. The credit has also been difficult to administer, 

resulting in audit issues and complicated recordkeeping requirements. 

 171 However, any unused credits may be carried forward up to twenty years, and in limited 

circumstances start-up firms with unused credits may be combined with other firms or with new business 

opportunities that generate tax liabilities. 

172 The credit was allowed to lapse from July 1, 1995, through June 30, 1996. 
78 

VI. ESTIMATING METHODOLOGY 

A. Recent Tax Expenditure Estimating Methodology 

This subsection summarizes how the JCT Staff has in the immediate past identified tax 

expenditures and estimated the revenues forgone by tax expenditures. The description explains 

our recent past practice; we summarize the differences between this and our new approach later 

in this Section VI. 

As described throughout this pamphlet, the determination of whether a provision is a tax 

expenditure is made on the basis of the “normal” tax, which is a broad concept of income that is 

larger in scope than “income” as defined under the general principles of the Internal Revenue 

Code. The JCT Staff has used its judgment in distinguishing between those income tax 

provisions (and regulations) that can be viewed as a part of normal income tax law and those 

special provisions that result in tax expenditures. A provision traditionally has been listed as a 

tax expenditure by the JCT Staff if there is a reasonable basis for such classification and the 

provision results in more than a de minimis revenue loss. 

If a tax expenditure provision were eliminated, Congress might choose to continue 

financial assistance through other means rather than terminate all Federal assistance for the 

activity. If a replacement spending program were enacted, the higher revenues received as a 

result of the elimination of a tax expenditure might not represent a net budget gain. A 

replacement program could involve direct expenditures, direct loans or loan guarantees, 

regulatory activity, a mandate, a different form of tax expenditure, or a general reduction in tax 

rates. JCT Staff estimates of tax expenditures have not addressed any of these possible policy 

responses; this will not change under the revised methodology summarized in this pamphlet. 

The JCT Staff’s methodology in the recent past did not include negative tax expenditures 

as a result of provisions in the Internal Revenue Code that provide special tax treatment that is 

less favorable than normal income tax law. Examples of such provisions include (1) the denial of 

deductions for certain lobbying expenses, (2) the denial of deductions for certain executive 

compensation, and (3) the two-percent floor on itemized deductions for unreimbursed employee 

expenses or personal investment expenses. 

Individual income tax

Under the JCT Staff’s methodology applied in the immediate past, the “normal” 

individual income tax had the following components: one personal exemption for each taxpayer 

and one for each dependent, the standard deduction, the existing tax rate schedule, and 

deductions for investment and employee business expenses. Most other tax benefits to individual 

taxpayers were classified as exceptions to normal income tax law.173 

 173 See Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 

2007-2011 (JCS-3-07) 9-13, September 24, 2007 (providing a detailed enumeration of the exceptions to 

the normal law under the previous methodology). 
79 

Business income taxation

Under the JCT Staff’s methodology applied in the immediate past, regardless of the legal 

form of organization (sole proprietorship, partnership, or S or C corporation), the same general 

principles were used in the computation of taxable business income. Thus, most business tax 

expenditures applied equally to unincorporated and incorporated businesses. 

One of the most difficult issues in defining tax expenditures for business income relates 

to the tax treatment of capital costs. Under present law, capital costs may be recovered under a 

variety of alternative methods, depending upon the nature of the costs and the status of the 

taxpayer. For example, investments in equipment and structures may qualify for tax credits, 

expensing, accelerated depreciation, or straight-line depreciation. The JCT Staff generally 

classified as tax expenditures cost recovery allowances that were more favorable than those 

provided under the alternative depreciation system (sec. 168(g)), which provides for straight-line 

recovery over tax lives that are longer than those permitted under the accelerated system. The 

JCT Staff assumed that “normal” income tax law would not provide for any indexing of the basis 

of capital assets. Thus, normal income tax law would not take into account the effects of inflation 

on tax depreciation. In estimating the tax expenditure for accelerated depreciation, the JCT Staff 

assumed that depreciation under sec. 168(g) is “normal” law. Our tax expenditure estimate 

therefore compared depreciation under sec. 168(g) with cost recovery methods actually 

allowable to taxpayers. Thus, all investments that would be depreciable under either sec. 168(g) 

or under accelerated depreciation are taken into account in deriving the tax expenditure; the tax 

expenditure estimate potentially includes the differential of cost recovery on investments made 

as many as forty years ago.174

The methodology applied by the JCT Staff in the recent past used several accounting 

standards in evaluating the provisions in the Code that govern the recognition of business 

receipts and expenses. Under the JCT Staff view, “normal” income tax law was assumed to 

require the accrual method of accounting, the standard of “economic performance” (used in the 

Code to test whether liabilities are deductible), and the general concept of matching income and 

expenses. In general, tax provisions that did not satisfy all three standards were viewed as tax 

expenditures. 

For example, the deduction for contributions to taxpayer-controlled mining reclamation 

reserve accounts was viewed as a tax expenditure because the contributions did not satisfy the 

economic performance standard. (Adherence to the standard would require that the taxpayer 

make an irrevocable contribution toward future reclamation, involving a trust fund or similar 

mechanism, as occurs in a number of areas in the Code.) The deductions for contributions to 

nuclear decommissioning trust accounts and certain environmental settlement trust accounts, by 

contrast, were not viewed as a tax expenditure, because the contributions are irrevocable (i.e., 

they satisfy the economic performance standard). However, present law provides for a reduced 

 174 The comparison of cost recovery for investments made over the last forty years is one way 

that the tax expenditure estimate is very different from a revenue estimate of a change in law affecting 

depreciable assets on a prospective basis. 
80 

rate of tax on the income of both types of trust accounts, and these tax rate reductions have been 

viewed as tax expenditures. 

The JCT Staff assumed that “normal” income tax law would provide for the carryback 

and carryforward of net operating losses. The staff also assumed that the general limits on the 

number of years that such losses may be carried back or forward were chosen for reasons of 

administrative convenience and compliance concerns and may be assumed to represent “normal” 

income tax law. Exceptions to the general limits on carrybacks and carryforwards were viewed 

as tax expenditures. 

Corporate income tax

The income of corporations (other than S corporations) generally is subject to the 

corporate income tax; the JCT Staff’s implementation of the “normal” tax treated the separate 

corporate income tax (and the double taxation of dividend income) as part of the “normal” tax 

base. The corporate income tax includes a graduated tax rate schedule. The lower tax rates in the 

schedule were classified by the JCT Staff as a tax expenditure (as opposed to normal income tax 

law) because they were intended to provide tax benefits to small business and, unlike the 

graduated individual income tax rates, are unrelated to concerns about ability of individuals to 

pay taxes. 

Exceptions to the corporate alternative minimum tax were not viewed as tax expenditures 

because the effects of the AMT exceptions are already incorporated in the estimates of related 

tax expenditures. 

Certain income of pass-through entities is exempt from the corporate income tax. The 

income of sole proprietorships, S corporations, most partnerships, and other entities (such as 

regulated investment companies and real estate investment trusts) is taxed only at the individual 

level. The special tax rules for these pass-through entities were not classified as tax expenditures 

because the tax benefits are available to any entity that chooses to organize itself and operate in 

the required manner. 

Nonprofit corporations that satisfy the requirements of Internal Revenue Code section 

501 also generally are exempt from corporate income tax. The tax exemption of certain nonprofit 

cooperative business organizations, such as trade associations, was not treated as a tax 

expenditure for the same reason applicable to for-profit pass-through business entities. With 

respect to other nonprofit organizations, such as charities, tax-exempt status was not classified as 

a tax expenditure because the nonbusiness activities of such organizations generally must 

predominate and their unrelated business activities are subject to tax. In general, the imputed 

income derived from nonbusiness activities conducted by individuals or collectively by certain 

nonprofit organizations is outside the normal income tax base. However, the ability of donors to 

such nonprofit organizations to claim a charitable contribution deduction is a tax expenditure, as 

is the exclusion of income granted to holders of tax-exempt financing issued by charities. 
81 

B. Tax Expenditure Estimates Generally 

A tax expenditure for a given year is measured as the difference between taxpayers’ 

aggregate tax liability under present law and their tax liability that would result from a 

recomputation of tax without benefit of the tax expenditure provision. Taxpayer behavior is 

assumed to remain unchanged for tax expenditure estimate purposes.175

The tax expenditure calculation for a given year reflects continuing timing differences 

attributable to investments made in prior years. Accelerated depreciation is the best-known 

example of this phenomenon. Estimates for this tax expenditure are based on the difference 

between tax depreciation deductions under present law and the deductions that would have been 

claimed in the current year if investments in the current year and all prior years had been 

depreciated using the alternative (normal income tax law) depreciation system. 

Neither the tax expenditure estimating methodology used in the immediate past nor the 

proposed methods for tax expenditures are the same as those used for revenue estimates, for 

three critically important reasons. First, our annual tax expenditure tables do not take into 

account the many large interactive effects that would be observed if Congress were 

simultaneously to repeal all the many tax expenditures that appear on our tables. In other words, 

if two or more tax expenditures were estimated simultaneously, the total change in tax liability 

could be smaller or larger than the sum of the amounts shown for each item separately, as a 

result of interactions among the tax expenditure provisions. 

Second, by tradition, tax expenditures are calculated on a static basis: that is, the 

behavioral consequences that would follow from repeal are ignored.176 By contrast, the JCT 

 175 An alternative way to measure tax expenditures is to express the values in terms of “outlay 

equivalents.” An outlay equivalent is the dollar size of a direct spending program that would provide 

taxpayers with net benefits that would equal what they now receive from a tax expenditure. The Treasury 

Department presents estimates of outlay equivalents in the President’s budget in addition to presenting 

estimates in the same manner as the JCT Staff. In the early 1980s, the Treasury Department adopted the 

concept of “outlay equivalency” for its tax expenditure analysis. In adopting this approach, Treasury 

presented tax expenditures using the more traditional “revenue loss” method in tandem with the tax 

expenditures’ outlay equivalents. Treasury calculated outlay equivalents in a manner designed to 

facilitate a “fair” (apples to apples) comparison between tax expenditures and direct government outlays. 

In calculating outlay equivalents, Treasury considered how a tax expenditure would be converted into a 

direct outlay and whether the outlay payment itself was likely to be taxable. To arrive at the outlay 

equivalent amount, Treasury then grossed up the tax expenditure amount to account for any tax liability 

that would be associated with a direct payment. 

176 The JCT Staff allows for “tax form” behavior when calculating a tax expenditure. That is, we 

assume the taxpayer will take the next most beneficial tax position. For example, if Congress repealed 

the education credits (the Hope and the Lifetime Learning Credits), we would assume that individuals 

otherwise eligible for these credits would avail themselves of the next best thing, for example, the tuition 

deduction. 

The tradition of scoring tax expenditures on a static basis is an attempt to put the tax expenditure 

on a more equal footing with other expenditures. The tax expenditure static assumption asks the question 
82 

Staff’s actual revenue estimates fully reflect anticipated behavioral effects of the proposal under 

consideration (subject only to the constraint that in the usual case we do not model any 

macroeconomic growth effects from the proposal).177

Third, tax expenditure calculations are applied retroactively, in the sense that a tax 

expenditure calculation for a year reflects timing differences attributable to investments made in 

prior years. In most cases, actual revenue legislation is not designed to have this kind of 

retroactive effect. 

Internal Revenue Service statistics from recent tax returns are used to develop projections 

of the tax credits, deductions, and exclusions that will be claimed under the present-law baseline. 

These statistics show the actual usage of the various tax expenditure provisions. In the case of 

some tax expenditures, such as the earned income credit, there is evidence that some taxpayers 

are not claiming all of the benefits to which they are entitled, while others are filing claims that 

exceed their entitlements. JCT Staff tax expenditure estimates are based on projections of actual 

claims under the various tax provisions, not the tax benefits to which taxpayers are entitled. 

 

of what is the total effect of the provision on current Federal budgets. By contrast, a revenue estimate in 

part asks the question of what is the taxpayer’s next best alternative; the revenue estimate contemplates 

that taxpayers will change their behaviors accordingly. 

177 Inside the JCT Revenue Estimating Process, A presentation by the Chief of Staff of the Joint 

Committee on Taxation to the New York State Bar Association, January 29, 2008. Revised January 30, 

2008, <http://www.house.gov/jct/Inside_Revenue_Estimating.pdf>. 
83 

C. New Methodology 

1. The baseline and presentation 

While the principal thrust of JCT’s proposed revised approach to tax expenditure analysis 

is to deemphasize the relevance of the “normal” tax as much as possible, the new approach must 

still define a baseline from which to measure the magnitude of tax expenditures. As previously 

described, current tax expenditure analysis employs the “normal” tax as the baseline from which 

the JCT Staff can calculate the dollar magnitude of a particular tax expenditure. 

On balance, we believe that the most feasible approach, and the one most consonant with 

the original legislative history of the Budget Act, is to follow general present-law tax rules (what 

the Treasury Department calls its reference tax base) for Tax Subsidies. We will develop our 

presentation of the general tax rules of present law in our next tax expenditure pamphlet, which 

will contain estimates of the revenues forgone in respect of those tax expenditures that are 

classified as Tax Subsidies. 

Solely for purposes of preserving continuity with past analyses, we will estimate the 

forgone revenues associated with those Tax-Induced Structural Distortions that in the recent past 

have been analyzed as tax expenditures by applying our immediately-past definition of the 

“normal” tax, as reflected in our recent annual tax expenditure pamphlets.178 Where helpful and 

feasible, we will supplement that analysis with revenue or tax-expenditure style estimates, but 

the principal presentation of each Tax-Induced Structural Distortion will be the written analysis 

of the relevant economic efficiency issues associated with that tax expenditure. 

Consistent with current JCT quantitative presentations, we do not envision presenting 

“outlay equivalents” in these subsequent pamphlets. While outlay equivalence is a useful 

concept for considering the budget consequences of converting a tax expenditure into a direct 

spending program, it is not always clear what the proper tax treatment would be for a direct 

payment that has been converted from a tax expenditure. Moreover, adoption of outlay 

equivalents would expose the lack of uniformity in accounting for appropriations, because 

current government accounting for direct outlays only measures what the government remits on a 

cash basis and does not take into account directly the taxability to a private person of a direct 

government payment. Thus, the imposition of outlay equivalence on the tax side alone would be 

asymmetric. 

2. Miscellaneous methodological issues 

We recognize that a few items that today are classified as tax expenditures may not fit 

neatly either as Tax Subsidies or as Tax-Induced Structural Distortions. We propose to continue 

to carry those items on our tax expenditure tables to preserve continuity with all of our prior 

 178 In every case, however, the substantive analysis of a Tax-Induced Structural Distortion will 

follow the summary presented earlier in this pamphlet, by identifying the economic distortion(s) 

embedded in current tax law, and possible alternative structural approaches that would address those 

economic distortions. 
84 

work in this area. We will reevaluate this decision periodically, in light of the success (or 

failure) of the new approach proposed here. 

Limitations directly linked to various positive tax expenditures, or to the alternative 

minimum tax or the limitation of itemized deductions, are not classified as negative tax 

expenditures. Instead, these items are considered reductions in those positive expenditures. This 

approach is consistent with that followed by the JCT Staff in the recent past. 

3. Areas for further research and development 

Moving forward, we will continue to review the methodology underlying the 

measurement of specific tax expenditures in light of our new taxonomy. We anticipate that the 

perspectives developed through our new approach will point to interesting areas for further 

research and development. 

For instance, the measurement of tax expenditures associated with retirement savings 

incentives is potentially affected both by demographic changes that might prompt a revised 

approach and by our new methodology. As the Baby Boom generation moves fully into 

retirement years, it may become increasingly important to consider the present discounted value 

of tax expenditures in addition to their current cash costs. Individual income tax expenditures 

that have a deferred tax consequence will be affected due to the increasing size of the retired 

population. IRAs and similar provisions will see a rise in distributions to retirees that could result 

in an attenuation of the estimated tax expenditure on a cash accounting method. A present 

discounted value approach would provide a more realistic picture of the true costs of the 

provision.179 On the other hand, it might be argued that the introduction of another method of 

accounting would be confusing to policymakers, particularly when it was not implemented 

consistently across the Federal budget.180 

 179 For a detailed discussion of the optimal budget window, see Alan Auerbach, Budget 

Windows, Sunsets, and Fiscal Control, 90 Journal of Public Economics 87-100 (2006). 

180 The Treasury Department has from time to time produced tables reporting present-value 

estimates of the revenue losses for tax expenditures that involved deferrals of tax payments or had similar 

long-term effects. The dual baseline approach was first introduced in the fiscal year 1995 budget. 

Analytical Perspectives, Budget of the United States, Fiscal Year 1995.