71

5. TAX EXPENDITURES

Tax expenditures are revenue losses due to preferential provisions of the Federal tax laws, such as

special exclusions, exemptions, deductions, credits, deferrals, or tax rates. They are alternatives to other policy instruments, such as spending or regulatory programs, as means of achieving Federal policy goals. Tax

expenditures are created for a variety of reasons, including to encourage certain activities, to improve fairness, to ease compliance with and administration of

the tax system, and to reduce certain tax-induced distortions. The Congressional Budget Act of 1974 (Public

Law 93–344) requires that a list of tax expenditures

be included in the budget.

The largest tax expenditures tend to be associated

with the individual income tax. For example, tax preferences are provided for employer contributions for

medical insurance, pension contributions and earnings,

mortgage interest payments on owner-occupied homes,

capital gains transferred at death, and payments of

State and local individual income taxes. Tax expenditures under the corporate income tax tend to be related

to the rate of cost recovery for various investments;

as is discussed below, the extent to which these provisions are classified as tax expenditures varies according

to the conceptual baseline used. Charitable contributions and credits for State death taxes are the largest

tax expenditures under the unified transfer (i.e., estate

and gift) tax.

Because of potential interactions among provisions,

this chapter does not present a grand total revenue

loss estimate for tax expenditures. Moreover, past tax

changes entailing broad elimination of tax expenditures

were generally accompanied by changes in tax rates

or other basic provisions, so that the net effects on

Federal revenues were considerably (if not totally) offset. Nevertheless, in aggregate, tax expenditures have

revenue impacts of hundreds of billions of dollars, and

are some of the most important ways in which the

Federal Government affects economic decisions and

social welfare.

While the significant economic impact is self-evident

for large provisions, smaller tax expenditures can be

important for certain sectors or types of taxpayers. As

is discussed later in this chapter, the Administration

is developing a framework for analyzing and reporting

the economic and other effects of tax expenditures, so

that they can be better compared with policy alternatives. Tax expenditures are also discussed in Section

VI of the Budget, which considers the Federal Government’s spending, regulatory, and tax policies across

functional areas.

Tax expenditures relating to the individual and corporate income taxes are considered first in this chapter.

They are estimated for fiscal years 1996–2002 using

three methods of accounting: revenue loss, outlay equivalent, and present value. The present value approach

provides estimates of the revenue losses for tax expenditures that involve deferrals of tax payments into the

future or have similar long-term effects. Tax expenditures relating to the unified transfer tax are considered

in a section at the end of the chapter.

TAX EXPENDITURES IN THE INCOME TAX

Tax Expenditure Estimates

The Treasury Department prepared all tax expenditure estimates presented here based upon tax law enacted as of December 31, 1996. The analysis includes

new tax expenditures which were enacted this year in

the Health Insurance Protection and Accountability Act

and the Small Business Job Protection Act of 1996.

Expired or repealed provisions are not listed if their

revenue effects result only from taxpayer activity occurring before fiscal year 1996.

The total revenue loss estimates for tax expenditures

for fiscal years 1996–2002 are displayed by the budget’s

functional categories in table 5–1. Descriptions of the

specific tax expenditure provisions follow the tables of

estimates and discussion of general features of the tax

expenditure concept.

As in prior years, two baseline concepts—the normal

tax baseline and the reference tax law baseline—are

used to identify tax expenditures. For the most part,

the two concepts coincide. However, items treated as

tax expenditures under the normal tax baseline, but

not the reference tax law baseline, are indicated by

the designation ‘‘normal tax method’’ in the tables. The

revenue losses for these items are zero using the reference tax rules. The alternative baseline concepts are

discussed in detail following the estimates.

Table 5–2 reports the respective portions of the total

revenue losses that arise under the individual and corporate income taxes. Listing revenue loss estimates

under the individual and corporate headings does not

imply that these categories of filers benefit from the

special tax provisions in proportion to the respective

tax expenditure amounts shown. Rather, these breakdowns show the specific tax accounts through which

the various provisions are cleared. The ultimate beneficiaries of corporate tax expenditures, for example,

could be stockholders, employees, customers, or others,

depending on the circumstances.
72 ANALYTICAL PERSPECTIVES

Table 5–3 ranks the major tax expenditures by fiscal

year 1998 revenue loss. This table merges several individual entries provided in table 5–1; for example, table

5–3 contains one merged entry for charitable contributions instead of the three separate entries found in

table 5–1.

Interpreting Tax Expenditure Estimates

Tax expenditure revenue loss estimates do not necessarily equal the increase in Federal revenues (or the

reduction in budget deficits) that would result from repealing the special provisions, for the following reasons:

• Eliminating a tax expenditure may have incentive

effects that alter economic behavior. These incentives can affect the resulting magnitudes of the

formerly subsidized activity or of other tax preferences or Government programs. For example,

if deductibility of mortgage interest were limited,

some taxpayers would hold smaller mortgages,

with a concomitantly smaller effect on the budget

than if no such limits were in force.

• Tax expenditures are interdependent even without

incentive effects. Repeal of a tax expenditure provision can increase or decrease the revenue losses

associated with other provisions. For example,

even if behavior does not change, repeal of an

itemized deduction could increase the revenue

losses from other deductions because some taxpayers would be moved into higher tax brackets.

Alternatively, repeal of an itemized deduction

could lower the revenue loss from other deductions

if taxpayers are led to claim the standard deduction instead of itemizing. Similarly, if two provisions were repealed simultaneously, the increase

in tax liability could be greater or less than the

sum of the two separate tax expenditures, since

each is estimated assuming that the other remains

in force. In addition, the estimates reported in

Table 5–1 are the totals of individual and corporate income tax revenue losses reported in Table

5–2 and do not reflect any possible interactions

between the individual and corporate income tax

receipts. For this reason, the figures in Table 5–1

(as well as those in Table 5–5, which are also

based on summing individual and corporate estimates) should be regarded as approximations.

• Revenues raised by changes to tax expenditures are

sensitive to timing effects and effective dates.

Changes in some provisions would yield their full

potential revenue gains relatively quickly, whereas

changes to other provisions would only gradually

yield their full revenue potential, as certain deductions or exemptions would likely be grandfathered.

• The annual value of tax expenditures for tax deferrals is reported on a cash basis in all tables except

table 5–4. Cash-based estimates reflect the difference between taxes deferred in the current year

and incoming revenues that are received due to

deferrals of taxes from prior years. While such

estimates are useful as a measure of cash flows

into the Government, they do not always accurately reflect the true economic cost of these provisions. For example, for a provision where activity

levels have changed, so that incoming tax receipts

from past deferrals are greater than deferred receipts from new activity, the cash-basis tax expenditure estimate can be negative, despite the

fact that in present-value terms current deferrals

do have a real cost to the Government. Alternatively, in the case of a newly enacted deferral

provision, a cash-based estimate can overstate the

real cost to the Government because the newly

deferred taxes will ultimately be received. Presentvalue estimates, which are a useful supplement

to the cash-basis estimates for provisions involving

deferrals, are discussed below.

• Repeal of some provisions could affect overall levels

of income and rates of economic growth. In principle, repeal of major tax provisions may have

some impact on the budget economic assumptions.

In general, however, most changes in particular

provisions are unlikely to have significant macroeconomic effects.

Present-Value Estimates

Discounted present-value estimates of revenue losses

are presented in table 5–4 for certain provisions that

involve tax deferrals or other long-term revenue effects.

These estimates complement the cash-based tax expenditure estimates presented in the other tables.

The present-value estimates represent the revenue

losses, net of future tax payments, that follow from

activities undertaken during calendar year 1997 which

cause the deferrals or other long-term revenue effects.

For instance, a pension contribution in 1997 would

cause a deferral of tax payments on wages in 1997

and on pension earnings on this contribution (e.g., interest) in later years. In some future year, however,

the 1997 pension contribution and accrued earnings will

be paid out and taxes will be due; these receipts are

included in the present-value estimate. In general, this

conceptual approach is similar to the one used for reporting the budgetary effects of credit programs, where

direct loans and guarantees in a given year affect future cash flows.
5. TAX EXPENDITURES 73

TABLE 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX

(In millions of dollars)

Provision

Total Revenue Loss

1996 1997 1998 1999 2000 2001 2002 1998–

2002

National defense:

Exclusion of benefits and allowances to armed forces personnel .......................................................................................... 2,060 2,080 2,095 2,120 2,140 2,160 2,180 10,695

International affairs:

Exclusion of income earned abroad by United States citizens ............................................................................................... 1,520 1,680 1,865 2,065 2,290 2,545 2,825 11,590

Exclusion of income of foreign sales corporations ................................................................................................................... 1,500 1,600 1,700 1,800 1,900 2,000 2,100 9,500

Inventory property sales source rules exception ...................................................................................................................... 1,400 1,500 1,600 1,700 1,800 1,900 2,000 9,000

Deferral of income from controlled foreign corporations (normal tax method) ....................................................................... 2,100 2,200 2,400 2,600 2,800 3,000 3,200 14,000

General science, space, and technology:

Expensing of research and experimentation expenditures (normal tax method) .................................................................... 40 195 430 580 685 740 765 3,200

Credit for increasing research activities .................................................................................................................................... 805 685 1,045 250 105 40 5 1,445

Energy:

Expensing of exploration and development costs, fuels .......................................................................................................... –210 –130 –40 20 100 75 80 235

Excess of percentage over cost depletion, fuels ..................................................................................................................... 1,125 1,145 1,170 1,190 1,205 1,225 1,255 6,045

Alternative fuel production credit ............................................................................................................................................... 570 600 485 565 535 505 485 2,575

Exception from passive loss limitation for working interests in oil and gas properties .......................................................... 50 50 55 55 60 60 65 295

Capital gains treatment of royalties on coal ............................................................................................................................. 15 15 15 20 20 20 20 95

Exclusion of interest on State and local IDBs for energy facilities ......................................................................................... 315 315 315 315 310 310 310 1,560

Enhanced oil recovery credit ..................................................................................................................................................... 80 85 90 100 105 105 110 510

New technology credit ............................................................................................................................................................... 30 35 40 40 40 45 45 210

Alcohol fuel credit 1 ................................................................................................................................................................... 10 10 10 10 10 10 10 50

Tax credit and deduction for clean-fuel burning vehicles and properties ............................................................................... 65 65 75 80 85 90 95 425

Exclusion from income of conservation subsidies provided by public utilities ........................................................................ 150 65 15 30 35 45 45 170

Natural resources and environment:

Expensing of exploration and development costs, nonfuel minerals ....................................................................................... 35 35 35 35 35 35 35 175

Excess of percentage over cost depletion, nonfuel minerals .................................................................................................. 285 295 300 305 315 320 325 1,565

Capital gains treatment of iron ore ........................................................................................................................................... ............ ............ ............ ............ ............ ............ ............ ..............

Special rules for mining reclamation reserves .......................................................................................................................... 50 50 50 50 50 50 50 250

Exclusion of interest on State and local IDBs for pollution control and sewage and waste disposal facilities .................... 700 690 675 655 640 600 545 3,115

Capital gains treatment of certain timber income ..................................................................................................................... 15 15 15 20 20 20 20 95

Expensing of multiperiod timber growing costs ........................................................................................................................ 395 415 440 460 485 505 525 2,415

Investment credit and seven-year amortization for reforestation expenditures ....................................................................... 45 50 50 50 50 50 50 250

Tax incentives for preservation of historic structures ............................................................................................................... 125 120 115 115 110 105 105 550

Agriculture:

Expensing of certain capital outlays ......................................................................................................................................... 65 65 65 70 70 70 70 345

Expensing of certain multiperiod production costs ................................................................................................................... 80 80 80 85 85 85 85 420

Treatment of loans forgiven solvent farmers as if insolvent .................................................................................................... 10 10 10 10 10 10 10 50

Capital gains treatment of certain income ................................................................................................................................ 165 170 175 180 185 190 195 925

Commerce and housing:

Financial institutions and insurance:

Exemption of credit union income ........................................................................................................................................ 660 700 745 790 835 885 940 4,195

Excess bad debt reserves of financial institutions ............................................................................................................... 90 70 40 15 5 ............ ............ 60

Deferral on income on life insurance and annuity contracts ............................................................................................... 10,525 11,210 11,940 12,715 13,540 14,420 15,360 67,975

Special alternative tax on small property and casualty insurance companies ................................................................... 5 5 5 5 5 5 5 25

Tax exemption of certain insurance companies ................................................................................................................... 240 245 255 260 280 295 310 1,400

Small life insurance company deduction .............................................................................................................................. 110 115 120 130 135 140 145 670

Housing:

Exclusion of interest on owner-occupied mortgage subsidy bonds .................................................................................... 1,765 1,755 1,735 1,715 1,690 1,665 1,640 8,445

Exclusion of interest on State and local debt for rental housing ........................................................................................ 755 760 755 760 765 760 750 3,790

Deductibility of mortgage interest on owner-occupied homes ............................................................................................. 47,525 49,820 52,115 54,440 56,830 59,345 62,060 284,790

Deductibility of State and local property tax on owner-occupied homes ............................................................................ 15,900 16,670 17,435 18,215 19,015 19,855 20,765 95,285

Deferral of income from post 1987 installment sales .......................................................................................................... 955 975 995 1,015 1,035 1,055 1,075 5,175

Deferral of capital gains on home sales .............................................................................................................................. 14,410 14,845 15,290 15,745 16,220 16,705 17,205 81,165

Exclusion of capital gains on home sales for persons age 55 and over ........................................................................... 5,225 5,230 5,095 5,515 5,295 5,810 5,495 27,210

Exception from passive loss rules for $25,000 of rental loss ............................................................................................. 3,950 3,700 3,470 3,260 3,065 2,885 2,715 15,395

Credit for low-income housing investments .......................................................................................................................... 2,600 2,840 3,270 3,500 3,595 3,445 3,325 17,135

Accelerated depreciation on rental housing (normal tax method) ....................................................................................... 1,190 1,350 1,555 1,955 2,335 2,240 2,310 10,395

Commerce:

Cancellation of indebtedness ................................................................................................................................................ 70 40 15 ............ –10 –5 –5 –5

Permanent exceptions from imputed interest rules .............................................................................................................. 150 155 155 160 160 160 165 800

Capital gains (other than agriculture, timber, iron ore, and coal) (normal tax method) ..................................................... 7,990 8,230 8,480 8,730 8,995 9,265 9,540 45,010

Capital gains exclusion of small corporation stock .............................................................................................................. ............ ............ 5 20 40 70 95 230

Step-up basis of capital gains at death ............................................................................................................................... 29,530 30,715 31,945 33,225 34,555 35,940 37,375 173,040

Carryover basis of capital gains on gifts .............................................................................................................................. 140 150 160 170 180 190 200 900

Ordinary income treatment of loss from small business corporation stock sale ................................................................ 35 35 35 35 40 40 40 190
74 ANALYTICAL PERSPECTIVES

TABLE 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued

(In millions of dollars)

Provision

Total Revenue Loss

1996 1997 1998 1999 2000 2001 2002 1998–

2002

Accelerated depreciation of buildings other than rental housing (normal tax method) ...................................................... 6,800 5,800 4,660 3,420 2,385 1,640 1,085 13,190

Accelerated depreciation of machinery and equipment (normal tax method) .................................................................... 25,430 27,280 29,285 32,500 35,730 38,325 40,125 175,965

Expensing of certain small investments (normal tax method) ............................................................................................. 1,440 1,065 900 890 850 700 560 3,900

Amortization of start-up costs (normal tax method) ............................................................................................................. 195 200 205 210 215 220 225 1,075

Graduated corporation income tax rate (normal tax method) ............................................................................................. 4,435 4,695 4,940 5,125 5,455 5,720 5,925 27,165

Exclusion of interest on small issue IDBs ............................................................................................................................ 275 265 260 255 250 250 240 1,255

Treatment of Alaska Native Corporations ............................................................................................................................ 20 15 10 5 5 5 ............ 25

Transportation:

Deferral of tax on shipping companies ..................................................................................................................................... 20 20 20 20 20 20 20 100

Exclusion of reimbursed employee parking expenses ............................................................................................................. 1,250 1,285 1,315 1,350 1,385 1,425 1,470 6,945

Exclusion for employer-provided transit passes ....................................................................................................................... 50 60 70 85 100 115 130 500

Community and regional development:

Investment credit for rehabilitation of structures (other than historic) ..................................................................................... 80 80 70 70 70 65 65 340

Exclusion of interest on IDBs for airports, docks, and sports and convention facilities ......................................................... 1,980 1,975 1,970 1,915 1,865 1,810 1,760 9,320

Exemption of certain mutuals’ and cooperatives’ income ........................................................................................................ 60 60 60 65 65 65 70 325

Empowerment zones ................................................................................................................................................................. 530 585 640 670 700 700 530 3,240

Education, training, employment, and social services:

Education:

Exclusion of scholarship and fellowship income (normal tax method) ............................................................................... 835 845 850 860 870 875 885 4,340

Exclusion of interest on State and local student loan bonds .............................................................................................. 305 290 280 265 260 250 250 1,305

Exclusion of interest on State and local debt for private nonprofit educational facilities ................................................... 955 930 895 860 830 800 775 4,160

Exclusion of interest on savings bonds transferred to educational institutions .................................................................. 5 10 10 15 15 15 20 75

Parental personal exemption for students age 19 or over .................................................................................................. 820 845 885 930 985 1,045 1,090 4,935

Deductibility of charitable contributions (education) ............................................................................................................. 1,865 1,960 2,060 2,165 2,270 2,385 2,500 11,380

Exclusion of employer provided educational assistance ...................................................................................................... 20 575 20 ............ ............ ............ ............ 20

Training, employment, and social services:

Work opportunity tax credit ................................................................................................................................................... ............ 120 150 85 30 10 ............ 275

Exclusion of employer provided child care ........................................................................................................................... 775 830 890 955 1,025 1,100 1,180 5,150

Adoption assistance ............................................................................................................................................................... ............ 10 200 320 355 370 365 1,610

Exclusion of employee meals and lodging (other than military) ......................................................................................... 570 600 630 665 700 735 775 3,505

Credit for child and dependent care expenses .................................................................................................................... 2,580 2,705 2,840 2,985 3,130 3,290 3,455 15,700

Credit for disabled access expenditures .............................................................................................................................. 80 85 85 85 90 90 90 440

Expensing of costs of removing certain architectural barriers to the handicapped ........................................................... 20 20 20 20 20 20 20 100

Deductibility of charitable contributions, other than education and health .......................................................................... 16,045 16,845 17,680 18,560 19,480 20,445 21,455 97,620

Exclusion of certain foster care payments ........................................................................................................................... 30 35 35 35 40 40 45 195

Exclusion of parsonage allowances ...................................................................................................................................... 295 315 335 360 380 410 435 1,920

Health:

Exclusion of employer contributions for medical insurance premiums and medical care ...................................................... 64,450 70,460 75,750 81,285 86,900 92,815 98,995 435,745

Medical savings accounts .......................................................................................................................................................... ............ 10 100 190 195 195 200 880

Deductibility of medical expenses ............................................................................................................................................. 3,675 4,060 4,535 4,895 5,270 5,670 6,100 26,470

Exclusion of interest on State and local debt for private nonprofit health facilities ................................................................ 2,135 2,080 2,005 1,930 1,855 1,790 1,745 9,325

Deductibility of charitable contributions (health) ....................................................................................................................... 2,360 2,480 2,600 2,735 2,870 3,005 3,155 14,365

Tax credit for orphan drug research ......................................................................................................................................... 5 20 10 ............ ............ ............ ............ 10

Special Blue Cross/Blue Shield deduction ................................................................................................................................ 120 135 95 150 165 200 250 860

Income security:

Exclusion of railroad retirement system benefits ...................................................................................................................... 440 440 450 450 455 455 465 2,275

Exclusion of workmen’s compensation benefits ....................................................................................................................... 4,695 4,970 5,305 5,550 5,855 6,220 6,660 29,590

Exclusion of public assistance benefits (normal tax method) .................................................................................................. 500 515 550 575 600 625 655 3,005

Exclusion of special benefits for disabled coal miners ............................................................................................................ 90 90 85 80 75 75 70 385

Exclusion of military disability pensions .................................................................................................................................... 130 130 130 130 130 130 130 650

Net exclusion of pension contributions and earnings:

Employer plans ...................................................................................................................................................................... 55,410 55,810 56,245 56,665 57,085 57,510 57,940 285,445

Individual Retirement Accounts ............................................................................................................................................. 8,025 8,345 8,600 8,880 9,125 9,340 9,520 45,465

Keogh plans ........................................................................................................................................................................... 3,030 3,200 3,325 3,500 3,680 3,875 4,080 18,460

Exclusion of employer provided death benefits ........................................................................................................................ 35 35 35 40 40 45 45 205

Exclusion of other employee benefits:

Premiums on group term life insurance ............................................................................................................................... 2,495 2,615 2,745 2,880 3,020 3,170 3,325 15,140

Premiums on accident and disability insurance ................................................................................................................... 155 165 175 185 195 205 215 975

Income of trusts to finance supplementary unemployment benefits ................................................................................... 20 20 20 20 20 20 20 100

Special ESOP rules ................................................................................................................................................................... 905 735 720 740 760 790 820 3,830

Additional deduction for the blind .............................................................................................................................................. 25 25 25 30 30 30 30 145

Additional deduction for the elderly ........................................................................................................................................... 1,470 1,485 1,495 1,500 1,510 1,515 1,515 7,535

Tax credit for the elderly and disabled ..................................................................................................................................... 45 50 50 50 50 50 50 250

Deductibility of casualty losses ................................................................................................................................................. 460 485 510 535 560 590 620 2,815

Earned income credit 2 .............................................................................................................................................................. 5,097 5,653 5,814 6,112 6,319 6,621 6,859 31,725
5. TAX EXPENDITURES 75

TABLE 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued

(In millions of dollars)

Provision

Total Revenue Loss

1996 1997 1998 1999 2000 2001 2002 1998–

2002

Social Security:

Exclusion of social security benefits:

OASI benefits for retired workers ......................................................................................................................................... 17,005 17,810 18,495 19,290 20,190 20,875 21,495 100,345

Disability insurance benefits .................................................................................................................................................. 2,090 2,375 2,615 2,820 3,045 3,290 3,545 15,315

Benefits for dependents and survivors ................................................................................................................................. 3,795 3,985 4,175 4,355 4,530 4,710 4,895 22,665

Veterans benefits and services:

Exclusion of veterans disability compensation ......................................................................................................................... 2,615 2,770 2,930 3,100 3,280 3,470 3,675 16,455

Exclusion of veterans pensions ................................................................................................................................................. 70 70 70 70 75 80 85 380

Exclusion of GI bill benefits ....................................................................................................................................................... 50 60 70 80 90 95 100 435

Exclusion of interest on State and local debt for veterans housing ....................................................................................... 40 40 35 35 35 35 35 175

General purpose fiscal assistance:

Exclusion of interest on public purpose State and local debt ................................................................................................. 15,720 15,800 15,735 15,595 15,445 15,300 15,170 77,245

Deductibility of nonbusiness State and local taxes other than on owner-occupied homes ................................................... 28,265 29,630 30,995 32,375 33,800 35,290 36,910 169,370

Tax credit for corporations receiving income from doing business in U.S. possessions ....................................................... 2,760 2,700 2,770 2,800 2,885 2,970 3,060 14,485

Interest:

Deferral of interest on savings bonds ....................................................................................................................................... 1,300 1,290 1,285 1,270 1,215 1,170 1,155 6,095

Addendum—Aid to State and local governments:

Deductibility of:

Property taxes on owner-occupied homes ........................................................................................................................... 15,900 16,670 17,435 18,215 19,015 19,855 20,765 95,285

Nonbusiness State and local taxes other than on owner-occupied homes ........................................................................ 28,265 29,630 30,995 32,375 33,800 35,290 36,910 169,370

Exclusion of interest on:

Public purpose State and local debt .................................................................................................................................... 15,720 15,800 15,735 15,595 15,445 15,300 15,170 77,245

IDBs for certain energy facilities ........................................................................................................................................... 315 315 315 315 310 310 310 1,560

IDBs for pollution control and sewage and waste disposal facilities .................................................................................. 700 690 675 655 640 600 545 3,115

Small-issue IDBs ................................................................................................................................................................... 275 265 260 255 250 250 240 1,255

Owner-occupied mortgage revenue bonds ........................................................................................................................... 1,765 1,755 1,735 1,715 1,690 1,665 1,640 8,445

State and local debt for rental housing ................................................................................................................................ 755 760 755 760 765 760 750 3,790

IDBs for airports, docks, and sports and convention facilities ............................................................................................ 1,980 1,975 1,970 1,915 1,865 1,810 1,760 9,320

State and local student loan bonds ...................................................................................................................................... 305 290 280 265 260 250 250 1,305

State and local debt for private nonprofit educational facilities ........................................................................................... 955 930 895 860 830 800 775 4,160

State and local debt for private nonprofit health facilities ................................................................................................... 2,135 2,080 2,005 1,930 1,855 1,790 1,745 9,325

State and local debt for veterans housing ........................................................................................................................... 40 40 35 35 35 35 35 175

1 In addition alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1996 $670; 1997 $670; 1998 $700; 1999 $740; 2000 $770; 2001 $800; and 2002 $840.

2 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1996 $19,159; 1997 $21,163; 1998 $21,983; 1999

$22,864; 2000 $23,818; 2001 $24,634; and 2002 $25,518.

Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law method.

All estimates have been rounded to the nearest $5 million.

Figures in table 5–1 are the arithmetic sums of corporate and individual income tax revenue loss estimates from table 5–2, and do not reflect possible interactions across these two taxes.
76 ANALYTICAL PERSPECTIVES

TABLE 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES

(In millions of dollars)

Provision

Revenue Loss

Corporations Individuals

1996 1997 1998 1999 2000 2001 2002 1996 1997 1998 1999 2000 2001 2002

National defense:

Exclusion of benefits and allowances to armed forces personnel ................. — — — — — — — 2,060 2,080 2,095 2,120 2,140 2,160 2,180

International affairs:

Exclusion of income earned abroad by United States citizens ...................... — — — — — — — 1,520 1,680 1,865 2,065 2,290 2,545 2,825

Exclusion of income of foreign sales corporations .......................................... 1,500 1,600 1,700 1,800 1,900 2,000 2,100 — — — — — — —

Inventory property sales source rules exception ............................................. 1,400 1,500 1,600 1,700 1,800 1,900 2,000 — — — — — — —

Deferral of income from controlled foreign corporations (normal tax method) 2,100 2,200 2,400 2,600 2,800 3,000 3,200 — — — — — — —

General science, space, and technology:

Expensing of research and experimentation expenditures (normal tax method) ................................................................................................................. 40 190 420 570 670 725 750 ............ 5 10 10 15 15 15

Credit for increasing research activities ........................................................... 790 670 1,035 250 105 40 5 15 15 10 ............ ............ ............ ............

Energy:

Expensing of exploration and development costs, fuels ................................. –155 –95 –30 15 80 55 60 –55 –35 –10 5 20 20 20

Excess of percentage over cost depletion, fuels ............................................ 845 860 875 890 905 920 940 280 285 295 300 300 305 315

Alternative fuel production credit ...................................................................... 535 565 450 535 505 475 455 35 35 35 30 30 30 30

Exception from passive loss limitation for working interests in oil and gas

properties ...................................................................................................... — — — — — — — 50 50 55 55 60 60 65

Capital gains treatment of royalties on coal .................................................... — — — — — — — 15 15 15 20 20 20 20

Exclusion of interest on State and local IDBs for energy facilities ................ 125 125 125 125 125 125 125 190 190 190 190 185 185 185

Enhanced oil recovery credit ............................................................................ 75 80 85 90 95 95 100 5 5 5 10 10 10 10

New technology credit ...................................................................................... 30 35 40 40 40 45 45 ............ ............ ............ ............ ............ ............ ............

Alcohol fuel credit 1 .......................................................................................... 5 5 5 5 5 5 5 5 5 5 5 5 5 5

Tax credit and deduction for clean-fuel burning vehicles and properties ...... 55 55 60 60 60 65 70 10 10 15 20 25 25 25

Exclusion from income of conservation subsidies provided by public utilities 100 10 –45 –35 –30 –25 –25 50 55 60 65 65 70 70

Natural resources and environment:

Expensing of exploration and development costs, nonfuel minerals ............. 25 25 25 25 25 25 25 10 10 10 10 10 10 10

Excess of percentage over cost depletion, nonfuel minerals ......................... 215 220 225 230 235 240 245 70 75 75 75 80 80 80

Capital gains treatment of iron ore .................................................................. — — — — — — — ............ ............ ............ ............ ............ ............ ............

Special rules for mining reclamation reserves ................................................ 45 45 45 45 45 45 45 5 5 5 5 5 5 5

Exclusion of interest on State and local IDBs for pollution control and sewage and waste disposal facilities ................................................................. 280 275 270 260 255 235 215 420 415 405 395 385 365 330

Capital gains treatment of certain timber income ........................................... — — — — — — — 15 15 15 20 20 20 20

Expensing of multiperiod timber growing costs ............................................... 225 235 250 260 275 285 295 170 180 190 200 210 220 230

Investment credit and seven-year amortization for reforestation expenditures .............................................................................................................. 20 20 20 20 20 20 20 25 30 30 30 30 30 30

Tax incentives for preservation of historic structures ...................................... 25 25 25 25 20 20 20 100 95 90 90 90 85 85

Agriculture:

Expensing of certain capital outlays ................................................................ 10 10 10 10 10 10 10 55 55 55 60 60 60 60

Expensing of certain multiperiod production costs .......................................... 10 10 10 10 10 10 10 70 70 70 75 75 75 75

Treatment of loans forgiven solvent farmers as if insolvent ........................... — — — — — — — 10 10 10 10 10 10 10

Capital gains treatment of certain income ....................................................... — — — — — — — 165 170 175 180 185 190 195

Commerce and housing:

Financial institutions and insurance:

Exemption of credit union income ............................................................... 660 700 745 790 835 885 940 — — — — — — —

Excess bad debt reserves of financial institutions ...................................... 90 70 40 15 5 ............ ............ — — — — — — —

Deferral on income on life insurance and annuity contracts ...................... 325 345 370 395 420 445 475 10,200 10,865 11,570 12,320 13,120 13,975 14,885

Special alternative tax on small property and casualty insurance companies ........................................................................................................... 5 5 5 5 5 5 5 — — — — — — —

Tax exemption of certain insurance companies ......................................... 240 245 255 260 280 295 310 — — — — — — —

Small life insurance company deduction ..................................................... 110 115 120 130 135 140 145 — — — — — — —

Housing:

Exclusion of interest on owner-occupied mortgage subsidy bonds ........... 705 700 690 685 675 665 655 1,060 1,055 1,045 1,030 1,015 1,000 985

Exclusion of interest on State and local debt for rental housing ............... 300 305 300 305 305 305 300 455 455 455 455 460 455 450

Deductibility of mortgage interest on owner-occupied homes .................... — — — — — — — 47,525 49,820 52,115 54,440 56,830 59,345 62,060

Deductibility of State and local property tax on owner-occupied homes ... — — — — — — — 15,900 16,670 17,435 18,215 19,015 19,855 20,765

Deferral of income from post 1987 installment sales ................................. 245 250 255 260 265 270 275 710 725 740 755 770 785 800

Deferral of capital gains on home sales ..................................................... — — — — — — — 14,410 14,845 15,290 15,745 16,220 16,705 17,205

Exclusion of capital gains on home sales for persons age 55 and over — — — — — — — 5,225 5,230 5,095 5,515 5,295 5,810 5,495

Exception from passive loss rules for $25,000 of rental loss .................... — — — — — — — 3,950 3,700 3,470 3,260 3,065 2,885 2,715

Credit for low-income housing investments ................................................ 520 570 655 700 720 690 665 2,080 2,270 2,615 2,800 2,875 2,755 2,660

Accelerated depreciation on rental housing (normal tax method) .............. 750 855 1,005 1,340 1,650 1,500 1,515 440 495 550 615 685 740 795

Commerce:

Cancellation of indebtedness ....................................................................... — — — — — — — 70 40 15 ............ –10 –5 –5
5. TAX EXPENDITURES 77

TABLE 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES—Continued

(In millions of dollars)

Provision

Revenue Loss

Corporations Individuals

1996 1997 1998 1999 2000 2001 2002 1996 1997 1998 1999 2000 2001 2002

Permanent exceptions from imputed interest rules .................................... — — — — — — — 150 155 155 160 160 160 165

Capital gains (other than agriculture, timber, iron ore, and coal) (normal

tax method) .............................................................................................. — — — — — — — 7,990 8,230 8,480 8,730 8,995 9,265 9,540

Capital gains exclusion of small corporation stock ..................................... — — — — — — — ............ ............ 5 20 40 70 95

Step-up basis of capital gains at death ...................................................... — — — — — — — 29,530 30,715 31,945 33,225 34,555 35,940 37,375

Carryover basis of capital gains on gifts ..................................................... — — — — — — — 140 150 160 170 180 190 200

Ordinary income treatment of loss from small business corporation stock

sale ........................................................................................................... — — — — — — — 35 35 35 35 40 40 40

Accelerated depreciation of buildings other than rental housing (normal

tax method) .............................................................................................. 4,780 4,070 3,260 2,385 1,695 1,185 800 2,020 1,730 1,400 1,035 690 455 285

Accelerated depreciation of machinery and equipment (normal tax method) ............................................................................................................. 20,195 21,510 23,055 25,510 27,980 29,625 31,080 5,235 5,770 6,230 6,990 7,750 8,700 9,045

Expensing of certain small investments (normal tax method) .................... 875 655 575 580 560 470 385 565 410 325 310 290 230 175

Amortization of start-up costs (normal tax method) .................................... 90 95 95 100 100 105 105 105 105 110 110 115 115 120

Graduated corporation income tax rate (normal tax method) .................... 4,435 4,695 4,940 5,125 5,455 5,720 5,925 — — — — — — —

Exclusion of interest on small issue IDBs ................................................... 110 105 105 100 100 100 95 165 160 155 155 150 150 145

Treatment of Alaska Native Corporations ................................................... 20 15 10 5 5 5 ............ — — — — — — —

Transportation:

Deferral of tax on shipping companies ............................................................ 20 20 20 20 20 20 20 — — — — — — —

Exclusion of reimbursed employee parking expenses .................................... — — — — — — — 1,250 1,285 1,315 1,350 1,385 1,425 1,470

Exclusion for employer-provided transit passes .............................................. — — — — — — — 50 60 70 85 100 115 130

Community and regional development:

Investment credit for rehabilitation of structures (other than historic) ............ 15 15 15 15 15 15 15 65 65 55 55 55 50 50

Exclusion of interest on IDBs for airports, docks, and sports and convention facilities .................................................................................................. 790 790 785 760 740 720 700 1,190 1,185 1,185 1,155 1,125 1,090 1,060

Exemption of certain mutuals’ and cooperatives’ income ............................... 60 60 60 65 65 65 70 — — — — — — —

Empowerment zones ........................................................................................ 500 550 600 625 650 650 490 30 35 40 45 50 50 40

Education, training, employment, and social services:

Education:

Exclusion of scholarship and fellowship income (normal tax method) ...... — — — — — — — 835 845 850 860 870 875 885

Exclusion of interest on State and local student loan bonds ..................... 120 115 110 105 105 100 100 185 175 170 160 155 150 150

Exclusion of interest on State and local debt for private nonprofit educational facilities ....................................................................................... 380 370 355 340 330 320 310 575 560 540 520 500 480 465

Exclusion of interest on savings bonds transferred to educational institutions .......................................................................................................... — — — — — — — 5 10 10 15 15 15 20

Parental personal exemption for students age 19 or over ......................... — — — — — — — 820 845 885 930 985 1,045 1,090

Deductibility of charitable contributions (education) .................................... 180 190 200 210 220 230 240 1,685 1,770 1,860 1,955 2,050 2,155 2,260

Exclusion of employer provided educational assistance ............................ — — — — — — — 20 575 20 ............ ............ ............ ............

Training, employment, and social services:

Work opportunity tax credit .......................................................................... ............ 100 130 70 25 10 ............ ............ 20 20 15 5 ............ ............

Exclusion of employer provided child care ................................................. — — — — — — — 775 830 890 955 1,025 1,100 1,180

Adoption assistance ..................................................................................... — — — — — — — ............ 10 200 320 355 370 365

Exclusion of employee meals and lodging (other than military) ................ — — — — — — — 570 600 630 665 700 735 775

Credit for child and dependent care expenses ........................................... — — — — — — — 2,580 2,705 2,840 2,985 3,130 3,290 3,455

Credit for disabled access expenditures ..................................................... 50 50 50 50 55 55 55 30 35 35 35 35 35 35

Expensing of costs of removing certain architectural barriers to the

handicapped ............................................................................................. 15 15 15 15 15 15 15 5 5 5 5 5 5 5

Deductibility of charitable contributions, other than education and health 670 700 730 760 790 820 850 15,375 16,145 16,950 17,800 18,690 19,625 20,605

Exclusion of certain foster care payments .................................................. — — — — — — — 30 35 35 35 40 40 45

Exclusion of parsonage allowances ............................................................. — — — — — — — 295 315 335 360 380 410 435

Health:

Exclusion of employer contributions for medical insurance premiums and

medical care ................................................................................................. — — — — — — — 64,450 70,460 75,750 81,285 86,900 92,815 98,995

Medical savings accounts ................................................................................. — — — — — — — ............ 10 100 190 195 195 200

Deductibility of medical expenses .................................................................... — — — — — — — 3,675 4,060 4,535 4,895 5,270 5,670 6,100

Exclusion of interest on State and local debt for private nonprofit health facilities ............................................................................................................ 850 825 795 765 735 710 695 1,285 1,255 1,210 1,165 1,120 1,080 1,050

Deductibility of charitable contributions (health) .............................................. 640 675 705 745 780 810 850 1,720 1,805 1,895 1,990 2,090 2,195 2,305

Tax credit for orphan drug research ................................................................ 5 20 10 ............ ............ ............ ............ — — — — — — —

Special Blue Cross/Blue Shield deduction ...................................................... 120 135 95 150 165 200 250 — — — — — — —

Income security:

Exclusion of railroad retirement system benefits ............................................. — — — — — — — 440 440 450 450 455 455 465

Exclusion of workmen’s compensation benefits .............................................. — — — — — — — 4,695 4,970 5,305 5,550 5,855 6,220 6,660

Exclusion of public assistance benefits (normal tax method) ......................... — — — — — — — 500 515 550 575 600 625 655
78 ANALYTICAL PERSPECTIVES

TABLE 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES—Continued

(In millions of dollars)

Provision

Revenue Loss

Corporations Individuals

1996 1997 1998 1999 2000 2001 2002 1996 1997 1998 1999 2000 2001 2002

Exclusion of special benefits for disabled coal miners ................................... — — — — — — — 90 90 85 80 75 75 70

Exclusion of military disability pensions ........................................................... — — — — — — — 130 130 130 130 130 130 130

Net exclusion of pension contributions and earnings:

Employer plans ............................................................................................. — — — — — — — 55,410 55,810 56,245 56,665 57,085 57,510 57,940

Individual Retirement Accounts .................................................................... — — — — — — — 8,025 8,345 8,600 8,880 9,125 9,340 9,520

Keogh plans .................................................................................................. — — — — — — — 3,030 3,200 3,325 3,500 3,680 3,875 4,080

Exclusion of employer provided death benefits ............................................... — — — — — — — 35 35 35 40 40 45 45

Exclusion of other employee benefits:

Premiums on group term life insurance ...................................................... — — — — — — — 2,495 2,615 2,745 2,880 3,020 3,170 3,325

Premiums on accident and disability insurance .......................................... — — — — — — — 155 165 175 185 195 205 215

Income of trusts to finance supplementary unemployment benefits .......... — — — — — — — 20 20 20 20 20 20 20

Special ESOP rules .......................................................................................... 845 675 660 680 700 730 760 60 60 60 60 60 60 60

Additional deduction for the blind .................................................................... — — — — — — — 25 25 25 30 30 30 30

Additional deduction for the elderly ................................................................. — — — — — — — 1,470 1,485 1,495 1,500 1,510 1,515 1,515

Tax credit for the elderly and disabled ............................................................ — — — — — — — 45 50 50 50 50 50 50

Deductibility of casualty losses ........................................................................ — — — — — — — 460 485 510 535 560 590 620

Earned income credit 2 ..................................................................................... — — — — — — — 5,097 5,653 5,814 6,112 6,319 6,621 6,859

Social Security:

Exclusion of social security benefits:

OASI benefits for retired workers ................................................................ — — — — — — — 17,005 17,810 18,495 19,290 20,190 20,875 21,495

Disability insurance benefits ......................................................................... — — — — — — — 2,090 2,375 2,615 2,820 3,045 3,290 3,545

Benefits for dependents and survivors ........................................................ — — — — — — — 3,795 3,985 4,175 4,355 4,530 4,710 4,895

Veterans benefits and services:

Exclusion of veterans disability compensation ................................................ — — — — — — — 2,615 2,770 2,930 3,100 3,280 3,470 3,675

Exclusion of veterans pensions ........................................................................ — — — — — — — 70 70 70 70 75 80 85

Exclusion of GI bill benefits ............................................................................. — — — — — — — 50 60 70 80 90 95 100

Exclusion of interest on State and local debt for veterans housing .............. 15 15 15 15 15 15 15 25 25 20 20 20 20 20

General purpose fiscal assistance:

Exclusion of interest on public purpose State and local debt ........................ 6,290 6,310 6,280 6,220 6,160 6,105 6,055 9,430 9,490 9,455 9,375 9,285 9,195 9,115

Deductibility of nonbusiness State and local taxes other than on owner-occupied homes ............................................................................................... — — — — — — — 28,265 29,630 30,995 32,375 33,800 35,290 36,910

Tax credit for corporations receiving income from doing business in U.S.

possessions .................................................................................................. 2,760 2,700 2,770 2,800 2,885 2,970 3,060 — — — — — — —

Interest:

Deferral of interest on savings bonds .............................................................. — — — — — — — 1,300 1,290 1,285 1,270 1,215 1,170 1,155

Addendum—Aid to State and local governments:

Deductibility of:

Property taxes on owner-occupied homes .................................................. — — — — — — — 15,900 16,670 17,435 18,215 19,015 19,855 20,765

Nonbusiness State and local taxes other than on owner-occupied homes — — — — — — — 28,265 29,630 30,995 32,375 33,800 35,290 36,910

Exclusion of interest on:

Public purpose State and local debt ........................................................... 6,290 6,310 6,280 6,220 6,160 6,105 6,055 9,430 9,490 9,455 9,375 9,285 9,195 9,115

IDBs for certain energy facilities .................................................................. 125 125 125 125 125 125 125 190 190 190 190 185 185 185

IDBs for pollution control and sewage and waste disposal facilities ......... 280 275 270 260 255 235 215 420 415 405 395 385 365 330

Small-issue IDBs .......................................................................................... 110 105 105 100 100 100 95 165 160 155 155 150 150 145

Owner-occupied mortgage revenue bonds .................................................. 705 700 690 685 675 665 655 1,060 1,055 1,045 1,030 1,015 1,000 985

State and local debt for rental housing ....................................................... 300 305 300 305 305 305 300 455 455 455 455 460 455 450

IDBs for airports, docks, and sports and convention facilities ................... 790 790 785 760 740 720 700 1,190 1,185 1,185 1,155 1,125 1,090 1,060

State and local student loan bonds ............................................................. 120 115 110 105 105 100 100 185 175 170 160 155 150 150

State and local debt for private nonprofit educational facilities ................. 380 370 355 340 330 320 310 575 560 540 520 500 480 465

State and local debt for private nonprofit health facilities .......................... 850 825 795 765 735 710 695 1,285 1,255 1,210 1,165 1,120 1,080 1,050

State and local debt for veterans housing .................................................. 15 15 15 15 15 15 15 25 25 20 20 20 20 20

1 In addition alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1996 $670; 1997 $670; 1998 $700; 1999 $740; 2000 $770; 2001 $800; and 2002 $840.

2 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1996 $19,159; 1997 $21,163; 1998 $21,983; 1999

$22,864; 2000 $23,818; 2001 $24,634; and 2002 $25,518.

Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law method.

All estimates have been rounded to the nearest $5 million.
5. TAX EXPENDITURES 79

TABLE 5–3. MAJOR TAX EXPENDITURES IN THE INCOME TAX, RANKED BY TOTAL 1998 REVENUE LOSS

(In millions of dollars)

Provision 1998 1998–2002

Exclusion of employer contributions for medical insurance premiums and medical care ............................................................................................................................. 75,750 435,745

Net exclusion of employer pension-plan contributions and earnings ............................................................................................................................................................. 56,245 285,445

Deductibility of mortgage interest on owner-occupied homes ........................................................................................................................................................................ 52,115 284,790

Step-up basis of capital gains at death .......................................................................................................................................................................................................... 31,945 173,040

Deductibility of nonbusiness State and local taxes other than on owner-occupied homes .......................................................................................................................... 30,995 169,370

Accelerated depreciation of machinery and equipment (normal tax method) ............................................................................................................................................... 29,285 175,965

Deductibility of charitable contributions ........................................................................................................................................................................................................... 22,340 123,365

Exclusion of OASI benefits for retired workers ............................................................................................................................................................................................... 18,495 100,345

Deductibility of State and local property tax on owner-occupied homes ....................................................................................................................................................... 17,435 95,285

Exclusion of interest on public purpose State and local debt ........................................................................................................................................................................ 15,735 77,245

Deferral of capital gains on home sales ......................................................................................................................................................................................................... 15,290 81,165

Deferral on income on life insurance and annuity contracts .......................................................................................................................................................................... 11,940 67,975

Exclusion of interest on State and local debt for various non-public purposes ............................................................................................................................................ 8,925 42,450

Net exclusion of Individual Retirement Account contributions and earnings ................................................................................................................................................. 8,600 45,465

Capital gains (other than agriculture, timber, iron ore, and coal) (normal tax method) ............................................................................................................................... 8,480 45,010

Earned income credit 1 .................................................................................................................................................................................................................................... 5,814 31,725

Exclusion of workmen’s compensation benefits .............................................................................................................................................................................................. 5,305 29,590

Exclusion of capital gains on home sales for persons age 55 and over ...................................................................................................................................................... 5,095 27,210

Graduated corporation income tax rate (normal tax method) ........................................................................................................................................................................ 4,940 27,165

Accelerated depreciation of buildings other than rental housing (normal tax method) ................................................................................................................................. 4,660 13,190

Deductibility of medical expenses .................................................................................................................................................................................................................... 4,535 26,470

Exclusion of Social Security benefits for dependents and survivors ............................................................................................................................................................. 4,175 22,665

Exception from passive loss rules for $25,000 of rental loss ........................................................................................................................................................................ 3,470 15,395

Net exclusion of Keogh plan contributions and earnings ............................................................................................................................................................................... 3,325 18,460

Credit for low-income housing investments ..................................................................................................................................................................................................... 3,270 17,135

Exclusion of veterans disability compensation ................................................................................................................................................................................................ 2,930 16,455

Credit for child and dependent care expenses ............................................................................................................................................................................................... 2,840 15,700

Tax credit for corporations receiving income from doing business in U.S. possessions .............................................................................................................................. 2,770 14,485

Exclusion of employer-provided premiums on group term life insurance ...................................................................................................................................................... 2,745 15,140

Exclusion of Social Security disability insurance benefits .............................................................................................................................................................................. 2,615 15,315

Deferral of income from controlled foreign corporations (normal tax method) .............................................................................................................................................. 2,400 14,000

Exclusion of benefits and allowances to armed forces personnel ................................................................................................................................................................. 2,095 10,695

Exclusion of interest on State and local debt for private nonprofit health facilities ...................................................................................................................................... 2,005 9,325

Exclusion of income earned abroad by United States citizens ...................................................................................................................................................................... 1,865 11,590

Exclusion of income of foreign sales corporations ......................................................................................................................................................................................... 1,700 9,500

Inventory property sales source rules exception ............................................................................................................................................................................................ 1,600 9,000

Accelerated depreciation on rental housing (normal tax method) .................................................................................................................................................................. 1,555 10,395

Additional deduction for the elderly ................................................................................................................................................................................................................. 1,495 7,535

Exclusion of reimbursed employee parking expenses .................................................................................................................................................................................... 1,315 6,945

Deferral of interest on savings bonds ............................................................................................................................................................................................................. 1,285 6,095

Excess of percentage over cost depletion (fuels) ........................................................................................................................................................................................... 1,170 6,045

Credit for increasing research activities .......................................................................................................................................................................................................... 1,045 1,445

Deferral of income from post 1987 installment sales ..................................................................................................................................................................................... 995 5,175

Expensing of certain small investments (normal tax method) ........................................................................................................................................................................ 900 3,900

Exclusion of employer provided child care ..................................................................................................................................................................................................... 890 5,150

Parental personal exemption for students age 19 or over ............................................................................................................................................................................. 885 4,935

Exclusion of scholarship and fellowship income (normal tax method) .......................................................................................................................................................... 850 4,340

Exemption of credit union income ................................................................................................................................................................................................................... 745 4,195

Special ESOP rules .......................................................................................................................................................................................................................................... 720 3,830

Empowerment zones ........................................................................................................................................................................................................................................ 640 3,240

Exclusion of employee meals and lodging (other than military) .................................................................................................................................................................... 630 3,505

Exclusion of public assistance benefits (normal tax method) ........................................................................................................................................................................ 550 3,005

Deductibility of casualty losses ........................................................................................................................................................................................................................ 510 2,815

Alternative fuel production credit ..................................................................................................................................................................................................................... 485 2,575

Exclusion of railroad retirement system benefits ............................................................................................................................................................................................ 450 2,275

Expensing of multiperiod timber growing costs .............................................................................................................................................................................................. 440 2,415

Expensing of research and experimentation expenditures (normal tax method) .......................................................................................................................................... 430 3,200

Exclusion of parsonage allowances ................................................................................................................................................................................................................. 335 1,920

Excess of percentage over cost depletion, nonfuel minerals ......................................................................................................................................................................... 300 1,565

Exclusion of interest on small issue IDBs ....................................................................................................................................................................................................... 260 1,255

Tax exemption of certain insurance companies ............................................................................................................................................................................................. 255 1,400

Amortization of start-up costs (normal tax method) ........................................................................................................................................................................................ 205 1,075

Adoption assistance .......................................................................................................................................................................................................................................... 200 1,610

Capital gains treatment of certain income ...................................................................................................................................................................................................... 175 925

Exclusion of employer-provided premiums on accident and disability insurance .......................................................................................................................................... 175 975

Carryover basis of capital gains on gifts ......................................................................................................................................................................................................... 160 900

Permanent exceptions from imputed interest rules ........................................................................................................................................................................................ 155 800

Work opportunity tax credit .............................................................................................................................................................................................................................. 150 275

Exclusion of military disability pensions .......................................................................................................................................................................................................... 130 650
80 ANALYTICAL PERSPECTIVES

TABLE 5–3. MAJOR TAX EXPENDITURES IN THE INCOME TAX, RANKED BY TOTAL 1998 REVENUE LOSS—Continued

(In millions of dollars)

Provision 1998 1998–2002

Small life insurance company deduction ......................................................................................................................................................................................................... 120 670

Tax incentives for preservation of historic structures ..................................................................................................................................................................................... 115 550

Medical savings accounts ................................................................................................................................................................................................................................ 100 880

Special Blue Cross/Blue Shield deduction ...................................................................................................................................................................................................... 95 860

Enhanced oil recovery credit ........................................................................................................................................................................................................................... 90 510

Credit for disabled access expenditures ......................................................................................................................................................................................................... 85 440

Exclusion of special benefits for disabled coal miners ................................................................................................................................................................................... 85 385

Expensing of certain multiperiod production costs ......................................................................................................................................................................................... 80 420

Tax credit and deduction for clean-fuel burning vehicles and properties ...................................................................................................................................................... 75 425

Exclusion for employer-provided transit passes .............................................................................................................................................................................................. 70 500

Investment credit for rehabilitation of structures (other than historic) ............................................................................................................................................................ 70 340

Exclusion of veterans pensions ....................................................................................................................................................................................................................... 70 380

Exclusion of GI bill benefits ............................................................................................................................................................................................................................. 70 435

Expensing of certain capital outlays ................................................................................................................................................................................................................ 65 345

Exemption of certain mutuals’ and cooperatives’ income .............................................................................................................................................................................. 60 325

Exception from passive loss limitation for working interests in oil and gas properties ................................................................................................................................ 55 295

Tax credit for the elderly and disabled ........................................................................................................................................................................................................... 50 250

Special rules for mining reclamation reserves ................................................................................................................................................................................................ 50 250

Investment credit and seven-year amortization for reforestation expenditures ............................................................................................................................................. 50 250

Excess bad debt reserves of financial institutions .......................................................................................................................................................................................... 40 60

New technology credit ...................................................................................................................................................................................................................................... 40 210

Exclusion of employer provided death benefits .............................................................................................................................................................................................. 35 205

Ordinary income treatment of loss from small business corporation stock sale ........................................................................................................................................... 35 190

Exclusion of certain foster care payments ...................................................................................................................................................................................................... 35 195

Expensing of exploration and development costs, nonfuel minerals ............................................................................................................................................................. 35 175

Additional deduction for the blind .................................................................................................................................................................................................................... 25 145

Exclusion of employer provided educational assistance ................................................................................................................................................................................ 20 20

Deferral of tax on shipping companies ........................................................................................................................................................................................................... 20 100

Exclusion of income of trusts to finance supplementary unemployment benefits ......................................................................................................................................... 20 100

Expensing of costs of removing certain architectural barriers to the handicapped ...................................................................................................................................... 20 100

Exclusion from income of conservation subsidies provided by public utilities .............................................................................................................................................. 15 170

Cancellation of indebtedness ........................................................................................................................................................................................................................... 15 –5

Capital gains treatment of royalties on coal ................................................................................................................................................................................................... 15 95

Capital gains treatment of certain timber income ........................................................................................................................................................................................... 15 95

Treatment of Alaska Native Corporations ....................................................................................................................................................................................................... 10 25

Treatment of loans forgiven solvent farmers as if insolvent .......................................................................................................................................................................... 10 50

Tax credit for orphan drug research ............................................................................................................................................................................................................... 10 10

Exclusion of interest on savings bonds transferred to educational institutions ............................................................................................................................................. 10 75

Alcohol fuel credit 2 .......................................................................................................................................................................................................................................... 10 50

Capital gains exclusion of small corporation stock ......................................................................................................................................................................................... 5 230

Special alternative tax on small property and casualty insurance companies .............................................................................................................................................. 5 25

Capital gains treatment of iron ore .................................................................................................................................................................................................................. ............................ ............................

Expensing of exploration and development costs (fuels) ............................................................................................................................................................................... –40 235

1 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1996 $19,159; 1997 $21,163; 1998 $21,983; 1999

$22,864; 2000 $23,818; 2001 $24,634; and 2002 $25,518. 2 In addition alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1996 $670; 1997 $670; 1998 $700; 1999 $740; 2000 $770; 2001 $800; and 2002 $840.

Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law method.

All estimates have been rounded to the nearest $5 million.

Figures in table 5–3 are the arithmetic sums of corporate and individual income tax revenue loss estimates from table 5-2, and do not reflect possible interactions across these two taxes.
5. TAX EXPENDITURES 81

1 Budget outlay figures generally reflect the pre-tax price of the resources. In some instances, however, Government purchases or subsidies are exempted from tax by a special

tax provision. When this occurs, the outlay figure understates the resource cost of the

program and is, therefore, not comparable with other outlay amounts. For example, the

outlays for certain military personnel allowances are not taxed. If this form of compensation

were treated as part of the employee’s taxable income, the Defense Department would

have to make larger cash payments to its military personnel to leave them as well off

after tax as they are now. The tax subsidy must be added to the tax-exempt budget

outlay to make this element of national defense expenditures comparable with other outlays.

TABLE 5–4. PRESENT VALUE OF SELECTED TAX EXPENDITURES FOR

ACTIVITY IN CALENDAR YEAR 1997

(In millions of dollars)

Provision

Present

Value of

Revenue

Loss

Deferral of income from controlled foreign corporations (normal tax method) .................................................. 2,150

Expensing of research and experimentation expenditures (normal tax method) ............................................... 1,610

Expensing of exploration and development costs—fuels .................................................................................... 205

Expensing of exploration and development costs—nonfuels .............................................................................. 60

Expensing of multiperiod timber growing costs ................................................................................................... 140

Expensing of certain multiperiod production costs—agriculture .......................................................................... 85

Expensing of certain capital outlays—agriculture ................................................................................................ 70

Deferral of income on life insurance and annuity contracts ............................................................................... 18,700

Deferral of capital gains on home sales .............................................................................................................. 14,630

Credit for low-income housing investments ......................................................................................................... 3,150

Accelerated depreciation of rental housing (normal tax method) ....................................................................... 2,025

Accelerated depreciation of buildings other than rental housing (normal tax method) ..................................... 420

Accelerated depreciation of machinery and equipment (normal tax method) .................................................... 29,830

Expensing of certain small investments (normal tax method) ............................................................................ 1,050

Amortization of start-up costs (normal tax method) ............................................................................................ 170

Deferral of tax on shipping companies ................................................................................................................ 10

Exclusion of pension contributions and earnings—employer plans .................................................................... 54,060

Exclusion of IRA contributions and earnings ....................................................................................................... 2,175

Exclusions of contribution and earnings for Keogh plans ................................................................................... 3,220

Exclusion of interest on State and local public-purpose bonds .......................................................................... 17,535

Exclusion of interest on State and local non-public purpose bonds .................................................................. 8,925

Deferral of interest on U.S. savings bonds ......................................................................................................... 210

Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law

method.

Outlay Equivalents

The concept of ‘‘outlay equivalents’’ complements

‘‘revenue losses’’ as a measure of the budget effect of

tax expenditures. It is the amount of outlay that would

be required to provide the taxpayer the same aftertax income as would be received through the tax preference. The outlay equivalent measure allows a comparison of the cost of the tax expenditure with that

of a direct Federal outlay. Outlay equivalents are reported in table 5–5.

The measure is larger than the revenue loss estimate

when the tax expenditure is judged to function as a

Government payment for service. This occurs because

an outlay program would increase the taxpayer’s pretax income. For some tax expenditures, however, the

revenue loss equals the outlay equivalent measure. This

occurs when the tax expenditure is judged to function

like a price reduction or tax deferral that does not

directly enter the taxpayer’s pre-tax income.1
82 ANALYTICAL PERSPECTIVES

TABLE 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX

(In millions of dollars)

Provision

Outlay Equivalents

1996 1997 1998 1999 2000 2001 2002 1998–2002

National defense:

Exclusion of benefits and allowances to armed forces personnel .................................................................................. 2,405 2,425 2,445 2,470 2,495 2,520 2,545 12,475

International affairs:

Exclusion of income earned abroad by United States citizens ....................................................................................... 2,025 2,240 2,485 2,755 3,055 3,390 3,770 15,455

Exclusion of income of foreign sales corporations .......................................................................................................... 2,310 2,460 2,615 2,770 2,925 3,075 3,230 14,615

Inventory property sales source rules exception ............................................................................................................. 2,155 2,310 2,460 2,615 2,770 2,925 3,075 13,845

Deferral of income from controlled foreign corporations (normal tax method) ............................................................... 2,100 2,200 2,400 2,600 2,800 3,000 3,200 14,000

General science, space, and technology:

Expensing of research and experimentation expenditures (normal tax method) ........................................................... 40 195 430 580 685 740 765 3,200

Credit for increasing research activities ........................................................................................................................... 1,245 1,055 1,610 380 160 60 10 2,220

Energy:

Expensing of exploration and development costs, fuels ................................................................................................. –210 –130 –40 20 100 75 80 235

Excess of percentage over cost depletion, fuels ............................................................................................................. 1,580 1,620 1,640 1,675 2,705 1,730 1,765 8,515

Alternative fuel production credit ...................................................................................................................................... 800 795 845 795 755 715 685 3,795

Exception from passive loss limitation for working interests in oil and gas properties ................................................. 50 50 55 55 60 60 65 295

Capital gains treatment of royalties on coal .................................................................................................................... 20 20 20 25 25 25 25 120

Exclusion of interest on State and local IDBs for energy facilities ................................................................................. 420 420 415 415 410 405 400 2,045

New technology credit ....................................................................................................................................................... 40 50 55 60 60 60 65 300

Alcohol fuel credit 1 ........................................................................................................................................................... 10 10 10 10 10 10 10 50

Tax credit and deduction for clean-fuel burning vehicles and properties ....................................................................... 90 95 105 110 120 125 130 590

Exclusion from income of conservation subsidies provided by public utilities ............................................................... 210 95 25 40 55 60 65 245

Natural resources and environment:

Expensing of exploration and development costs, nonfuel minerals .............................................................................. 35 35 35 35 35 35 35 175

Excess of percentage over cost depletion, nonfuel minerals .......................................................................................... 405 415 425 435 440 455 460 2,215

Capital gains treatment of iron ore ................................................................................................................................... ............ ............ ............ .............. .............. .............. .............. ...................

Special rules for mining reclamation reserves ................................................................................................................. 50 50 50 50 50 50 50 250

Exclusion of interest on State and local IDBs for pollution control and sewage and waste disposal facilities ............ 925 900 870 845 815 755 675 3,960

Capital gains treatment of certain timber income ............................................................................................................ 20 20 20 25 25 25 25 120

Expensing of multiperiod timber growing costs ............................................................................................................... 395 415 440 460 485 505 525 2,415

Investment credit and seven-year amortization for reforestation expenditures .............................................................. 65 65 75 75 75 75 75 375

Tax incentives for preservation of historic structures ...................................................................................................... 125 120 115 115 110 105 105 550

Agriculture:

Expensing of certain capital outlays ................................................................................................................................. 65 65 65 70 70 70 70 345

Expensing of certain multiperiod production costs .......................................................................................................... 80 80 80 85 85 85 85 420

Treatment of loans forgiven solvent farmers as if insolvent ........................................................................................... 10 10 10 10 10 10 10 50

Capital gains treatment of certain income ....................................................................................................................... 220 225 235 240 245 255 260 1,235

Commerce and housing:

Financial institutions and insurance:

Exemption of credit union income ................................................................................................................................ 840 895 945 1,005 1,065 1,130 1,200 5,345

Excess bad debt reserves of financial institutions ...................................................................................................... 90 70 40 15 5 .............. .............. 60

Deferral on income on life insurance and annuity contracts ...................................................................................... 10,525 11,210 11,940 12,715 13,540 14,420 15,360 67,975

Special alternative tax on small property and casualty insurance companies ........................................................... 5 5 5 5 5 5 5 25

Tax exemption of certain insurance companies .......................................................................................................... 315 320 335 340 370 390 405 1,840

Small life insurance company deduction ...................................................................................................................... 145 150 160 170 175 185 190 880

Housing:

Exclusion of interest on owner-occupied mortgage subsidy bonds ............................................................................ 2,305 2,265 2,230 2,190 2,150 2,110 2,070 10,750

Exclusion of interest on State and local debt for rental housing ............................................................................... 990 985 980 985 990 980 970 4,905

Deductibility of mortgage interest on owner-occupied homes .................................................................................... 47,525 49,820 52,115 54,440 56,830 59,345 62,060 284,790

Deductibility of State and local property tax on owner-occupied homes ................................................................... 15,900 16,670 17,435 18,215 19,015 19,855 20,765 95,285

Deferral of income from post 1987 installment sales .................................................................................................. 955 975 995 1,015 1,035 1,055 1,075 5,175

Deferral of capital gains on home sales ...................................................................................................................... 14,410 14,845 15,290 15,745 16,220 16,705 17,205 81,165

Exclusion of capital gains on home sales for persons age 55 and over .................................................................. 6,965 6,975 6,795 7,355 7,060 7,745 7,325 36,280

Exception from passive loss rules for $25,000 of rental loss ..................................................................................... 3,950 3,700 3,470 3,260 3,065 2,885 2,715 15,395

Credit for low-income housing investments ................................................................................................................. 2,660 2,945 3,270 3,500 3,595 3,445 3,325 17,135

Accelerated depreciation on rental housing (normal tax method) .............................................................................. 1,190 1,350 1,560 1,955 2,340 2,240 2,310 10,405

Commerce:

Cancellation of indebtedness ........................................................................................................................................ 70 40 15 .............. –10 –5 –5 –5

Permanent exceptions from imputed interest rules ..................................................................................................... 150 155 155 160 160 160 165 800

Capital gains (other than agriculture, timber, iron ore, and coal) ............................................................................... 10,655 10,975 11,295 11,640 11,995 12,355 12,720 60,005

Capital gains exclusion of small corporation stock ..................................................................................................... ............ ............ 5 25 55 95 125 305

Step-up basis of capital gains at death ....................................................................................................................... 39,375 40,955 42,595 44,300 46,075 47,920 49,835 230,725

Carryover basis of capital gains on gifts ..................................................................................................................... 140 150 160 170 180 190 200 900

Ordinary income treatment of loss from small business corporation stock sale ....................................................... 45 45 50 50 55 55 55 265

Accelerated depreciation of buildings other than rental housing (normal tax method) ............................................. 6,800 5,795 4,655 3,420 2,380 1,640 1,085 13,180

Accelerated depreciation of machinery and equipment (normal tax method) ............................................................ 25,430 27,280 29,285 32,500 35,730 38,320 40,125 175,960
5. TAX EXPENDITURES 83

TABLE 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued

(In millions of dollars)

Provision

Outlay Equivalents

1996 1997 1998 1999 2000 2001 2002 1998–2002

Expensing of certain small investments (normal tax method) .................................................................................... 1,435 1,065 900 890 845 700 560 3,895

Amortization of start-up costs (normal tax method) .................................................................................................... 195 200 205 210 215 220 225 1,075

Graduated corporation income tax rate (normal tax method) ..................................................................................... 5,995 6,345 6,675 6,925 7,370 7,730 8,005 36,705

Exclusion of interest on small issue IDBs ................................................................................................................... 335 310 300 290 285 275 270 1,420

Treatment of Alaska Native Corporations .................................................................................................................... 20 15 10 5 5 5 .............. 25

Transportation:

Deferral of tax on shipping companies ............................................................................................................................ 20 20 20 20 20 20 20 100

Exclusion of reimbursed employee parking expenses ..................................................................................................... 1,625 1,670 1,715 1,755 1,805 1,855 1,910 9,040

Exclusion for employer-provided transit passes ............................................................................................................... 65 80 100 115 135 155 180 685

Community and regional development:

Investment credit for rehabilitation of structures (other than historic) ............................................................................. 80 80 70 70 70 65 65 340

Exclusion of interest on IDBs for airports, docks, and sports and convention facilities ................................................ 2,570 2,550 2,525 2,445 2,360 2,280 2,200 11,810

Exemption of certain mutuals’ and cooperatives’ income ............................................................................................... 60 60 60 65 65 65 70 325

Empowerment zones ......................................................................................................................................................... 530 585 640 670 700 700 530 3,240

Education, training, employment, and social services:

Education:

Exclusion of scholarship and fellowship income (normal tax method) ....................................................................... 915 925 935 945 955 965 980 4,780

Exclusion of interest on State and local student loan bonds ..................................................................................... 380 360 335 320 305 295 290 1,545

Exclusion of interest on State and local debt for private nonprofit educational facilities .......................................... 1,225 1,175 1,120 1,065 1,015 970 935 5,105

Exclusion of interest on savings bonds transferred to educational institutions .......................................................... 5 10 10 15 15 15 20 75

Parental personal exemption for students age 19 or over ......................................................................................... 910 935 980 1,030 1,090 1,155 1,205 5,460

Deductibility of charitable contributions (education) ..................................................................................................... 2,480 2,605 2,730 2,870 3,000 3,155 3,295 15,050

Exclusion of employer provided educational assistance ............................................................................................. 25 710 25 .............. .............. .............. .............. 25

Training, employment, and social services:

Work opportunity tax credit ........................................................................................................................................... ............ 120 150 85 30 10 .............. 275

Exclusion of employer provided child care .................................................................................................................. 1,035 1,105 1,185 1,275 1,365 1,465 1,575 6,865

Adoption assistance ...................................................................................................................................................... ............ 10 240 385 430 450 435 1,940

Exclusion of employee meals and lodging (other than military) ................................................................................. 695 730 770 810 855 900 950 4,285

Credit for child and dependent care expenses ........................................................................................................... 3,440 3,605 3,785 3,980 4,175 4,385 4,605 20,930

Credit for disabled access expenditures ...................................................................................................................... 105 115 115 115 120 120 120 590

Expensing of costs of removing certain architectural barriers to the handicapped ................................................... 20 20 20 20 20 20 20 100

Deductibility of charitable contributions, other than education and health ................................................................. 27,365 28,740 30,185 31,735 33,305 34,965 36,365 166,555

Exclusion of certain foster care payments ................................................................................................................... 40 40 45 45 50 50 55 245

Exclusion of parsonage allowances ............................................................................................................................. 365 390 415 440 470 505 540 2,370

Health:

Exclusion of employer contributions for medical insurance premiums and medical care .............................................. 82,200 90,035 96,950 104,220 111,490 119,100 127,045 558,805

Medical savings accounts ................................................................................................................................................. ............ 10 110 205 210 210 220 955

Deductibility of medical expenses ..................................................................................................................................... 3,675 4,060 4,535 4,895 5,270 5,670 6,100 26,470

Exclusion of interest on State and local debt for private nonprofit health facilities ....................................................... 2,740 2,630 2,510 2,390 2,275 2,175 2,095 11,445

Deductibility of charitable contributions (health) ............................................................................................................... 3,175 3,325 3,585 3,655 3,825 4,005 4,195 19,265

Tax credit for orphan drug research ................................................................................................................................ 5 30 15 .............. .............. .............. .............. 15

Special Blue Cross/Blue Shield deduction ....................................................................................................................... 155 175 125 200 220 260 330 1,135

Income security:

Exclusion of railroad retirement system benefits ............................................................................................................. 440 440 450 450 455 455 465 2,275

Exclusion of workmen’s compensation benefits ............................................................................................................... 4,695 4,970 5,305 5,550 5,855 6,220 6,660 29,590

Exclusion of public assistance benefits (normal tax method) ......................................................................................... 500 515 550 575 600 625 655 3,005

Exclusion of special benefits for disabled coal miners .................................................................................................... 90 90 85 80 75 75 70 385

Exclusion of military disability pensions ........................................................................................................................... 130 130 130 130 130 130 130 650

Net exclusion of pension contributions and earnings:

Employer plans .............................................................................................................................................................. 72,195 77,045 77,625 78,175 78,760 79,350 79,950 314,510

Individual Retirement Accounts .................................................................................................................................... 11,110 11,615 12,045 12,515 12,950 13,370 13,755 64,635

Keogh plans .................................................................................................................................................................. 3,990 4,215 4,380 4,610 4,850 5,105 5,375 24,320

Exclusion of employer provided death benefits ............................................................................................................... 45 50 50 55 55 60 65 285

Exclusion of other employee benefits:

Premiums on group term life insurance ....................................................................................................................... 3,280 3,440 3,610 3,790 3,975 4,170 4,375 19,920

Premiums on accident and disability insurance .......................................................................................................... 200 210 225 235 250 260 275 1,245

Income of trusts to finance supplementary unemployment benefits ........................................................................... 20 20 20 20 20 20 20 100

Special ESOP rules ........................................................................................................................................................... 1,255 1,020 1,000 1,030 1,055 1,095 1,140 5,320

Additional deduction for the blind ..................................................................................................................................... 30 30 35 35 35 35 40 180

Additional deduction for the elderly .................................................................................................................................. 1,780 1,795 1,805 1,815 1,825 1,830 1,830 9,105

Tax credit for the elderly and disabled ............................................................................................................................ 60 60 60 60 60 60 60 300

Deductibility of casualty losses ......................................................................................................................................... 600 630 660 695 730 765 805 3,655

Earned income credit 2 ..................................................................................................................................................... 5,663 6,281 6,460 6,792 7,021 7,357 7,621 35,251
84 ANALYTICAL PERSPECTIVES

TABLE 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued

(In millions of dollars)

Provision

Outlay Equivalents

1996 1997 1998 1999 2000 2001 2002 1998–2002

Social Security:

Exclusion of social security benefits:

OASI benefits for retired workers ................................................................................................................................. 17,005 17,810 18,495 19,290 20,190 20,875 21,495 100,345

Disability insurance benefits ......................................................................................................................................... 2,090 2,375 2,615 2,820 3,045 3,290 3,545 15,315

Benefits for dependents and survivors ......................................................................................................................... 3,795 3,985 4,175 4,355 4,530 4,710 4,895 22,665

Veterans benefits and services:

Exclusion of veterans disability compensation ................................................................................................................. 2,615 2,770 2,930 3,100 3,280 3,470 3,675 16,455

Exclusion of veterans pensions ........................................................................................................................................ 70 70 70 70 75 80 85 380

Exclusion of GI bill benefits .............................................................................................................................................. 50 60 70 80 90 95 100 435

Exclusion of interest on State and local debt for veterans housing ............................................................................... 50 45 45 45 40 40 40 210

General purpose fiscal assistance:

Exclusion of interest on public purpose State and local debt ......................................................................................... 19,840 19,700 19,490 19,225 18,950 18,675 18,420 94,760

Deductibility of nonbusiness State and local taxes other than on owner-occupied homes ........................................... 28,265 29,630 30,995 32,375 33,800 35,290 36,910 169,370

Tax credit for corporations receiving income from doing business in U.S. possessions ............................................... 3,940 3,860 3,960 4,000 4,120 4,245 4,370 20,695

Interest:

Deferral of interest on savings bonds .............................................................................................................................. 1,300 1,290 1,285 1,270 1,215 1,170 1,155 6,095

Addendum—Aid to State and local governments:

Deductibility of:

Property taxes on owner-occupied homes ................................................................................................................... 15,900 16,670 17,435 18,215 19,015 19,855 20,765 95,285

Nonbusiness State and local taxes other than on owner-occupied homes ............................................................... 28,265 29,630 30,995 32,375 33,800 35,290 36,910 169,370

Exclusion of interest on:

Public purpose State and local debt ............................................................................................................................ 19,840 19,700 19,490 19,225 18,950 18,675 18,420 94,760

IDBs for certain energy facilities .................................................................................................................................. 420 420 415 415 410 405 400 2,045

IDBs for pollution control and sewage and waste disposal facilities .......................................................................... 925 900 870 845 815 755 675 3,960

Small-issue IDBs ........................................................................................................................................................... 335 310 300 290 285 275 270 1,420

Owner-occupied mortgage revenue bonds .................................................................................................................. 2,305 2,265 2,230 2,190 2,150 2,110 2,070 10,750

State and local debt for rental housing ....................................................................................................................... 990 985 980 985 990 980 970 4,905

IDBs for airports, docks, and sports and convention facilities .................................................................................... 2,570 2,550 2,525 2,445 2,360 2,280 2,200 11,810

State and local student loan bonds ............................................................................................................................. 380 360 335 320 305 295 290 1,545

State and local debt for private nonprofit educational facilities .................................................................................. 1,225 1,175 1,120 1,065 1,015 970 935 5,105

State and local debt for private nonprofit health facilities ........................................................................................... 2,740 2,630 2,510 2,390 2,275 2,175 2,095 11,445

State and local debt for veterans housing ................................................................................................................... 50 45 45 45 40 40 40 210

1 In addition, alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1996 $670; 1997 $670; 1998 $700; 1999 $740; 2000 $770; 2001 $800; and 2002 $840.

2 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1996 $19,159; 1997 $21,163; 1998 $21,983; 1999

$22,864; 2000 $23,818; 2001 $24,634; and 2002 $25,518.

Note: Provisions with estimates denoted ‘‘normal tax method’’ have outlay equivalents of zero under the reference tax law method.

All estimates have been rounded to the nearest $5 million.

Tax Expenditure Baselines

A tax expenditure is a preferential exception to the

baseline provisions of the tax structure. The 1974 Congressional Budget Act does not, however, specify the

baseline provisions of the tax law. Deciding whether

provisions are preferential exceptions, therefore, is a

matter of judgement. As in prior years, this year’s tax

expenditure estimates are presented using two baselines: the normal tax baseline, which is used by the

Joint Committee on Taxation, and the reference tax

law baseline, which has been used by the Administration since 1983.

The normal tax baseline is patterned on a comprehensive income tax, which defines income as the

sum of consumption and the change in net wealth in

a given period of time. The normal tax baseline allows

personal exemptions, a standard deduction, and deductions of the expenses incurred in earning income. It

is not limited to a particular structure of tax rates,

or by a specific definition of the taxpaying unit.

The reference tax law baseline is also patterned on

a comprehensive income tax, but in practice is closer

to existing law. Reference law tax expenditures are limited to special exceptions in the tax code that serve

programmatic functions. These functions correspond to

specific budget categories such as national defense, agriculture, or health care. While tax expenditures under

the reference law baseline are generally tax expenditures under the normal tax baseline, the reverse is

not always true.

Both the normal and reference tax baselines allow

several major departures from a pure comprehensive

income tax. For example:

• Income is taxable when realized in exchange. Thus,

neither the deferral of tax on unrealized capital

gains nor the tax exclusion of imputed income

(such as the rental value of owner-occupied housing or farmers’ consumption of their own produce)

is regarded as a tax expenditure. Both accrued

and imputed income would be taxed under a comprehensive income tax.

• There is a separate corporation income tax. Under

a comprehensive income tax corporate income

would be taxed only once—at the shareholder
5. TAX EXPENDITURES 85

2Gross income does, however, include transfer payments associated with past employment,

such as social security benefits. 3 In the cases of individuals who hold ‘‘passive’’ equity interests in businesses, however,

the pro rata shares of sales and expense deductions reportable in a year are limited.

A passive business activity is defined to be one in which the holder of the interest, usually

a partnership interest, does not actively perform managerial or other participatory functions.

The taxpayer may generally report no larger deductions for a year than will reduce taxable

income from such activities to zero. Deductions in excess of the limitation may be taken

in subsequent years, or when the interest is liquidated.

level, whether or not distributed in the form of

dividends.

• Values of assets and debt are not adjusted for inflation. A comprehensive income tax would adjust

the cost basis of capital assets and debt for

changes in the price level during the time the

assets or debt are held. Thus, under a comprehensive income tax baseline the failure to take account of inflation in measuring depreciation, capital gains, and interest income would be regarded

as a negative tax expenditure (i.e., a tax penalty),

and failure to take account of inflation in measuring interest costs would be regarded as a positive

tax expenditure (i.e., a tax subsidy).

While the reference law and normal tax baselines

are generally similar, areas of difference include:

• Tax rates. The separate schedules applying to the

various taxpaying units are included in the reference law baseline. Thus, corporate tax rates

below the maximum statutory rate do not give

rise to a tax expenditure. The normal tax baseline

is similar, except that it specifies the current maximum rate as the baseline for the corporate income tax. The lower tax rates applied to the first

$10 million of corporate income are thus regarded

as a tax expenditure. Similarly, under the reference law baseline, preferential tax rates for capital gains generally do not yield a tax expenditure;

only capital gains treatment of otherwise ‘‘ordinary income,’’ such as that from coal and iron

ore royalties and the sale of timber and certain

agricultural products, is considered a tax expenditure. The alternative minimum tax is treated as

part of the baseline rate structure under both the

reference and normal tax methods.

• Income subject to the tax. Income subject to tax

is defined as gross income less the costs of earning

that income. The Federal income tax defines gross

income to include: (1) consideration received in

the exchange of goods and services, including labor

services or property; and (2) the taxpayer’s share

of gross or net income earned and/or reported by

another entity (such as a partnership). Under the

reference tax rules, therefore, gross income does

not include gifts—defined as receipts of money or

property that are not consideration in an exchange—or most transfer payments, which can be

thought of as gifts from the Government.2 The

normal tax baseline also excludes gifts between

individuals from gross income. Under the normal

tax baseline, however, all cash transfer payments

from the Government to private individuals are

counted in gross income, and exemptions of such

transfers from tax are identified as tax expenditures. The costs of earning income are generally

deductible in determining taxable income under

both the reference and normal tax baselines.3

• Capital recovery. Under the reference tax law

baseline no tax expenditures arise from accelerated depreciation. Under the normal tax baseline,

the depreciation allowance for machinery and

equipment is determined using straight-line depreciation over tax lives equal to mid-values of

the asset depreciation range (a depreciation system in effect from 1971 through 1980). The normal

tax baseline for real property is computed using

40-year straight-line depreciation.

• Treatment of foreign income. Both the normal and

reference tax baselines allow a tax credit for foreign income taxes paid (up to the amount of U.S.

income taxes that would otherwise be due), which

prevents double taxation of income earned abroad.

Under the normal tax method, however, controlled

foreign corporations (CFCs) are not regarded as

entities separate from their controlling U.S. shareholders. Thus, the deferral of tax on income received by CFCs is regarded as a tax expenditure

under this method. In contrast, except for tax

haven activities, the reference law baseline follows

current law in treating CFCs as separate taxable

entities whose income is not subject to U.S. tax

until distributed to U.S. taxpayers. Under this

baseline, deferral of tax on CFC income is not

a tax expenditure because U.S. taxpayers generally are not taxed on accrued, but unrealized,

income.

In addition to these areas of difference, the Joint

Committee on Taxation considers a somewhat broader

set of tax expenditures under its normal tax baseline

than is considered here.

Performance Measures and the Economic

Effects of Tax Expenditures

Under the Government Performance and Results Act

of 1993 (GPRA), Federal agencies, in conjunction with

the Office of Management and Budget, are directed to

develop strategic plans for their functions and programs, with specific performance measures and performance goals. Consistent with this effort, OMB and

the Department of the Treasury have started to develop

a framework for evaluating the performance and economic effects of tax expenditures. This framework is

expected to evolve based on additional work within the

Executive branch and consultation with Congressional

units, including the Joint Committee on Taxation and

the General Accounting Office. Initial work is summarized below and will be updated in the Administration’s

May 1997 report on GPRA implementation.

Tax expenditures have a variety of objectives and

effects. These include encouraging certain types of activities (e.g., saving for retirement or investing in certain sectors); increasing certain types of after-tax income (e.g., favorable tax treatment of social security
86 ANALYTICAL PERSPECTIVES

income); reducing private compliance costs and government administrative costs (e.g., favorable treatment of

certain employer-provided fringe benefits); and promoting tax neutrality (e.g., accelerated depreciation in the

presence of inflation). Some of these objectives are well

suited to quantitative measurement, while others are

less suited. Also, many tax expenditures, including

those cited above, may have more than one objective.

As just one example, favorable treatment of employerprovided pensions might be argued to have aspects of

most, or even all, of the goals mentioned above. In

addition, the economic effects of particular provisions

can extend beyond their intended objectives (e.g., a provision intended to promote an activity or raise certain

incomes may have positive or negative effects on tax

neutrality).

Performance measurement is generally concerned

with inputs, outputs, and outcomes. In the case of tax

expenditures, the principal input is likely to be the

tax revenue loss. Outputs are quantitative or qualitative measures of goods and services, or changes in

income and investment, directly produced by these inputs. Outcomes, in turn, represent the changes in the

economy, society, or environment that are the ultimate

goals of programs.

Thus, for a provision that reduces taxes on investment in a certain activity, an increase in the amount

of investment would likely be a key output. The resulting production from that investment, and, in turn, the

associated improvements in national income, welfare,

or security, could be the outcomes of interest. For other

provisions, such as those designed to address a potential inequity or unintended consequence in the tax code,

an important performance measure might be how they

change effective tax rates (the discounted present-value

of taxes owed on new investments or incremental earnings) or excess burden (an economic measure of the

distortions caused by taxes). Distributional effects on

incomes may be an important concern for certain provisions.

Estimation of these performance indicators and economic effects may be pursued via economic modeling

and use of tax data. It is anticipated that OMB, Treasury, and other agencies will work together, as appropriate, on determining a set of useful measures and

in developing quantitative and other estimates of provisions’ impacts.

The discussion below considers the types of measures

that might be useful for some major programmatic

groups of tax expenditures. The discussion is intended

to be illustrative, and not all encompassing.

One major set of tax expenditures benefits retirement

savings, through employer-provided pensions, individual retirement accounts, Keogh plans and other instruments, such as annuities. These provisions might be

evaluated in terms of their effects on boosting retirement incomes and private savings. In considering the

provisions’ distributional effects, it may be of interest

to consider beneficiaries’ incomes while retired and over

their entire lifetimes.

Individuals also benefit from favorable treatment of

employer-provided health insurance. Measures of these

benefits could include increased coverage and the distribution of this coverage across different income

groups. In principle, the effects of insurance coverage

on final outcome measures of actual health (e.g., infant

mortality, days of work lost due to illness, or life expectancy) or intermediate outcomes (e.g., use of preventative health care) could also be investigated.

Other provisions principally have income distribution,

rather than incentive, effects. For example, tax-favored

treatment of social security benefits provides increased

incomes to eligible groups; the distribution of these increased incomes may be a useful performance measure.

The earned-income tax credit, in contrast, should probably be evaluated both for its effects on labor force

participation and its distributional properties.

Housing investment also benefits from tax expenditures, including the mortgage interest deduction and

preferential treatment of capital gains on housing.

Measures of the effectiveness of these provisions could

include consideration of their effects on increasing the

extent of home ownership and the quality of housing.

The effects of the capital gains provisions in terms of

offsetting inflationary gains are also likely to be relevant. Deductibility of State and local property taxes

assists with making housing more affordable as well

as easing the cost of providing community services

through these taxes. Provisions that are intended to

promote investment in rental housing could be evaluated for their effects on making rental housing more

available and affordable.

A series of tax expenditures reduces the cost of investment, both in specific activities—such as research

and experimentation, extractive industries, and certain

financial activities—and more generally, through accelerated depreciation for plant and equipment. These provisions can be evaluated along a number of dimensions.

For example, in addition to considering revenue effects,

it is can be useful to consider the extent of the incentive

delivered by measuring the provisions’ effects on the

cost of capital (the interest rate which investments

must yield to cover their pretax tax costs) and effective

tax rates. Another set of measures would reflect the

impact of these provisions on the amounts of corresponding forms of investment—such as research

spending, exploration activity, or equipment. A third

group of measures would, in turn, consider the provisions’ effects on production from these investments—

such as numbers or value of patents, energy production

and reserves, and industrial production. Other measures could consider objectives which are less directly

attributable but still are ultimate goals, such as assisting the U.S. technological base, energy security, or economic growth.

The above illustrative discussion, while broad, is nevertheless incomplete, both for the provisions mentioned

and the many that are not explicitly cited. Developing

a framework which is appropriately comprehensive, accurate, and flexible to reflect the objectives and effects
5. TAX EXPENDITURES 87

of the wide range of tax expenditures will be a significant challenge. It is expected that this framework will

evolve and improve over the next several years and

that quantitative estimates will be made to the extent

possible. Such estimates could then be compared with

the costs of the provisions and with the costs and benefits of other means of achieving the same performance

goals.

Other Considerations

The tax expenditure analysis could be extended beyond the income and transfer taxes to include payroll

and excise taxes. The exclusion of certain forms of compensation from the wage base, for instance, reduces

payroll taxes, as well as income taxes. Payroll tax exclusions are complex to analyze, however, because they

also affect social insurance benefits. Certain targeted

excise tax provisions might also be considered tax expenditures. In this case challenges include determining

an appropriate baseline.

Descriptions of Income Tax Provisions

Descriptions of the individual and corporate income

tax expenditures reported upon in this chapter follow.

NATIONAL DEFENSE

Benefits and allowances to armed forces personnel.—The housing and meals provided military personnel, either in cash or in kind, as well as certain

amounts of pay related to combat service are excluded

from income subject to tax.

INTERNATIONAL AFFAIRS

Income earned abroad.—A U.S. citizen or resident

alien who resides in a foreign country or who stays

in one or more foreign countries for a minimum of

11 out of the past 12 months may exclude $70,000

per year of foreign-earned income. Eligible taxpayers

also may exclude or deduct reasonable housing costs

in excess of one-sixth of the salary of a civil servant

at grade GS –14, step 1. These provisions do not apply

to Federal employees working abroad; however, the tax

expenditure estimate does reflect certain allowances

that are excluded from their taxable income.

Income of Foreign Sales Corporations.—The Foreign Sales Corporation (FSC) provisions exempt from

tax a portion of U.S. exporters’ foreign trading income

to reflect the FSC’s sales functions as foreign corporations. These provisions conform to the General Agreement on Tariffs and Trade.

Source rule exceptions.—The worldwide income of

U.S. persons is taxable by the United States and a

credit for foreign taxes paid is allowed. The amount

of foreign taxes that can be credited is limited to the

pre-credit U.S. tax on the foreign source income. The

treatment of sales of inventory property is a tax expenditure because it permits greater use of foreign tax

credits by U.S. exporters by allowing the exporters to

attribute a larger portion of their earnings abroad than

would be the case if the allocation of earnings was

based upon actual economic activity.

Income of U.S.-controlled foreign corporations.—

The income of foreign corporations controlled by U.S.

shareholders is not subject to U.S. taxation. The income

becomes taxable only when the controlling U.S. shareholders receive dividends or other distributions from

their foreign stockholding. Under the normal tax method, the currently attributable foreign source pre-tax income from such a controlling interest is subject to U.S.

taxation, whether or not distributed. Thus, under the

normal tax baseline the excess of controlled foreign corporation income over the amount distributed to a U.S.

shareholder gives rise to a tax expenditure in the form

of a tax deferral.

GENERAL SCIENCE, SPACE, AND TECHNOLOGY

Expensing R&E expenditures.—Research and experimentation (R&E) projects can be viewed as investments because their benefits accrue for several years

when they are successful. It is difficult, however, to

identify whether a specific R&E project is completed

and successful and, if it is successful, what its expected

life will be. For these reasons, the statutory provision

that these expenditures may be expensed is considered

part of the reference law. Under the normal tax method, however, the expensing of R&E expenditures is

viewed as a tax expenditure. The baseline assumed for

the normal tax method is that all R&E expenditures

are successful and have an expected life of five years.

R&E credit.—The R&E credit, which had expired

on July 1, 1995, was reinstated under the Small Business Job Protection Act of 1996 for 11 months (July

1, 1996 through May 31, 1997). The 1996 Act also provided a special rule for taxpayers that elect an alternative credit regime. The tax credit is 20 percent of

qualified research expenditures in excess of a base

amount. The base amount is generally determined by

multiplying a ‘‘fixed-base percentage’’ (limited to a maximum of .16) by the average amount of the company’s

gross receipts for the 1984 to 1988 period. Certain

start-up companies are assigned a fixed-base percentage

of .03 for the first five taxable years, which is gradually

phased out in years 6 through 10 and replaced by the

firm’s actual fixed- base percentage. Under the alternative credit regime, the credit rate is reduced and

the taxpayer is assigned a three-tiered fixed-base percentage that is lower than the fixed-base percentage

that would otherwise apply. A credit with a separate

threshold is provided for a taxpayer’s payments to universities for basic research.

ENERGY

Exploration and development costs.—In the case

of successful investments in domestic oil and gas wells,
88 ANALYTICAL PERSPECTIVES

intangible drilling costs, such as wages, the costs of

using machinery for grading and drilling, and the cost

of unsalvageable materials used in constructing wells,

may be expensed rather than amortized over the productive life of the property.

Integrated oil companies may currently deduct only

70 percent of such costs and amortize the remaining

30 percent over five years. The same rule applies to

the exploration and development costs of surface stripping and the construction of shafts and tunnels for

other fuel minerals.

Percentage depletion.—Independent fuel mineral

producers and royalty owners are generally allowed to

take percentage depletion deductions rather than cost

depletion on limited quantities of output. Under cost

depletion, outlays are deducted over the productive life

of the property based on the fraction of the resource

extracted. Under percentage depletion taxpayers deduct

a percentage of gross income from mineral production

at rates of 22 percent for uranium, 15 percent for oil,

gas and oil shale, and 10 percent for coal. The deduction is limited to 50 percent of net income from the

property, except for oil and gas where the deduction

can be 100 percent of net property income. Production

from geothermal deposits is eligible for percentage depletion at 65 percent of net income, but with no limit

on output and no limitation with respect to qualified

producers. Unlike depreciation or cost depletion, percentage depletion deductions can exceed the cost of the

investment.

Alternative fuel production credit.—A nontaxable

credit of $3 per barrel (in 1979 dollars) of oil-equivalent

production is provided for several forms of alternative

fuels. It is generally available as long as the price of

oil stays below $29.50 (in 1979 dollars). The credit generally expires on December 31, 2002.

Oil and gas exception to passive loss limitation.—Although owners of working interests in oil and

gas properties are subject to the alternative minimum

tax, they are exempted from the ‘‘passive income’’ limitations. This means that the working interest-holder,

who manages on behalf of himself and all other owners

the development of wells and incurs all the costs of

their operation, may aggregate negative taxable income

from such interests with his income from all other

sources. Thus, he will be relieved of the minimum tax

rules limit on tax deferrals.

Capital gains treatment of royalties on coal.—

Sales of certain coal under royalty contracts can be

treated as capital gains. While the top statutory rate

on ordinary income is 39.6 percent, the rates on capital

gains are limited to 28 percent.

Tax-exempt bonds for energy facilities.—Certain

energy facilities, such as municipal electric and gas utilities, may benefit from tax-exempt financing.

Enhanced oil recovery credit.—A credit is provided

equal to 15 percent of the taxpayer’s costs for tertiary

oil recovery on projects in the United States. Qualifying

costs include tertiary injectant expenses, intangible

drilling and development costs on a qualified enhanced

oil recovery project, and amounts incurred for tangible

depreciable property.

New technology credits.—A credit of 10 percent is

available for investment in solar and geothermal energy

facilities. In addition, a credit of 1.5 cents is provided

per kilowatt hour of electricity produced from renewable

resources such as wind and biomass. The renewable

resources credit applies only to electricity produced by

a facility placed in service before July 1, 1999.

Alcohol fuel credit.—Gasohol, a motor fuel composed of at least 10 percent alcohol, is exempt from

5.4 of the 18.4 cents per gallon Federal excise tax on

gasoline. Smaller exemptions are allowed for motor fuel

with lower alcohol content. There is a corresponding

income tax credit for alcohol used as a fuel in applications where the excise tax is not assessed. This credit,

equal to a subsidy of 54 cents per gallon for alcohol

used as a motor fuel, is intended to encourage substitution of alcohol for petroleum-based gasoline. In addition, small producers of ethanol are eligible for a 10

cent per gallon credit.

Credit and deduction for clean-fuel vehicles and

property.—A tax credit of 10 percent is provided for

electric vehicles. In addition, a deduction is provided

for other clean-fuel burning vehicles as well as refueling

property.

Exclusion of utility conservation subsidies.—Subsidies by public utilities for customer expenditures on

energy conservation measures are excluded from the

gross income of the customer. After December 31, 1996,

the exclusion does not apply to subsidies provided to

businesses.

NATURAL RESOURCES AND ENVIRONMENT

Exploration and development costs.—As is true

for fuel minerals, certain capital outlays associated with

exploration and development of nonfuel minerals may

be expensed rather than depreciated over the life of

the asset.

Percentage depletion.—Most nonfuel mineral extractors also make use of percentage depletion rather

than cost depletion, with percentage depletion rates

ranging from 22 percent for sulphur down to 5 percent

for sand and gravel.

Capital gains treatment of iron ore and of certain timber income.—Iron ore and certain timber sold

under a royalty contract can be treated as capital gains.

Mining reclamation reserves.—Taxpayers are allowed to establish reserves to cover certain costs of
5. TAX EXPENDITURES 89

4The insolvent taxpayer’s carryover losses and unused credits are extinguished first,

and then his basis in assets reduced to no less than amounts still owed creditors. Finally,

the remainder of the forgiven debt is excluded from tax.

mine reclamation and of closing solid waste disposal

properties. Net increases in reserves may be taken as

a deduction against taxable income.

Tax-exempt bonds for pollution control and

waste disposal.—Interest on State and local government debt issued to finance private pollution control

and waste disposal facilities was excludable from income subject to tax. This authorization was repealed

for most pollution control equipment and limits placed

on the amount of debt that can be issued for private

waste disposal facilities by the Tax Reform Act of 1986.

Expensing multiperiod timber growing costs.—

Generally, costs must be capitalized when goods are

produced for inventory used in one’s own trade or business, or under contract to another party. Timber production, however, was specifically exempted from these

multiperiod cost capitalization rules, creating a special

benefit derived from this deferral of taxable income.

Credit and seven-year amortization for reforestation.—A special 10 percent investment tax credit is

allowed for up to $10,000 invested annually in clearing

land and planting trees for the ultimate production of

timber. The same amount of forestation investment

may also be amortized over a seven-year period. Without this preference, the amount would have to be capitalized and could be recovered (deducted) only when

the trees were sold or harvested 20 or more years later.

Moreover, the amount of forestation investment that

is amortizable is not reduced by any of the investment

credit that is allowed.

Historic preservation.—Expenditures to preserve

and restore historic structures qualify for a 20 percent

investment credit, but the depreciable basis must be

reduced by the full amount of the credit taken.

AGRICULTURE

Expensing certain capital outlays.—Farmers, except for certain agricultural corporations and partnerships, are allowed to deduct certain expenditures for

feed and fertilizer, as well as for soil and water conservation measures. Expensing is allowed, even though

these expenditures are for inventories held beyond the

end of the year, or for capital improvements that would

otherwise be capitalized.

Expensing multiperiod livestock and crop production costs.—The production of livestock and crops

with a production period of less than two years is exempted from the uniform cost capitalization rules.

Farmers establishing orchards, constructing farm facilities for their own use, or producing any goods for sale

with a production period of two years or more may

elect not to capitalize costs. If they do, they must apply

straight-line depreciation to all depreciable property

they use in farming.

Loans forgiven solvent farmers.—Farmers are

granted special tax treatment by being forgiven the

tax liability on certain forgiven debt. Normally, the

amount of loan forgiveness is accounted for as a gain

(income) of the debtor and he must either report the

gain, or reduce his recoverable basis in the property

to which the loan relates. If the debtor elects to reduce

basis and the amount of forgiveness exceeds his basis

in the property, the excess forgiveness is taxable. However, in the case of insolvent (bankrupt) debtors, the

amount of loan forgiveness never results in an income

tax liability.4 Farmers with forgiven debt are considered

insolvent for tax purposes, and thus qualify for income

tax forgiveness.

Capital gains treatment of certain income.—Certain agricultural income, such as unharvested crops,

can be treated as capital gains.

COMMERCE AND HOUSING

This category includes a number of tax expenditure

provisions that also affect economic activity in other

functional categories. For example, provisions related

to investment, such as accelerated depreciation, could

also have been classified under the energy, natural resources and environment, agriculture, or transportation

categories.

Credit union income.—The earnings of credit

unions not distributed to members as interest or dividends are exempt from income tax.

Bad debt reserves.—Small (less than $500 million

in assets) commercial banks, mutual savings banks,

and savings and loan associations may deduct additions

to bad debt reserves in excess of actually experienced

losses. Before January 1, 1996, all thrifts could use

either the ‘‘experience’’ method or the ‘‘percentage of

taxable income’’ method for determining deductible additions to bad debt reserves.

Deferral of income on life insurance and annuity contracts.—Favorable tax treatment is provided for

investment income (‘‘inside buildup’’) within qualified

life insurance and annuity contracts. Investment income earned on qualified life insurance contracts held

until death is permanently exempted from Federal income tax. Investment income distributed prior to the

death of the insured is tax-deferred, if not tax-exempt.

Investment income earned on annuities is treated less

favorably than income earned on life insurance contracts, but it benefits from tax deferral without annual

contribution or income limits generally applicable to

other tax-favored retirement income plans.

Small property and casualty insurance companies.— Insurance companies that have annual net premium incomes of less than $350,000 are exempted from
90 ANALYTICAL PERSPECTIVES

tax; those with $350,000 to $2,100,000 of net premium

incomes may elect to pay tax only on the income earned

by their investment portfolio.

Insurance companies owned by exempt organizations.—Generally, the income generated by life and

property and casualty insurance companies is subject

to tax, albeit by special rules. Insurance operations conducted by such exempt organizations as fraternal societies and voluntary employee benefit associations, however, are exempted from tax.

Mortgage housing bonds.—Interest on all mortgage

revenue bonds issued by State and local governments

is exempt from taxation. Proceeds are used to finance

homes purchased by first-time buyers—with low to

moderate incomes—of dwellings with prices under 90

percent of the average area purchase price.

There are limits imposed on the amount of tax-exempt State and local government bonds that could be

issued to fund private activity. The volume cap for single-family mortgage revenue bonds and multifamily

rental housing bonds is combined with the cap for student loans and industrial development bonds (IDBs).

The cap is set at $50 per capita or a minimum of

$150 million for each State.

States are authorized to issue mortgage credit certificates (MCCs) in lieu of qualified mortgage revenue

bonds because the bonds are relatively inefficient subsidies to first-time home buyers. MCCs entitle home

buyers to income tax credits for a specified percentage

of interest on qualified mortgage loans. In this way,

the entire amount of the subsidy flows directly to the

home buyer without being partly diverted to financial

middlemen or bondholders. A State cannot issue an

aggregate annual amount of MCCs greater than 25 percent of its annual ceiling for qualified mortgage bonds.

Because of the relationship between MCCs and qualified mortgage bonds, their estimates are presented as

one line item in the tables.

Rental housing bonds.—State and local government

issues of IDBs are restricted to multifamily rental housing projects in which 20 percent (15 percent in targeted

areas) of the units are reserved for families whose income does not exceed 50 percent of the area’s median

income; or 40 percent for families with incomes of no

more than 60 percent of the area median income. Other

tax-exempt bonds for multifamily rental projects are

generally issued with the requirement that all tenants

must be low or moderate income families. Rental housing bonds are subject to the volume cap discussed in

the mortgage housing bond section above.

Interest and taxes on owner-occupied homes.—

Owner-occupants of homes may deduct mortgage interest and property taxes on their primary and secondary

residences as itemized nonbusiness deductions. The

mortgage interest deduction is limited to interest on

debt no greater than the owner’s basis in the residence

and, for debt incurred after October 13, 1987, it is

limited to no more than $1 million. Interest on up to

$100,000 of other debt secured by a lien on a principal

or second residence is also deductible, irrespective of

the purpose of borrowing, provided the debt does not

exceed the fair market value of the residence. Mortgage

interest deductions on personal residences are tax expenditures because the taxpayers are not required to

report the value of owner-occupied housing services as

gross income.

Real property installment sales.—Dealers in real

and personal property, i.e., sellers that regularly hold

property for sale or resale, cannot defer taxable income

from installment sales until the receipt of the loan repayment. Nondealers, defined as sellers of real property

used in their business, are required to pay interest

to the Federal Government on deferred taxes attributable to their total installment obligations in excess

of $5 million. Only properties with sales prices exceeding $150,000 are includable in the total. The payment

of a market rate of interest eliminates the benefit of

the tax deferral. The tax exemption for nondealers with

total installment obligations of less than $5,000,000 is,

therefore, a tax expenditure.

Capital gains on home sales.—When a primary

residence is sold, the homeowner can defer paying a

capital gains tax on the proceeds by purchasing or constructing a home of value at least equal to that of

the prior home (net of sales and qualified fix-up expenses) within two years. This deferral is a tax expenditure.

Capital gains on sales by owners aged 55 or

older.—A taxpayer who is 55 years of age or older

at the time of the sale of his residence may elect to

exclude from tax up to $125,000 of the gain from its

sale. This is a once-in-a-lifetime election. In effect, this

provision converts some prior deferrals of tax into forgiveness of tax.

Passive loss real estate exemption.—In general,

passive losses may not offset income from other sources.

Losses up to $25,000 attributable to certain rental real

estate activity, however, are exempted from this rule.

Low-income housing investment.—Through 1989,

a tax credit for investment in new, substantially rehabilitated, and certain unrehabilitated low-income housing was structured to have a present value of 70 percent of construction or rehabilitation costs incurred and

was allowed over 10 years. For Federally subsidized

projects and those involving unrehabilitated existing

low income housing, the credit was structured to have

a present value of 30 percent. Beginning on January

1, 1990, the credit was extended at a present value

of 70 percent, including projects financed with other

Federal subsidies, but only if substantial rehabilitation

was done. Notwithstanding the capital grant character

of this subsidy, the investor’s recoverable basis is not

reduced by the substantial credit allowed.
5. TAX EXPENDITURES 91

5Thus, when a borrower on December 31, 1996, issues a promise to pay $1,000 plus

interest at 10 percent on December 30, 1997, for a total repayment of $1,100, and accepts

$900 from a lender in exchange for the contract, the rules require that both parties: (a)

recognize that $900 is the amount lent, so that the effective loan interest rate is not

the nominal 10 percent rate but is 22.2 percent; and (b) both report $200 as interest

paid or received in 1996, as the case may be.

Accelerated depreciation of real property, machinery and equipment.—As previously noted, the tax

depreciation allowance provisions are part of the reference law rules, and thus do not cause tax expenditures under the reference method. Under the normal

tax method, however, a 40-year tax life for depreciable

real property is the norm. So, the statutory depreciation

period in effect from 1987 to 1993 for nonresidential

properties of 31.5 years, and the 39-year period for

property placed in service after February 25, 1993, give

rise to tax expenditures. The statutory depreciation period for residential property is 27.5 years, which also

results in tax expenditures. Statutory depreciation of

machinery, equipment, and some other property also

is somewhat accelerated relative to the normal tax

baseline. In addition, tax expenditures arise from pre1987 tax allowances for real and personal property.

Cancellation of indebtedness.—Individuals are not

required to report the cancellation of certain indebtedness as current income. However, if they do not, it

would be included as an adjustment in the basis of

the underlying property.

Imputed interest rules.—Under reference law rules

commonly referred to as original issue discount (OID),

both the holder and seller of a financial contract are

generally required to report interest earned in the period it accrues, not when the contract payments are

made. Moreover, the amount of interest accruable is

determined by the actual price paid for the contract,

not by the stated or nominal principal and interest

stipulated in the contract.5

Exceptions to the general rules for accounting for

interest expense or income include the following: (a)

permission for the mortgagor of his personal residence

to treat the discount from the nominal principal of his

mortgage loan, commonly called ‘‘points,’’ as prepaid

interest which is deductible in the year paid, not the

year accrued; and (b) sellers of farms and small businesses worth less than $1 million, in exchange for the

purchaser’s debt obligation, are exempted from the OID

rules. This is $750,000 more than the $250,000 exemption that the reference tax law generally allows for

such transactions.

Capital gains (other than agriculture, timber,

iron ore and coal).—While the top statutory rate on

ordinary income is 39.6 percent, the rates on capital

gains are limited to 28 percent. This treatment is considered a tax expenditure under the normal tax method

but not under the reference law method.

Capital gains exclusion for small business

stock.—An exclusion of 50 percent is provided for capital gains from qualified small business stock held by

individuals for more than 5 years. A qualified small

business is a corporation whose gross assets do not

exceed $50 million as of the date of issuance of the

stock. Certain activities such as personal services and

banking are ineligible for the exclusion.

Step-up in basis of capital gains at death.—Capital gains on assets held at the owner’s death are not

subject to capital gains taxes. The cost basis of the

appreciated assets is adjusted upward to the market

value at the owner’s date of death. The step-up in the

heir’s cost basis means that, in effect, the capital gain

is forgiven.

Carryover basis of capital gains on gifts.—When

a gift is made, the transferred property carries to the

donee the donor’s basis—the cost that was incurred

when the property was first acquired. The carryover

of the donor’s basis allows a continued deferral of unrealized capital gains.

Ordinary income treatment of losses from sale

of small business corporate stock shares.—Up to

$100,000 in losses from the sale of such stock may

be treated as ordinary losses, and therefore not be subject to the $3,000 annual capital loss write-off limit

if the corporation’s capitalization is less than $1 million.

Expensing of certain small investments.—In

1996, qualifying investments in tangible property up

to $18,500 can be expensed rather than depreciated

over time. (The expensing limit increases annually until

2003, when it reaches $25,000). To the extent that

qualifying investment during the year exceeds

$200,000, the amount eligible for expensing is decreased. In 1996, the amount expensed is completely

phased out when qualifying investments exceed

$218,500.

Business start-up costs.—When an individual or

corporation acquires or otherwise enters into a new

business, certain start-up expenses, such as the costs

of investigating opportunities and legal services, are

normally incurred. The taxpayer may elect to amortize

these outlays over 60 months although they are similar

to other payments he makes for nondepreciable intangible assets that are not recoverable until the business

is sold. Under the normal tax method this gives rise

to a tax expenditure, while under the reference method

it does not.

Graduated corporation income tax rate schedule.—The schedule is graduated, with rates of 15 percent on the first $50,000 of taxable income, 25 percent

on the next $25,000, 34 percent on the next $9.925

million, and a rate of 35 percent on income over $10

million. As compared with a flat 35 percent tax rate,

the lower rates provide a $111,000 reduction in tax

liability for corporations with taxable incomes of $10

million. This benefit is recaptured in the cases of corporations with taxable incomes exceeding $100,000.
92 ANALYTICAL PERSPECTIVES

This is accomplished by (1) a 5 percent additional tax

on corporate incomes in excess of $100,000, but less

than $335,000 and (2) a 3 percent additional tax on

income over $15 million but less than $18.33 million.

At this point the $111,000 is fully recaptured. Since

this rate schedule is part of the reference tax law, it

does not give rise to a tax expenditure under the reference method. A flat corporation income tax rate is

taken as the baseline under the normal tax method;

therefore the lower rates do yield a tax expenditure

under this concept.

Small issue industrial development bonds.—The

interest on small issue industrial development bonds

(IDBs) issued by State and local governments to finance

private business property is excluded from income subject to tax. Depreciable property financed with small

issue IDBs must be depreciated, however, using the

straight-line method. The tax exemption of small issue

bonds expired in 1986, except for small issue IDBs exclusively issued to finance manufacturing facilities for

which the tax exemption is permanent. The annual volume of small issue IDBs is subject to the unified volume cap discussed in the mortgage housing bond section above.

Treatment of Alaskan Native Corporations

losses.—Tax law restricts the ability of profitable corporations to reduce their tax liabilities by merging or

buying corporations with accumulated net operating

losses (NOLs) and as yet unrefunded claims to investment credits. Alaska Native Corporations have a limited exemption (fifteen years after the NOL or credit

claim was first experienced) from these restrictions that

includes NOLs and credits claimable prior to April 26,

1988.

TRANSPORTATION

Shipping companies that are U.S. flag carriers.—Certain companies that operate U.S. flag vessels receive a deferral of income taxes on that portion

of their income used for shipping purposes, primarily

construction, modernization and major repairs to ships,

and repayment of loans to finance these qualified investments. Once indefinite, the deferral has been limited to 25 years since January 1, 1987.

Exclusion of reimbursed employee parking expenses.—Parking at or near an employer’s business

premises that is paid for by the employer is excludable

from the income of the employee as a working condition

fringe benefit. The maximum amount of the parking

exclusion is $155 month (in 1993 dollars), indexed in

$5 increments. The tax expenditure estimate does not

include parking at facilities owned by the employer.

Exclusion of employer-provided transit passes.—

Transit passes, tokens, and fare cards provided by an

employer to defray an employee’s commuting costs are

excludable from the employee’s income as a de minimis

fringe benefit, if the total value of the benefit does

not exceed $60 per month (in 1993 dollars), indexed

in $5 increments.

COMMUNITY AND REGIONAL DEVELOPMENT

Rehabilitation of structures.—A 10 percent investment tax credit is available for the rehabilitation of

buildings that are used for business or productive activities and that were erected before 1936 for other

than residential purposes. A full reduction by the

amount of the credit is required in the taxpayer’s recoverable basis.

Tax-exempt bonds for airports and similar facilities.—Government-owned airports, docks and

wharves, as well as high-speed rail facilities that need

not be government-owned, may be financed with taxexempt bonds. These bonds are not covered by a volume

cap.

Exemption of certain mutuals’ and cooperatives’

income.—The incomes of mutual and cooperative telephone and electric companies are exempted from tax

if at least 85 percent of their revenues are derived

from patron service charges.

Empowerment zones.—Qualifying businesses in designated economically depressed areas can receive tax

benefits such as an employer wage credit, increasing

expensing of investment in equipment, tax-exempt financing, and accelerated depreciation. In addition, a

tax credit for contributions to certain community development corporations can be available.

EDUCATION, TRAINING, EMPLOYMENT, AND SOCIAL

SERVICES

Scholarship and fellowship income.—Scholarships and fellowships are excluded from taxable income

to the extent they pay for tuition and course-related

expenses of the grantee. Similarly, tuition reductions

for employees of educational institutions and their families are not included in taxable income. From an economic point of view, scholarships and fellowships are

either gifts not conditioned on the performance of services, or they are rebates of educational costs. Thus,

under the reference law method, this exclusion is not

a tax expenditure because this method does not include

either gifts or price reductions in a taxpayer’s gross

income. Under the normal tax method, however, the

exclusion is considered a tax expenditure because under

this method gift-like transfers of government funds—

and many scholarships are derived directly or indirectly

from government funding—are included in gross income.

Tax-exempt bonds for educational purposes.—Interest on State and local government debt issued to

finance student loans or the construction of facilities

used by private nonprofit educational institutions is excluded from income subject to tax. The aggregate vol-
5. TAX EXPENDITURES 93

ume of such private activity bonds that each State may

issue during any calendar year is limited.

U.S. savings bonds for education.—Interest on

U.S. savings bonds, issued after December 31, 1989,

may be excluded from tax if the bonds, plus accrued

interest, are transferred to an educational institution

as payment for educational expenses. The exclusion

from tax is phased out for joint returns with adjusted

gross incomes of $74,200 to $104,200 and $49,250 to

$64,250 for single and head of household returns in

1996.

Dependent students age 19 or older.—Taxpayers

can claim personal exemptions for dependent children

age 19 or over who receive parental support payments

of $1,000 or more per year, are full-time students, and

do not claim a personal exemption on their own tax

returns. This preferential arrangement usually generates tax savings because the students’ marginal tax

rates are more often than not lower than their parents’

marginal tax rates.

Charitable contributions.—Contributions to charitable, religious, and certain other nonprofit organizations are allowed as an itemized deduction for individuals, generally up to 50 percent of adjusted gross income. Taxpayers who donate capital assets to charitable

or educational organizations can deduct the assets’ current value without the taxation of any appreciation in

value. Corporations can also deduct charitable contributions up to 10 percent of their pre-tax income. Tax

expenditures resulting from the deductibility of contributions are shown separately for educational and

other institutions. Contributions to health institutions

are reported under the health function.

Employer provided benefits.—Many employers provide employee benefits that are not counted in employee

income. The employers’ costs for these benefits are deductible business expenses. The exclusion from an employee’s income of the value of educational assistance,

child care, meals and lodging, as well as ministers’

housing allowances and the rental value of parsonages

are tax expenditures. The exclusion for educational assistance expires in mid-1997. After June 30, 1996, the

exclusion does not apply to graduate courses. Health

and other insurance benefits are reported under the

health and income security functions. Certain parking

and transit benefits are reported under the transportation function.

Work opportunity tax credit.—Employers can

claim a tax credit for qualified wages paid to individuals who begin work after September 30, 1996 and

before October 1, 1997 and who are certified as members of various targeted groups. The amount of the

credit that can be claimed is 35 percent of the first

$6,000 paid during the first year of employment. Employers must reduce their deduction for wages paid by

the amount of the credit claimed. The work opportunity

tax credit is similar to the targeted jobs tax credit,

which applied to employees hired before January 1,

1995.

Child and dependent care expenses.—A tax credit

may be claimed by married couples for child and dependent care expenses incurred when one spouse works

full time and the other works at least part time or

goes to school. The credit may also be claimed by divorced or separated parents who have custody of children, and by single parents. Expenditures up to a maximum $2,400 for one dependent and $4,800 for two or

more dependents are eligible for the credit. The credit

is equal to 30 percent of qualified expenditures for taxpayers with incomes of $10,000 or less. The credit is

reduced to a minimum of 20 percent by one percentage

point for each $2,000 of income between $10,000 and

$28,000.

Adoption assistance.—Beginning January 1, 1997,

taxpayers can receive a nonrefundable tax credit for

qualified adoption expenses. The maximum credit is

$5,000 per child ($6,000 for special needs adoptions,

except foreign adoptions). The credit is phased-out ratably for taxpayers with modified AGI between $75,000

and $115,000. Unused credits may be carried forward.

In lieu of the tax credit, taxpayers may exclude qualified adoption expenses from income, subject to the same

maximum amounts and phase-out as the credit. The

non-special needs adoption assistance and foreign special needs assistance expire on December 31, 2001.

Disabled access expenditures.—A credit is provided of 50 percent of eligible disabled access expenditures in excess of $250. The credit is limited to $5,000.

Costs of removing architectural barriers to the

handicapped.—The investment cost of making any

business accessible to persons suffering physical or

mental disabilities may be deducted, rather than capitalized as part of the taxpayer’s basis in such property

and recovered by subsequent depreciation allowances,

as is generally required.

Foster care payments.—Foster parents provide a

home and care for children who are wards of the State,

under contract with the State. Compensation received

for this service is explicitly excluded from the gross

incomes of foster parents, making the expenses they

incur nondeductible. This activity is, in effect, tax-exempt.

HEALTH

Employer paid medical insurance and expenses.—Employee compensation, in the form of payments by employers for health insurance premiums and

other medical expenses (including long-term care), is

deducted as a business expense by employers, but it

is not included in employee gross income. The selfemployed also may deduct part of their family health

insurance premiums.
94 ANALYTICAL PERSPECTIVES

Medical savings accounts.—Beginning January 1,

1997, some employees may deduct annual contributions

to a medical savings account (MSA); employer contributions to MSAs (except those made through cafeteria

plans) for qualified employees are also excluded from

income. An employee may contribute to an MSA in

a given year only if the employer does not contribute

to the MSA in that year. MSAs are only available to

self-employed individuals or employees covered under

an employer-sponsored high deductible health plan of

a small employer. The maximum annual MSA contribution is 75 percent of the deductible under the high

deductible plan for family coverage (65 percent for individual coverage). Earnings from MSAs are excluded

from taxable income. Distributions from an MSA for

medical expenses are not taxable. The number of taxpayers who may benefit annually from MSAs is generally limited to 750,000. No new MSAs may be established after December 31, 2000.

Medical care expenses.—Personal expenditures for

medical care (including the costs of prescription drugs)

exceeding 7.5 percent of the taxpayer’s adjusted gross

income are deductible.

Tax-exempt bonds for hospital construction.—Interest earned on State and local government debt issued to finance hospital construction is excluded from

income subject to tax.

Charitable contributions to health institutions.—Contributions to nonprofit health institutions

are allowed as a deduction for individuals and corporations. Tax expenditures resulting from the deductibility

of contributions to other charitable institutions are listed under the education, training, employment, and social services function.

Orphan drugs.—To encourage the development of

drugs for the treatment of rare diseases or physical

conditions, a tax credit was granted equal to 50 percent

of the costs for clinical testing that must be completed

before manufacture and distribution are approved by

the Food and Drug Administration. Because the drug

firm was not required to reduce its deduction for testing

expenses (an R&D expenditure) by the amount of this

credit, the private cost of clinically testing orphan drugs

was reduced substantially. This tax expenditure expires

on May 31, 1997.

Blue Cross and Blue Shield.—Although these organizations are not qualified as exempt, they are provided

exceptions from otherwise applicable insurance company income tax accounting rules that effectively eliminate their tax liabilities.

INCOME SECURITY

Railroad retirement benefits.—These benefits are

not generally subject to the income tax unless the recipient’s gross income reaches a certain threshold discussed more fully under the social security function.

Workmen’s compensation benefits.—Workmen’s

compensation provides payments to disabled workers.

These benefits, although income to the recipients, are

a tax preference because they are not subject to the

income tax.

Public assistance benefits.—The exclusion from

taxable income of public assistance benefits received

by individuals is listed as a tax expenditure under the

normal tax method because, under this method, cash

transfers from government are included in gross income. In contrast, gifts not conditioned on the performance of services, including transfers from government,

are not taxable under the reference law. Therefore,

under the reference tax method, the tax exclusion for

public assistance benefits is not shown as a tax expenditure.

Special benefits for disabled coal miners.—Disability payments to former coal miners out of the Black

Lung Trust Fund, although income to the recipient,

are not subject to the income tax.

Military disability pensions.—Most of the military

pension income received by current disabled retired veterans is excluded from their income subject to tax.

Pension contributions and earnings.—Certain

employer contributions to pension plans, along with individual contributions to individual retirement accounts

(IRAs) and amounts set aside by the self-employed, are

excluded from adjusted gross income in the year of

contribution. The investment income earned by pension

funds and other qualifying retirement plans is not taxable when earned, and this deferral is, therefore, also

a tax expenditure.

In 1997, $9,500 (indexed) can be excluded from an

employee’s adjusted gross income under a qualified cash

or deferred arrangement with the employer (401(k)

plan). An employee’s own contribution of no more than

$9,500 or the 401(k) limitation (whichever is greater)

may be excluded annually from an employee’s adjusted

gross income when placed in a tax-sheltered annuity

(403(b) plan).

In 1996, employees could deduct annual contributions

to an IRA of $2,000 (or 100 percent of compensation,

if less), or $2,250 on a joint return with only one spouse

earning income (beginning January 1, 1997, each

spouse may contribute $2,000 to a deductible IRA), if:

(a) neither the individual or spouse is an active participant in an employer-provided retirement plan; or (b)

their adjusted gross income falls below $40,000 ($25,000

for a single taxpayer). The allowable IRA deduction

is phased out between $40,000 and $50,000 for a joint

return and $25,000 and $35,000 for a single return.

Beyond these income limits, nondeductible contributions to IRAs are available to taxpayers who are active

participants in employer-provided retirement plans.

Self-employed persons can make deductible contributions to their own retirement (Keogh) plans equal to
5. TAX EXPENDITURES 95

25 percent of their income, up to a maximum of $30,000

per year.

Employer provided insurance benefits.—Many

employers cover part or all the cost of premiums or

payments for: (a) employees’ life insurance benefits; (b)

accident and disability benefits; (c) death benefits; and

(d) supplementary unemployment benefits. The

amounts are deductible by the employers and are excluded as well from employees’ gross incomes for tax

purposes.

Employer Stock Ownership Plan (ESOP) provisions.—A special type of employee benefit plan, organized as a trust, is tax-exempt. Employer-paid contributions (the value of stock issued to the ESOP) are deductible by the employer as part of employee compensation costs. They are not included in the employees’ gross

income for tax purposes, however, until they are paid

out as benefits. The following special income tax provisions for ESOPs are intended to increase ownership

of corporations by their employees: (1) annual employer

contributions are subject to less restrictive limitations

(percentages of employees’ cash compensation); (2)

ESOPs may borrow to purchase employer stock, guaranteed by their agreement with the employer that the

debt will be serviced by his payment (deductible by

him) of a portion of wages (excludable by the employees) to service the loan; (3) ESOPs’ lenders may exclude

half the interest from their gross income (the ESOP

interest exclusion expired on June 10, 1996); (4) employees who sell appreciated company stock to the

ESOP may defer any taxes due until they withdraw

benefits; and (5) dividends paid to ESOP-held stock

are deductible by the employer.

Support of the aged and the blind.—Taxpayers

who are blind or 65 years of age or older may take

an additional $1,000 standard deduction if single, or

$800 if married. In addition, individuals who are 65

years of age or older, or who are permanently disabled,

can take a tax credit equal to 15 percent of the sum

of their earned and retirement income. Qualified income

is limited to no more than $2,500 for single individuals

or married couples filing a joint return where only one

spouse is 65 years of age or older, and up to $3,750

for joint returns where both spouses are 65 years of

age or older. These limits are reduced by one-half of

the taxpayer’s adjusted gross income over $7,500 for

single individuals and $10,000 for married couples filing a joint return.

Casualty losses.—Neither the purchase of property

nor insurance premiums to protect its value are deductible as costs of earning income; therefore, reimbursement for insured loss of such property is not reportable

as a part of gross income. However, a special provision

permits relief for taxpayers suffering an uninsured loss.

They may deduct casualty and theft losses of more than

$100 each, but only to the extent that total losses during the year exceed 10 percent of adjusted gross income.

Earned income credit.—This credit may be claimed

by low income workers. For a family with one qualifying child, the credit is 34 percent of the first $6,500

of earned income in 1997. The credit is 40 percent

of the first $9,140 of income for a family with two

or more qualifying children. When the taxpayer’s income exceeds $11,930, the credit is phased out at the

rate of 15.98 percent (21.06 percent if two or more

qualifying children are present). It is completely phased

out at $25,760 of adjusted gross income ($29,290 if two

or more qualifying children are present).

The credit may also be claimed by workers who do

not have children living with them. Qualifying workers

must be at least age 25 and may not be claimed as

a dependent on another taxpayer’s return. The credit

is not available to workers age 65 or older. In 1996,

the credit is 7.65 percent of the first $4,340 of earned

income. When the taxpayer’s income exceeds $5,430,

the credit is phased out at the rate of 7.65 percent.

It is completely phased out at $9,770 of adjusted gross

income.

For workers with or without children, the income

level at which the credit’s phase-outs begin and the

maximum amounts of income on which the credit can

be taken are adjusted for inflation. Earned income tax

credits in excess of tax liabilities are refundable to individuals, and as such are paid by the Federal Government. This portion of the credit is included in outlays,

while the amount that offsets tax liabilities is shown

as a tax expenditure.

SOCIAL SECURITY

Old Age and Survivors Insurance (OASI) benefits for retired workers.—Social security benefits that

exceed the beneficiary’s contributions out of taxed income are deferred employee compensation and the deferral of tax on that compensation is a tax expenditure.

These additional retirement benefits are paid for partly

by employers’ contributions that were not included in

employees’ taxable compensation. Portions (reaching as

much as 85 percent) of recipients’ social security and

tier 1 railroad retirement benefits are included in the

income tax base, however, if the recipient’s provisional

income exceeds certain base amounts. Provisional income is equal to adjusted gross income plus foreign

or U.S. possession income and tax-exempt interest, and

one half of social security and tier 1 railroad retirement

benefits. The tax expenditure is limited to the portion

of the benefits received by taxpayers who are below

the base amounts at which 85 percent of the benefits

are taxable.

Social Security benefits for the disabled, dependents and survivors.—Benefit payments from the Social Security Trust Fund, for disability and for dependents and survivors, are excluded from the beneficiaries’

gross incomes, and thus give rise to tax expenditures.
96 ANALYTICAL PERSPECTIVES

6 An additional tax, at a flat rate of 55 percent, is imposed on lifetime, generationskipping transfers in excess of $1 million. It is considered a generation-skipping transfer

whenever the transferee is at least two generations younger than the transferor, as it

would be in the case of transfers to grandchildren or great-grandchildren. The liability

of this tax is on the recipients of the transfer.

VETERANS BENEFITS AND SERVICES

Veterans benefits.—All compensation due to death

or disability and pensions paid by the Veterans Administration are excluded from taxable income.

Tax-exempt mortgage bonds for veterans.—Interest earned on general obligation bonds issued by State

and local governments to finance housing for veterans

is excluded from taxable income. The issuance of such

bonds is limited, however, to five pre-existing State programs and to amounts based upon previous volume levels for the period January 1, 1979 to June 22, 1984.

Furthermore, future issues are limited to veterans who

served on active duty before 1977.

GENERAL GOVERNMENT

Public purpose State and local debt.—Interest on

State and local government debt, issued to finance government activities, is excluded from Federal taxation.

State and local governments, therefore, can sell debt

obligations at a lower interest cost than would be possible if such interest were subject to tax. Only the excluded interest on bonds for public purposes, such as

schools, roads, and sewers, is included here.

Nonbusiness State and local taxes excluding

home-owner property taxes.—The deductibility of

nonbusiness State and local income and personal property taxes gives indirect assistance to these governments by reducing the costs of the services they provide.

Business income earned in U.S. possessions.—

Under certain conditions, U.S. corporations receiving

income from an active trade or business, or from investments located in a U.S. possession, can claim a special

credit against U.S. tax otherwise due.

INTEREST

U.S. savings bonds.—The interest on U.S. savings

bonds is not taxable until the bonds are redeemed,

thereby deferring tax liability. The deferral is equivalent to an interest-free loan and, therefore, it is a tax

expenditure.

TAX EXPENDITURES IN THE UNIFIED TRANSFER TAX

Exceptions to the general terms of the Federal unified

transfer tax favor particular transferees or dispositions

of transferors, similar to Federal direct expenditure or

loan programs. The transfer tax provisions identified

as tax expenditures satisfy the reference law criteria

for inclusion in the tax expenditure budget that were

described above. There is no generally accepted normal

tax baseline for transfer taxes.

Unified Transfer Tax Reference Rules

The reference tax rules for the unified transfer tax

from which departures represent tax expenditures include:

• Definition of the taxpaying unit. The payment of

the tax is the liability of the transferor whether

the transfer of cash or property was made by gift

or bequest.

• Definition of the tax base. The base for the tax

is the transferor’s cumulative, taxable lifetime

gifts made plus the net estate at death. Gifts in

the tax base are all annual transfers in excess

of $10,000 to any donee except the donor’s spouse.

Excluded are, however, payments on behalf of

family members’ educational and medical expenses, as well as the cost of ceremonial gatherings and celebrations that are not in honor of

the donor.

• Property valuation. In general, property is valued

at its fair market value at the time it is transferred. This is not necessarily the case in the valuation of property for transfer tax purposes. Executors of estates are provided the option to value

assets at the time of the testator’s death or up

to six months later.

• Tax rate schedule. A single graduated tax rate

schedule applies to all taxable transfers. This is

reflected in the name of the ‘‘unified transfer tax’’

that has replaced the former separate gift and

estate taxes. The tax rates vary from 18 percent

on the first $10,000 of aggregate taxable transfers,

to 55 percent on amounts exceeding $3 million.

A $192,800 lifetime credit is provided against the

tax in determining the final amount of transfer

taxes that are due and payable. This allows each

taxpayer to make a $600,000 tax-free transfer of

assets that otherwise would be liable to the unified transfer tax.6

• Time when tax is due and payable. Donors are

required to pay the tax annually as gifts are

made. The generation-skipping transfer tax is payable by the donees whenever they accede to the

gift. The net estate tax liability is due and payable

within nine months after the decedent’s death.

The Internal Revenue Service may grant an extension of up to 10 years for a reasonable cause.

Interest is charged on the unpaid tax liability at

a rate equal to the cost of Federal short-term borrowing, plus three percentage points.
5. TAX EXPENDITURES 97

TABLE 5–6. REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE FEDERAL UNIFIED TRANSFER TAX

(In millions of dollars)

Description

Fiscal Years

1996 1997 1998 1999 2000 2001 2002 1998–2002

Natural Resources and Environment:

Deductions for donations of conservation easements ........................................................................................................ ............ ............ ............ ............ ............ ............ ............ ...................

Agriculture:

Special use valuation of farm real property ........................................................................................................................ 75 80 85 90 95 100 105 475

Tax deferral of closely held farms ....................................................................................................................................... 10 10 10 15 15 15 15 70

Commerce:

Special use valuation of real property used in closely held businesses ........................................................................... 20 20 25 25 25 25 30 130

Tax deferral of closely held business .................................................................................................................................. 60 65 70 75 80 85 90 400

Education, training, employment, and social services:

Deduction for charitable contributions (education) .............................................................................................................. 940 1,005 1,080 1,155 1,240 1,330 1,430 6,235

Deduction for charitable contributions (other than education and health) ......................................................................... 2,765 2,965 3,180 3,415 3,665 3,930 4,220 18,410

Health:

Deduction for charitable contributions (health) .................................................................................................................... 845 905 975 1,045 1,120 1,205 1,290 5,635

General government:

Credit for State death taxes ................................................................................................................................................. 3,235 3,465 3,720 3,990 4,285 4,600 4,935 21,530

Note: All estimates have been rounded to the nearest $5 million.

Tax Expenditures by Function

The estimates of tax expenditures in the Federal unified transfer tax for fiscal years 1996–2002 are displayed by functional category in table 5–6. Outlay

equivalent estimates are similar to revenue loss estimates for transfer tax expenditures and, therefore, are

not shown separately. A description of the provisions

follows.

NATURAL RESOURCES AND ENVIRONMENT

Donations of conservation easements.—Bequests

for conservation are excluded from taxable estates. A

conservation bequest is the value of property and easements (in perpetuity) to such property the use of which

is restricted to any one or more of the following: the

public for outdoor recreation; protection of the natural

habitats of fish, wildlife, plants, etc.; scenic enjoyment

of the public; and preservation of historic land areas

and structures. Similar conservation gifts are excluded

from the gift tax base and are also deductible from

the donor’s otherwise taxable income in the year of

the gift.

AGRICULTURE

Special use valuation of farms.—Farmland owned

and operated by a decedent and/or a member of the

family may be valued for estate tax purposes on the

basis of its ‘‘continued use’’ as a farm if: the farmland

is at least 25 percent of the decedent’s gross estate;

the entire value of all farm property is at least 50

percent of the gross estate; and family heirs to the

farm agree to continue to operate the property as a

farm for at least 10 years. Since continued use valuation of farmland is frequently substantially less than

the fair market value, the resulting reduction in tax

liability serves as a subsidy to the continued operation

of family farms.

Tax deferral of closely held farms.—Decedents’ estates may use a preferential, extended installment payment period of five to 15 years to discharge estate tax

liabilities if the value of the farm properties exceeds

35 percent of the net estates. The interest charged is

only 4 percent for the first five years, rather than the

standard Federal short-term borrowing rate plus three

percentage points, which applies during the last 10

years of the repayment period.

COMMERCE AND HOUSING CREDIT

Special use valuation of closely held businesses.—The two estate tax incentives to family farming are also available to the estates of owners of 1995

nonfarm family businesses. If the same three conditions

previously described are met, the real property in their

estates is eligible for continued use valuation.

Tax deferral of closely held businesses.—Nonfarm

family businesses that satisfy the net estate requirements qualify for preferential 15 year deferred estate

tax payment. To be eligible for this special provision,

the value of stock in closely held corporations must

exceed 35 percent of the decedent’s gross estate, less

debt and funeral expenses.

EDUCATION, TRAINING, EMPLOYMENT, AND SOCIAL

SERVICES

Bequests to tax-exempt organizations.—These bequests are deductible from decedent’s otherwise taxable

lifetime transfers.
98 ANALYTICAL PERSPECTIVES

HEALTH

Bequests to health providers.—Such bequests, that

are exempt from the income tax, are deductible from

otherwise taxable lifetime transfers of decedents.

GENERAL GOVERNMENT

State and local death taxes.—A credit is allowed

for state death taxes against any Federal estate tax

that otherwise would be due. The amount of the state

death tax credit is determined by a rate schedule that

reaches a limit of 16 percent of the taxable estate in

excess of $60,000.