Tax Policy: Factors for Evaluating Expiring Tax Provisions
Published: 2012-06-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO was asked to discuss the extension of tax provisions, sometimes called tax extenders, that either expired in 2011 or are scheduled to expire at the end of 2012. For a prior hearing of this subcommittee, the Joint Committee on Taxation (JCT) prepared a document detailing 64 expiring tax provisions. Most of these provisions are tax expendituresreductions in a federal taxpayers tax liability that result from special credits, deductions, exemptions and exclusions from taxation, deferral of tax liability, and preferential tax rates. Tax expenditures are often aimed at policy goals similar to those of spending programs, such as encouraging economic development in disadvantaged areas and stimulating research and development. Because revenue is foregone, these provisions may, in effect, be viewed as spending programs channeled through the tax system. For those provisions the President proposed extending through 2013, JCT estimated the budgetary effect would be at least $40 billion in foregone revenue over its 10-year budget window.
This testimony outlines factors useful for considering trade-offs when deciding whether and how to extend provisions and illustrates their application to some of the expiring provisions. GAOs testimony is based on previous work on tax reform and tax expenditures.
section_title: What GAO Found
paragraphs: Factors commonly used to evaluate tax policy, as well as other policy tools such as spending programs or regulations, can be applied to decisions about whether and how to extend expiring tax expenditures, as discussed below.
Revenue Effects . Revenues foregone through tax expenditures either reduce resources available to fund other federal activities or require higher tax rates to raise a given amount of revenue. Like decisions about spending, deciding whether to extend an expiring tax expenditure involves considering whether the benefit of the intended outcome is worth the effect on other programs or tax rates. The nations long-term fiscal challenge makes it all the more important to ensure tax expenditures are efficient and relevant.
Criteria for Good Tax Policy . Three long-standing criteria typically used to evaluate tax policyequity; economic efficiency; and a combination of simplicity, transparency, and administrabilitycan be applied to the expiring tax expenditures. Because the criteria may sometimes conflict with one another, there are usually trade-offs to consider when evaluating particular tax expenditures.
Relationship to Other Policy Tools . Tax expenditures represent just one policy tool of severalincluding spending, grants, loans, and regulationsthat policymakers can use to achieve policy goals. If not well designed, tax expenditures can create the potential for duplication with other policy tools.
Measurement Challenges . Unavailable or insufficient data can hinder policymakers ability to consider how the factors described above relate to particular tax expenditures. A key challenge is that data necessary to assess how a tax expenditure is used and by whom generally are not collected on tax returns unless the Internal Revenue Service needs the information to ensure tax compliance or is legislatively mandated to collect or report the information.
GAOs prior reports on tax expenditures illustrate how these factors can be used to evaluate whether and how to extend expiring tax provisions. For example, GAO found that the research tax credit, as currently designed, provides many recipients with windfall benefits earned for spending they would have done anyway. A report on domestic ethanol productionin which GAO suggested modifying or phasing out a tax credit that was duplicative of the renewable-fuel standardhighlights the importance of considering how tax expenditures relate to other policy tools. GAOs work on higher-education tax expenditures illustrates how tax expenditures that are not transparent (i.e., cannot be easily understood by taxpayers) can result in taxpayers making decisions that do not maximize their tax benefits. This work also concluded that little is known about the effectiveness of education-related federal grants, loans, and tax expenditures in promoting certain student outcomes, such as college attendance. Research gaps may be due, in part, to data and methodological challengessuch as difficulty isolating the behavioral effects of the tax expenditure under study from other changesthat have proven difficult to overcome.
section_title: What GAO Recommends
paragraphs: GAO has made many recommendations in its previous reports on tax expenditures that reflect the factors described in this testimony. Some have been acted on, while others have not.

section_title: Letter
paragraphs: I am pleased to be here to discuss the extension of tax provisions,  sometimes called tax extenders, which either expired in 2011 or are  scheduled to expire at the end of 2012. These provisions were the subject  of an April hearing before this subcommittee, for which the Joint  Committee on Taxation (JCT) prepared a document detailing 64 expiring  provisions. Most of the 64 expiring provisions are tax expenditures— reductions in a federal taxpayer’s tax liability that result from special  credits, deductions, exemptions and exclusions from taxation, deferral of  tax liability, and preferential tax rates. Tax expenditures are provisions  that are exceptions to the “normal structure” of the individual and  corporate income tax. Other provisions that reduce tax liability, such as  many deductions for business expenses, are considered to be part of the  normal tax structure and are not considered tax expenditures.
Tax expenditures are often aimed at policy goals similar to those of  spending programs, such as encouraging economic development in  disadvantaged areas, promoting energy efficiency, or stimulating  research and development. Because revenue is foregone, these  provisions may, in effect, be viewed as spending programs channeled  through the tax system. JCT’s publication providing revenue estimates for  provisions contained in the President’s fiscal year 2013 budget proposal  does not include all of the 64 expiring provisions. However, for those  provisions the President proposed extending through 2013, JCT  estimated that the budgetary effect would be at least $40 billion in  foregone revenue over its 10-year budget window.
Like budget decisions for spending programs, decisions on whether and  how to extend expiring tax provisions involve trade-offs between policy  goals and revenue costs. My testimony today will outline a set of factors  useful for understanding these trade-offs and illustrate their application to  some of the expiring provisions. Although the main focus of my testimony  is on how the factors apply to evaluating expiring tax expenditure  provisions, the factors are also relevant to evaluating other expiring  provisions, such as those related to tax administration. This testimony is  based on previous GAO reports on tax reform and tax expenditures.  Additional information on our scope and methodology is available in those  published products, which are referenced throughout this statement.
The work for this testimony and the reports on tax expenditures upon  which it is based were conducted in accordance with generally accepted  government auditing standards. Those standards require that we plan  and perform the audit to obtain sufficient, appropriate evidence to provide  a reasonable basis for our findings and conclusions based on our audit  objectives. We believe that the evidence obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
subsections: section_title: Factors to Consider When Evaluating Expiring Tax Provisions
paragraphs: Factors commonly used to evaluate tax policy in general can be applied  to decisions of whether and how to extend expiring tax provisions,  including tax expenditure provisions. The factors, listed in table 1 and  discussed below, may also be relevant to evaluating other policy tools,  such as spending programs or regulations.  1. Revenue Effects. Tax expenditures may, in effect, be viewed as  spending programs channeled through the tax system. Tax expenditures  can be viewed this way because they grant special tax relief for certain  kinds of behavior by a taxpayer or for taxpayers in special circumstances.  Revenues foregone through tax expenditures either reduce funding  available for other federal activities or require higher tax rates to raise a  given amount of revenue. Like decisions about spending, deciding  whether to extend an expiring tax expenditure involves considering  whether the benefit of the intended outcome is worth the effect on other  programs or tax rates. Revenue the government would have collected  absent a tax expenditure could have been used for other federal priorities,  deficit reduction, or tax rate reductions.
GAO-05-1009SP. gain that is said to improve economic efficiency. These gains improve  peoples’ well-being in a variety of ways, including increased income  and consumption opportunities.
Estimating efficiency gains and losses can be challenging. Studies  may be limited by what can be quantified; for example, studies may  examine dollars spent on qualified research or the number of  economic development projects built, rather than whether the use of  funds for these activities constitute a better use of resources.
Simplicity, transparency, and administrability. A tax expenditure’s  design can affect three related and desirable features of tax  provisions: simplicity, transparency, and administrability. Simple tax  expenditures impose less taxpayer compliance burden, such as  keeping records, learning about tax rules, filing tax returns, and other  compliance activities. Transparent tax provisions are easy to  understand, that is, taxpayers can grasp the logic behind them.  Administrable tax expenditures have lower administrative costs for  both the Internal Revenue Service (IRS) and third parties, such as  banks or employers required to submit information on taxpayers’  income and transactions to IRS. Administration includes processing  returns, programming information systems, answering taxpayer  questions, and enforcement activities. Simplicity, transparency, and  administrability are not the same but are interrelated. For example,  extensions of expiring tax code provisions, sometimes retroactively,  can add compliance burden, reduce taxpayers’ understanding of the  tax laws, and impose additional costs on IRS, such as more phone  calls from taxpayers.  3. Relationship to Other Policy Tools. Tax expenditures are one policy  tool out of several—including spending, grants, loans and loan  guarantees, and regulations—that policymakers can use to achieve public  goals. The choice of whether to use tax expenditures, spending, or other  tools depends on which approach better meets the goal at the lowest  cost.
Different policy tools may be more effective than others in achieving a  particular policy outcome. With tax expenditures, certain activities may  be cheaper and simpler to subsidize through the tax code because  IRS has the administrative infrastructure to collect and remit money to  millions of taxpayers. For example, the incremental administrative and  compliance costs to deliver the tax credit for child and dependent care  expenses may be relatively low compared to the costs of setting up a  separate system for processing child care applications and sending  vouchers to those eligible.
How a tax expenditure is designed can affect its revenue effects and  how it relates to the criteria for a good tax system. For example,  depending on their design, tax expenditures can result in taxpayers  receiving benefits for actions they would have taken absent the tax  expenditure. Also, each type of tax expenditure creates tax savings in  different ways and, consequently, reduces federal revenues in  different ways and may have different distributional effects. The  amount of tax relief per dollar that a taxpayer receives using an  exclusion, exemption, or deduction depends on the taxpayer’s  marginal tax rate. Generally, the higher a taxpayer’s marginal tax rate,  the greater the tax savings from these tax expenditure types. Tax  credits reduce tax liability dollar-for-dollar, so the value of a credit is  the same regardless of a taxpayer’s marginal tax rate.
The Government Performance and Results Act (GPRA)
Modernization Act of 2010 (GPRAMA)expenditures in that it establishes a framework for providing a more  crosscutting and integrated approach to focusing on results and  improving government performance. GPRAMA makes clear that tax  expenditures are to be included in identifying the range of federal  agencies and activities that contribute to crosscutting goals. Moving  forward, GPRAMA implementation can help inform tough choices in  setting priorities as policymakers address the rapidly building fiscal  pressures facing our national government.  can help in evaluating tax  If not well designed or effectively implemented, tax expenditures can  contribute to mission fragmentation and program overlap, thus  creating the potential for duplication with other policy tools. All federal  spending and tax policy tools, including tax expenditures, should be  reexamined to ensure that they are achieving their intended purposes  and are designed in the most efficient and equitable manner.  4. Measurement Challenges. Unavailable or insufficient data can hinder  policymakers’ ability to consider how the factors described above relate to  particular tax expenditures. A key challenge is that data necessary to  assess how and by whom a tax expenditure is used generally are not  collected on tax returns unless IRS needs the information to ensure tax  compliance or is legislatively mandated to collect or report the  information. In some cases, IRS may combine reporting requirements to  minimize its workload and taxpayer burden, and as a result, the  information collected may not identify specific beneficiaries or activities  targeted by a tax expenditure. Also, the influence of other economic and  social factors can confound efforts to measure a tax expenditure’s effects  on efficiency and equity. We and the Office of Management and Budget  (OMB) have noted that the desired outcomes of a tax expenditure or  other policy tool are often the combination of effects of the program and  external factors.
If policymakers conclude that additional data would facilitate reexamining  a particular tax expenditure, decisions would be required on what data  are needed, who should provide the data, who should collect the data,  how to collect the data, what it would cost to collect the data, and whether  the benefits of collecting additional data warrant the cost of doing so.  Another factor to consider is how to facilitate data sharing and  collaborative evaluation efforts amongst federal agencies.
section_title: Illustrating These Factors Using Examples from GAO’s Past Work
paragraphs: Our prior reports on tax expenditures illustrate how these factors can be  used to help evaluate whether and how to extend expiring tax provisions.
Domestic Ethanol Production. Our past work related to domestic  ethanol production highlights the importance of considering how tax  expenditures relate to other policy tools. Congress has supported  domestic ethanol production through two policy tools: (1) a tax credit, the  most recent version of which expired after December 31, 2011, and (2) a  renewable-fuel standard that generally requires transportation fuels in the  United States to contain certain volumes of biofuels, such as ethanol. In  2009, we reported that the tax credit was important in helping to create a  profitable corn starch ethanol industry when the industry had to fund  investment in new facilities, but is less important now for sustaining the  industry because most of the capital investment has already been made.  We found that Congress’s efforts to support domestic ethanol production  through a tax credit and renewable-fuel standard were duplicative. The  fuel standard is now at a level high enough to ensure that a market for  domestic ethanol production exists in the absence of the ethanol tax  credit. As such, we suggested that Congress consider modifying the  credit or phasing it out. Congress allowed the credit to expire at the end of  2011. JCT did not include an estimate of the budgetary effect of  extending the credit through December 31, 2013, in its March 2012  estimates, as the President did not propose to extend the credit.
Higher Education. Our past work on higher-education tax expenditures  illustrates how tax expenditures that are not transparent (i.e., cannot be  easily understood by taxpayers) can result in taxpayers making decisions  that do not maximize their tax benefits. The tuition and fees deduction,  which expired after December 31, 2011, helped students and their  families pay for higher education by allowing them to deduct qualified  education expenses from income that would otherwise be taxable. In  2008, we found that tax filers did not always claim higher-education tax  expenditures, such as the tuition and fees deduction, that maximize their  potential tax benefits, potentially because of the complexity of higher- education tax provisions.provisions involved could potentially increase transparency in the system.  JCT estimates the budgetary effect of extending this provision through  December 31, 2013, would be about $1.5 billion in fiscal years 2012- 2022.
Further analysis and simplification of the tax  Higher education tax expenditures also illustrate how measurement and  methodological challenges can impede evaluating their effectiveness. In  2005, we reported that little is known about the effectiveness of  education-related federal grants, loans, and tax expenditures in promoting  student outcomes including college attendance, students’ choice among  colleges, and the likelihood that students will continue their education. We  also found that research gaps may be due, in part, to data and  methodological challenges—such as difficulty isolating the behavioral  effects of the tax expenditure under study from other changes—that have  proven difficult to overcome.
Research Tax Credit. Our past work on the research tax credit provides  insights into how improving the design of a tax expenditure could improve  its economic efficiency and reduce revenue costs. Economists widely  agree that some government subsidy for research is justified because the  social returns from research exceed the private returns that investors  receive. Since 1981, the research tax credit has provided significant  subsidies (an estimated $6 billion for fiscal year 2011) to encourage  business to invest in research and development. The most recent version  of the credit expired after December 31, 2011. Despite the widespread  support for the concept of a credit for increasing research activities,  concerns have been raised about the cost-effectiveness of the design of  the current credit and its administrative and compliance costs. We found  that the research tax credit, as currently designed, distributes incentives  unevenly across taxpayers and provides many recipients with windfall  benefits, earned for research that they would have done anyway. For  example, we found that for those claiming the regular credit, more than  half of the credit such claimants earned was a windfall. The disparities in  incentives can lead to an inefficient allocation of investment resources  across businesses, and the windfall benefits represent foregone tax  revenue that does not contribute to the credit’s objective. Accordingly, we  suggested that Congress modify the research tax credit to reduce  economic inefficiencies and excessive revenue costs. JCT estimates the  budgetary effect of the President’s proposal to enhance and make  permanent this provision would be about $99 billion in fiscal years 2012- 2022.
Our past work on the research tax credit also provides insight into how  tax expenditure design can affect transparency and administrability. In  2009, we reported that there are numerous areas of disagreement  between IRS and taxpayers concerning what types of spending qualify for  the research credit because of issues such as the definitions used to  determine eligibility and the documentation needed to support the claim.  These disputes raise the cost of the credit to both taxpayers and IRS and  diminish the credit’s incentive effect by making the ultimate benefit to  taxpayers less certain. We made several recommendations to the  Department of the Treasury (Treasury) to reduce the uncertainty that  some taxpayers have about their ability to earn credits for their research  activities. To date, Treasury has not fully implemented these  recommendations.
New Markets Tax Credit (NMTC). Our past work on the NMTC provides  examples highlighting issues of simplicity and the need to consider tax  expenditures in light of other policy tools. Congress enacted the NMTC  in 2000 as part of an ongoing effort to revitalize low-income communities.  Treasury awards tax credits to Community Development Entities (CDE),  which sell the credits to investors to raise funds. JCT estimates the  budgetary effect of the President’s proposal extending and modifying the  NMTC would be about $3.5 billion in fiscal years 2012-2022.
In 2007, we reported that the NMTC appeared to increase investment in  low-income communities. However, in 2010 we reported that the  complexity of NMTC transaction structures appeared to make it difficult to  complete smaller projects and often results in less of the money investors  initially put into the project ending up in low-income community  businesses—the beneficiaries of NMTC financing—than would be the  case if the program were simplified. We suggested Congress consider  offering grants to CDEs that would provide the funds to low-income  community businesses and assess the extent to which the grant program  would increase the amount of federal subsidy provided to low-income  community businesses compared to the NMTC. One option would be for  Congress to set aside a portion of funds to be used as grants and a  portion to be used as tax credits under the current NMTC program to  facilitate a comparison of the two programs.
Revitalization Programs. Our past work on revitalization programs,  including the Empowerment Zone (EZ), Enterprise Community (EC), and  Renewal Community (RC) programs, provides an example of  measurement challenges when evaluating tax expenditures. Congress  established the EZ, EC, and RC programs to reduce unemployment and  generate economic growth in selected Census tracts. Urban and rural  communities designated as EZs, ECs, or RCs received grants, tax  expenditures, or a combination of both to stimulate community  development and business activity. Tax provisions for empowerment  zones and the District of Columbia (DC) enterprise zone (including the  first-time homebuyer credit for the District of Columbia) expired after  December 31, 2011. JCT estimates that the budgetary effect of extending  these provisions through December 31, 2013, would be $585 million from  fiscal years 2012-2022.
Our prior work has found improvements in certain measures of  community development in EZ communities, but data and methodological  challenges make it difficult to establish causal links. In the case of the EZ,  EC, and RC programs, the lack of tax benefit data limited the ability of the  Department of Housing and Urban Development (HUD) and the  Department of Agriculture to evaluate the overall mix of grant and tax  programs to revitalize selected urban and rural communities. In response  to our recommendations, HUD and the IRS collaborated to share data on  some program tax credits. However, the IRS data did not tie the program  tax incentives to specific designated communities, making it difficult to  assess the effect of the tax benefits. We have previously reported that if  Congress authorizes similar programs that rely heavily on tax  expenditures in the future, it would be prudent for federal agencies  responsible for administering the programs to collect information  necessary for determining whether the tax benefits are effective in  achieving program goals.
Nonbusiness Energy Property Credit. Our work on the nonbusiness  energy property credit highlights the importance of considering revenue  foregone and the criteria for good tax policy when determining whether  and how to extend specific tax provisions. Enacted as part of the Energy  Policy Act of 2005, the nonbusiness energy property credit was intended  to increase homeowners’ investment in energy-conserving improvements,  such as insulation systems, exterior windows, and metal roofs, by  reducing their after-tax costs. The credit expired on December 31, 2011.  JCT estimates the budgetary effect of the President’s proposal extending  and modifying this provision through December 31, 2013, would be about  $2.4 billion in fiscal years 2012-2022.
The design of the credit affects its economic efficiency and revenue costs.  The credit combines features of both cost-based and performance-based  credits. Cost-based credits provide incentives that are usually a fixed  percentage of qualified spending, whereas performance-based credits  provide incentives that are tied to specific measures of energy savings  and therefore may require before and after energy audits. The  nonbusiness energy property credit is cost-based in that the amount of  credit claimed is directly proportional to a taxpayer’s qualified spending. It  is performance-based in that only certain qualifying purchases are  eligible. In 2012, we reported that both the performance-based and cost- based credits have advantages and disadvantages with neither design  being unambiguously the better option based on current information. For  example, a performance-based credit is more likely to effectively reduce  energy use and carbon dioxide emissions because it rewards energy  savings from the investment rather than the cost-based credit’s rewarding  of spending regardless of whether this spending results in energy  savings. However, the performance-based credit may have significant up- front costs for energy audits, not required by the cost-based credit, which  could reduce its effectiveness by discouraging investment.
The credit’s design also can affect its administrability and equity. For  taxpayers who do invest, these up-front costs may mean that a  performance-based credit may have significantly higher taxpayer  compliance and IRS administrative costs than a cost-based credit. Views  on what is a fair distribution of the credit’s costs and benefits can differ  dramatically across individuals. However, whatever one’s views of  fairness, an analysis of the distribution of costs and benefits by such  factors as income level can be useful.
Indian Reservation Depreciation. Our work on this provision is another  example of how measurement challenges can hinder evaluation of tax  expenditures. The provision allows taxpayers to take larger deductions  for depreciation from their business income earlier than they otherwise  would be allowed for certain property on Indian reservations. For the  deduction, taxpayers are not required to identify the reservation on which  the depreciated property is located, preventing assessments linking  investment to economic indicators on specific reservations. We  suggested Congress consider requiring IRS to collect this information, but  we noted that Congress would need to weigh the associated costs of  collecting and analyzing the information as well as the effects on IRS’s  other priorities. The credit expired on December 31, 2011. JCT estimates  the budgetary effect of extending this provision through December 31,  2013, would be $100 million in fiscal years 2012-2022.
In closing, considering the various factors I have laid out today can help  when deciding whether and how to extend expiring tax provisions.  Improving tax expenditure design may enable individual tax expenditures  to achieve better results for the same revenue loss or the same results  with less revenue loss. Also, reductions in revenue losses from  eliminating ineffective or redundant tax expenditures could be substantial  depending on the size of the eliminated provisions. As we have stated in  prior reports,  we believe that tax expenditure performance is an area  that would benefit from enhanced congressional scrutiny as Congress  considers ways to address the nation’s long-term fiscal imbalance.
Chairman Tiberi, Ranking Member Neal, and Members of the  Subcommittee, this completes my prepared statement. I would be happy  to respond to any questions you and Members of the Subcommittee may  have at this time.
GAO-05-690 and GAO, Tax Policy: Tax Expenditures Deserve More Scrutiny,  GAO/GGD/AIMD-94-122 (Washington, D.C.: June 3, 1994).
section_title: Contacts and Staff Acknowledgments
paragraphs: For further information regarding this testimony, please contact James R.  White, Director, Strategic Issues, at (202) 512-9110 or whitej@gao.gov.  Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this statement. Individuals  making key contributions to this statement include Jeff Arkin, Assistant  Director; Shannon Finnegan; Melanie Papasian; MaryLynn Sergent; Anne  Stevens; and Sabrina Streagle. Kevin Daly, Tom Gilbert, Susan J. Irving,  Thomas McCabe, Timothy Minelli, Ed Nannenhorn, Michael O’Neill, and  Jim Wozny also provided technical support.
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