Spending and Tax Expenditures: Distinctions and Major Programs
Released: 2016-06-17T00:00:00

Introduction

Spending programs and tax expenditures are the two primary ways that the federal government provides benefits to the public. Though each type of intervention increases net budget deficits, differences in the budget process, saliency, and targeting of each may have ramifications for usage across different types of services. This report briefly describes spending programs and tax expenditures, observes a few ways that they differ, and discusses how those distinctions may inform the relative use of each type of intervention across the government portfolio.

Description

Spending

Federal expenditures (or spending) are transfers from the federal government to individuals, firms, or institutions that do not draw directly from individual or corporate tax liability. Federal spending programs fall into three broad categories: (1) discretionary spending, (2) mandatory spending, and (3) net interest payments. The Congressional Budget Office (CBO) estimates that federal spending will total $3.897 trillion in FY2016, or 21.1% of annual gross domestic product (GDP).

Federal discretionary spending activity describes expenditures that are controlled by appropriation acts. Discretionary spending includes most of the expenditures devoted to the general operations of federal agencies, including the Department of Defense, Department of Homeland Security, and Environmental Protection Agency. CBO estimates that the federal government will devote $1.196 trillion to discretionary spending in FY2016, or 6.5% of GDP.

Mandatory spending represents expenditures that are controlled by laws other than appropriation acts. Also known as direct spending, programs that are exclusively or primarily funded through mandatory spending include Social Security, Medicaid, and Medicare. CBO estimates that the federal government will devote $2.449 trillion to mandatory spending in FY2016, or 13.2% of GDP.

Net interest payments equal the total payments made to federal debt holders, less payments on interest received by the federal government. The magnitude of net interest payments is determined by the size of the federal debt and the interest rate of outstanding debt instruments. CBO estimates that the federal government will spend $0.253 trillion on net interest in FY2016, or 1.5% of GDP.

Tax Expenditures

Tax expenditures are revenue losses attributable to federal tax provisions. There are three main types of tax expenditures: (1) exclusions, exemptions, and deductions from gross personal or corporate income; (2) preferential tax rates for certain programs; and (3) refundable and nonrefundable tax credits. The Joint Committee on Taxation (JCT) estimates the revenue losses attributable to certain programs. Tax expenditures were projected to increase net deficits in FY2016 by $1.521 trillion, or 8.2% of GDP.

Exclusions, exemptions, and deductions lower the taxes paid through reductions in the amount of income that is eligible for taxation. The financial value of exclusions, exemptions, and deductions is a function of the amount of income subject to the rule and the tax rate that would have otherwise been paid on the income. All else equal, an exemption that reduces an individual's taxable income by $1,000 is more valuable than an exemption that reduces individual taxable income by $500. Similarly, a deduction from income that would have otherwise been subject to a 39.6% income tax rate will lead to a greater revenue reduction than a deduction from income otherwise treated with a 15% income tax. Thus, the value of exclusions, exemptions, and deductions generally increases with income.

Preferential tax rates represent levies on parts of personal or corporate income that are lower than their normal rates, as defined by law (but which are nonzero). As with exclusions, exemptions and deductions, the value of preferential tax rates is a function of the amount of income affected and the rate of tax that would otherwise be applicable. Preferential tax rates will only have value in cases where the rate of tax would otherwise have been higher than the preferred rate. For instance, a law placing a tax rate of 30% on income will have value (be preferential) for an individual who otherwise would have been taxed at a 35% rate, but will have no value (or be harmful, if forced to adopt) to an individual otherwise subject to a 25% tax rate on the income.

Tax credits directly reduce the tax liability of an individual or corporation. Unlike other types of tax expenditures, tax credits do not modify the definition of income in the federal tax code. Tax credits may be designated as non-refundable or refundable. Nonrefundable credits cap benefit claims at the amount of remaining tax liability, while refundable credit benefits are not inherently limited by the tax liability threshold (and thus can also affect federal outlay projections).

For a more detailed inspection of tax expenditures and related issues facing Congress, see CRS Report R44012, Tax Expenditures: Overview and Analysis , by [author name scrubbed].

Program Comparison

Differences in the construction of spending and tax expenditure programs have direct ramifications for their treatment in the legislative process, for budget outcomes, for targeting and enforcement, and for the distribution of benefits. This section examines these differences and discusses how those distinctions may influence the use of each intervention across the budget process.

Legislative Process

Treatment in the way that spending programs and tax expenditures are legislated depends on a number of factors, including the expiration (or lack) of legislative authority and committee assignment. These factors may have implications for the relative usage of spending programs and tax expenditures in meeting certain policy objectives.

Spending Programs

Discretionary spending programs are funded through the appropriations process, which often involves input from several working committees in each chamber. The appropriations committees are tasked with allocating discretionary budget authority across 12 spending categories, which are responsible for further allotment to agencies and programs. For more information on discretionary spending legislation, see CRS Report 98-721, Introduction to the Federal Budget Process , coordinated by [author name scrubbed].

The federal budget process provides for allocation of discretionary budget authority through annual appropriation acts, which expire at the end of each fiscal year. In the event that a discretionary budget has not been agreed to as a new fiscal year approaches, Congress and the President have two choices: (1) enactment of a continuing resolution, which provides temporary budget authority for discretionary programs (typically as a function of the budget authority available in the previous year until permanent authority is passed); or (2) allow discretionary budget authority to lapse. The lapsing of budget authority can produce a "government shutdown," which involves the closure of some federal operations that rely on discretionary funding.

Unless designated otherwise, mandatory programs are permanently funded by the federal government. Therefore, the funding provided for mandatory programs is typically not affected by the annual appropriations process. Absent the enactment of modifying legislation, the eligibility and benefit rules governing mandatory spending programs remain constant across budget years. Much of the legislative process surrounding such programs falls to issue-specific committees. Most mandatory spending programs are either permanent or, if temporary, handled by legislative committees on an alternative schedule to the annual appropriations process.

Tax Expenditures

Tax expenditures are similar to spending programs in that their legislative processes vary with the type of program under consideration. However, unlike with spending programs, the process surrounding tax expenditure legislation is not typically reliant on the benefit allocation mechanism (i.e., exclusions, exemptions, and deductions; preferential rates; or tax credits). In this case, whether the tax expenditure is permanent or expiring is the biggest determinant of the legislative role in its maintenance.

Many tax expenditures have been permanently incorporated into the tax code. In those instances, legislative action is required to change the implementation and benefits provided by the tax expenditures. Moreover, the level of their benefits is not subject to change based on the state of the appropriations process, which is similar to the treatment of mandatory spending programs.

Tax expenditures may also serve as temporary provisions, with a scheduled expiration after a certain date or tax year. Such cases introduce increased uncertainty, as temporary provisions may be allowed to lapse, expire, or change in legislation that extends their inclusion in the tax code. In this way, temporary provisions may be comparable to the uncertain outcomes that are part of the legislative process for discretionary spending.

Recent legislation changed the length of effectiveness for a number of tax expenditures that recently expired. Division Q of the Consolidated Appropriations Act, 2016 ( P.L. 114-113 ) extended 56 tax expenditure provisions that expired in 2014. Of those provisions, 30 programs were extended for two years, through tax year 2016; 4 were extended for five years, through tax year 2019; and 22 were made permanent.

Budget Outcomes

Holding other activities constant, increases in resources devoted to spending programs and tax expenditures lead to increases in net budget deficits—spending programs through increases in federal outlays, and tax expenditures through reductions in federal receipts. However, congressional control over budget outcomes may differ both across and within spending and tax expenditure programs.

Spending Programs

Generally, discretionary spending affords Congress with a high degree of certainty over budget outcomes, as it directly controls the amount of money available for such programs. Any uncertainty with budget outcomes for discretionary spending is typically the result of debate over discretionary budget authority allocation extending into the beginning of the fiscal year under discussion. In those cases, funding lapses, continuing resolutions, and congressional action may lead to changes in the resources available for such programs from year to year.

Mandatory spending programs are legislated outside of the appropriations process. For these programs, Congress may use legislation to control the eligibility criteria and benefits afforded. However, the amount of resources devoted is a function of program participation and usage, which means that Congress has no direct control over final spending amounts. The degree to which this lack of discretion adds to the uncertainty of budget outcomes depends on how unanticipated public changes translate into variation in the popularity of mandatory programs.

Tax Expenditures

Congressional discretion over the budget outcomes of tax expenditures is similar to its control over mandatory spending programs. For both permanent and temporary tax expenditures, the eligibility and benefit levels are controlled by federal legislation. However, the exact amount of resources allocated to expenditures depends on public take-up, which can be influenced by a number of outside factors.

A further constraint on budget certainty for tax expenditures is the fact that changes to one type of expenditure can have budgetary ramifications for all other expenditures. For all tax expenditures except refundable tax credits, the ability and intensity of tax expenditure adoption is dependent on the amount of tax liability "available" to each potential participant. That liability is affected by participation in other tax expenditures; reductions in the usage of one tax expenditure may increase participation levels in a different tax expenditure program.

Targeting and Enforcement

Before transferring resources to the public, the government must first identify eligible parties for the transfer, and in some cases, address improper benefit claims. The ease and ability to complete this process may differ across spending and tax expenditure programs.

Spending Programs

The financial costs of targeting and enforcement may vary significantly across spending programs. Some spending programs may have straightforward means of identifying eligible recipients for resources. For instance, income resources for active military servicemembers use military employment records already available to the federal government. Other types of programs can require additional steps to ensure that resources find their way to eligible parties. For example, the Supplemental Nutrition Assistance Program (SNAP) has net and gross income eligibility requirements that depend on a number of household characteristics. The mechanisms for targeting and enforcement implemented by spending programs are dependent on context.

Tax Expenditures

Targeting mechanisms are already in place for the personal and corporate income tax system, which may minimize the additional resources needed to perform such targeting activities for tax expenditures. This is because the criteria for tax expenditures are often already reported on income tax returns. For instance, one restriction for earned income tax credit eligibility is based on household income, which is also used in gross income tax liability calculations.

Additionally, enforcement for program eligibility may be conducted through the tax auditing system run by the Internal Revenue Service (IRS), which is designed to encourage accurate income reporting on tax returns. The use of this service to enforce eligibility for tax expenditure programs may add to the budgetary importance of accurate tax reporting, however, and increase the complexity of the auditing system needed by the IRS.

Distribution

While utilization of the tax code may help the government efficiently target recipients and address improper benefit claims, it may also limit the types of households such programs can reach. This section explores the distributional implications of spending programs and tax expenditures.

Spending Programs

Since spending programs do not adhere to a uniform method of benefit allocation, there are no theoretical restrictions on the individuals, households, and firms that can be reached by such programs. In practice, individual spending programs can and often do place restrictions on eligibility, though those limits are generally the function of policy goals and not typically influenced by the spending mechanism.

The recipients of program benefits may be affected by the type of spending used. Discretionary spending programs usually allocate benefits to federal agencies, which have the autonomy to spend those funds as needed (within the limits provided in the authorizing statute). In many cases, these programs are used to finance spending on "public goods." Public goods are defined here as goods that are non-rival (their "use" by one person does not reduce amounts available to others) and non-excludable (benefits are available to everyone, regardless of payment contribution).

Providing public goods by levying fees on individuals or firms in return for service may allow for the possibility of "free-riding," where some market participants benefit with no or reduced payment for services paid for in full by other actors. For example, national defense is commonly thought of as a public good. In that case, payment by one group of people for defense services is likely to have benefits for all individuals in the local area—including individuals who did not contribute payments for those services. The potential for free-riding may be one reason why discretionary spending is used for most national defense programs, as benefits can be applied broadly by the government and paid for through general tax revenues. Conversely, mandatory spending programs, including Social Security, Medicare, and Medicaid, typically provide benefits directly to individuals and households. This direct means of financing generally excludes such programs from funding public goods.

Tax Expenditures

The adoption of tax expenditure programs may be restricted by the use of income tax returns to allocate benefits. Specifically, tax expenditures may have distributional limitations in two major areas: (1) serving portions of the population that do not file tax returns, including low-income households; and (2) financing public goods.

Tax returns are typically completed by employed individuals and firms. Therefore, for policy issues targeted to individuals, tax expenditure programs may be best targeted to households with at least one employed person, and which are thus much more likely to fill out a tax return than the population at large. However, populations that have below-average employment, such as low-income and elderly households, may be less likely to participate in tax expenditure programs, as the lower filing rate of tax returns could reduce their exposure to such programs. As with mandatory spending programs, individuals must claim tax expenditures to receive benefits. This process typically makes it difficult to use tax expenditures to finance public goods, as the benefit allocation process allows for excludability that is not available in public goods.

Usage by Budget Function

The following tables identify the largest spending and tax expenditure programs in eight categories of federal activity: (1) defense and international affairs; (2) general science, space and technology, natural resources and the environment, and agriculture; (3) commerce and housing, community and regional development, and transportation; (4) education, training, employment, and social services; (5) health, including Medicare; (6) income security; (7) Social Security and veterans' benefits; and (8) administration of justice and general governance.

For the purposes of this study, spending programs will be distinguished by type (i.e., discretionary or mandatory) and by budget subfunction, in accordance with the March 2016 CBO baseline. Expenditure items will be identified as they appear in two December 2015 JCT publications. These tables do not include three types of federal interventions: net interest (budget function 900), federal allowances (budget function 920), or undistributed offsetting receipts (budget function 950). Net interest, the largest of the three functions, is omitted from this analysis because it is a function of previous spending and tax expenditure decisions in the other categories, and thus does not afford Congress with the control provided by other types of programs. Allowances and undistributed receipts are not included here because the nature of those types of programs makes their beneficiaries hard to determine, rendering it difficult to make comparisons with tax expenditure programs.

Importantly, while spending and tax expenditure programs both increase net deficits, the mechanisms that allocate resources for each program type are different. Specifically, spending programs rely on funds that are collected by the federal government, while tax expenditures are typically financed through forgone revenues, or money not collected due to the creation of the program. This difference may have policy implications that are not addressed in this report.

Defense and International Affairs (Budget Functions 050 and 150)

Budget functions 050 and 150 cover activities related to national defense and international affairs, respectively. Table 1 shows the projected costs of operations classified as national defense and international affairs, as estimated by CBO and JCT. Defense and international affairs spending programs devote most of their outlays to military activities. Other spending activities include engagement in international relations and nonmilitary defense programs. In contrast, the largest tax expenditure programs devote resources to foreign-based individuals and households with interests in the United States, while also offering some tax benefits to active military servicemembers. National defense and international diplomacy are some of the more notable public goods typically regulated by governments. Programs that call for more frequent congressional action (such as discretionary spending programs and expiring tax expenditures) may also be useful for defense and international affairs activities, as the location and intensity of resource demands may be highly dependent on international events that are not always foreseeable.

General Science, Space and Technology, Energy, Natural Resources and Environment, and Agriculture (Budget Functions 250, 270, 300, and 350)

Budget functions 250, 270, 300, and 350 are devoted to government activities related to science and technology, energy, natural resources, and agriculture, respectively. Table 2 shows the CBO and JCT projections of the cost of such programs. Both spending programs and tax expenditures devote the most resources in this area to support scientific and technological research and for agricultural services. These interventions also offer a wide range of programs, as the amount of resources devoted to "Other" policies is greater than the combined resources spent on the largest three programs in each case. The complementary nature of spending programs and tax expenditure programs in the science and technology, energy, natural resources, and agriculture sectors may reflect an intention to offer support to both government agencies and private firms in these areas.

Commerce and Housing, Transportation, and Community and Regional Development (Budget Functions 370, 400, and 450)

Budget functions 370, 400, and 450 capture government activities related to commerce and housing, transportation, and community and regional development, respectively. Table 3 provides information on the costs of these programs as estimated by CBO and JCT. The largest shares of spending resources are devoted to air and ground transportation programs. Spending programs in these areas are also related to providing assistance in response to unexpected events. Meanwhile, a variety of tax expenditures are used to offer incentives for activities related to homeownership, business activity, and community development. The combined resources devoted to tax expenditures listed as "Other" in Table 3 are larger than any single tax expenditure.

Education, Training, Employment, and Social Services (Budget Function 500)

Budget function 500 is devoted to government activities related to education, training, employment, and social services. Table 4 provides the projected costs of these programs in FY2016, as estimated by CBO and JCT. Federal spending resources in these areas are focused mostly in the education sector, particularly in higher education financing (state and local governments are responsible for much of the policies for elementary and secondary schools). Conversely, tax expenditure programs for budget function 500 activities provide much of their resources to supporting social services. Compared with total federal spending levels, interventions in these areas are more likely to come from tax expenditure programs.

Health, Including Medicare (Budget Functions 550 and 570)

Budget functions 550 and 570 are devoted to government activities related to health (excluding Medicare) and Medicare, respectively. Table 5 shows the projected resources allocated to health and Medicare programs in FY2016, as estimated by CBO and JCT. Spending programs devote the vast majority of their health resources to Medicare and other health services, with the mandatory components of budget subfunctions 571 and 551 alone accounting for more than $1 trillion worth of projected FY2016 outlays. Tax expenditure programs are targeted to incentivize health insurance enrollment and to encourage certain types of health care consumption.

Income Security (Budget Function 600)

Budget function 600 is devoted to government activities related to income security. Table 6 provides CBO and JCT estimates for the resources devoted to income security programs. Federal spending on income security programs is used to finance payments to current and former federal employees and to certain low-income households. Tax expenditure resources are devoted primarily to private retirement contributions, and to income support for low income families.

Social Security and Veterans' Benefits (Budget Functions 650 and 700)

Budget functions 650 and 700 are devoted to government activities related to Social Security and veterans' benefits, respectively. CBO and JCT estimates of the cost of those programs in FY2016 are shown in Table 7 . Nearly 80% of the resources devoted to any type of federal program in these budget categories are spent as outlays on Social Security. Other federal spending is allocated to income security and health care programs for veterans. Tax expenditure programs use the Internal Revenue Code to devote resources to Social Security and railroad retirement benefits and to exclude certain benefits for military veterans from taxation.

Administration of Justice and General Governance (Budget Functions 750 and 800)

Budget functions 750 and 800 are devoted to government activities related to administration of justice and general governance, respectively. Table 8 shows CBO and JCT estimates of resources devoted to those programs. Federal spending programs for budget function 750 and 800 are primarily focused on funding government services, including law enforcement, judicial, and fiscal activities. Tax expenditures in these areas devote the majority of their resources to exempting certain state and local government activities from federal taxation.