To understand the trends in the size of tax expenditures, it is helpful to understand how tax expenditures are defined and how the different types affect taxpayer liability. For this report, we also provide an overview of the broad purposes of tax expenditures—one method the federal government can use to achieve national objectives—and a discussion of how tax expenditures interact with the federal budget. Tax expenditures are revenue losses—the amount of revenue that the government forgoes—resulting from federal tax provisions that grant special tax relief for certain kinds of behavior by taxpayers or for taxpayers in special circumstances. These provisions may, in effect, be viewed as spending programs channeled through the tax system and are classified in the U.S. budget by the same functional categories as other spending, such as energy and health. Tax expenditures are provisions that are exceptions to the “normal structure” of the individual and corporate income tax necessary to collect government revenues. Deciding whether an individual provision should be characterized as a tax expenditure is a matter of judgment, and disagreements about classification stem from different views about what should be included in the income tax base. As a practical matter, the term tax expenditure has been used in the federal budget for three decades, and the tax expenditure concept—while not precisely defined—is a valid representation of one tool that the federal government uses to allocate resources. Both the congressional Joint Committee on Taxation (JCT) and Treasury’s Office of Tax Analysis annually compile a list of tax expenditures and estimates of their cost. (App. III provides additional information on how tax expenditures are measured and reported and perspective on differences among the lists of tax expenditures reported by JCT and Treasury.) Treasury’s tax expenditure estimates are included as an informational supplement to the annual federal budget by the OMB. The revenue loss is estimated for each tax expenditure separately by comparing the revenue raised under current law with the revenue that would have been raised if the single provision did not exist, assuming all other parts of the tax code remain constant and taxpayer behavior is unchanged. Revenue loss estimates are intended to provide information about the value of tax expenditures. However, tax expenditure estimates do not incorporate any behavioral responses and thus do not necessarily represent the exact amount of revenue that would be gained if a specific tax expenditure were repealed. For example, when the consumer interest deduction was phased out gradually beginning in 1987, some taxpayers shifted to interest-deductible home equity loans to finance consumption, thereby affecting the revenue gain from eliminating the consumer interest deduction. In addition to estimating revenue loss, Treasury also measures tax expenditures on an outlay-equivalent basis. Outlay-equivalent estimates represent the amount of budget outlays that would be required if the government were to provide taxpayers with the same after-tax income they receive through the tax expenditure. Outlay-equivalent estimates are often higher than revenue loss estimates to reflect that a comparable outlay program could result in additional taxable income to recipients. Outlay- equivalent estimates are useful to compare tax expenditures and other parts of the federal budget. For example, the outlay-equivalent estimate for the tax exclusion for housing and meal allowances for military personnel reflects the additional pretax income that military personnel would have to be paid to raise their income after federal taxes by the amount of the tax expenditure. The outlay-equivalent estimate can be used to compare this tax expenditure with other outlays for defense compensation on a more consistent basis. The Congressional Budget and Impoundment Control Act of 1974 lists six types of tax expenditures: exclusions, exemptions, deductions, credits, preferential tax rates, and deferral of tax liability. Some tax expenditures apply only to individual taxpayers, such as deductions and exclusions for employer-provided contributions for medical insurance, and some only to corporate taxpayers, such as a tax credit for corporations doing business in U.S. possessions. Other tax expenditures, such as accelerated depreciation, apply both to corporations and to individual taxpayers with income from businesses such as sole proprietorships or partnerships. Table 1 shows examples of each type of tax expenditure and the taxpayer group that may claim a particular type. Figure 1 illustrates how tax expenditures appear on the U.S. Individual Income Tax Return (Form 1040). Exclusions are those items of income that would otherwise constitute a part of the taxpayer’s gross income, but are excluded under a specific provision of the tax code. Exclusions generally do not appear on the Form 1040, and excluded income is not reflected in total reported income. For example, the income tax exclusion of employer contributions to medical insurance premiums and medical care is not reported in a taxpayer’s wages or salaries. An exemption, such as the parent personal exemption for students over age 19 but under age 24, is a reduction in taxable income offered to taxpayers because of their status or circumstances. Deductions are adjustments from adjusted gross income. Deductions claimed before the adjusted gross income line on the Form 1040, such as the tuition and fees deduction (this appears on line 27 in fig. 1), are sometimes called “above-the-line” deductions. Taxpayers may also claim “below-the-line” deductions after the adjusted gross income line; to do so, taxpayers must itemize their deductions. Each type of tax expenditure creates tax savings in different ways and, consequently, reduces federal revenues in different ways. 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 the 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 the taxpayer’s marginal tax rate. A nonrefundable tax credit can be used to reduce current year tax liability to zero, and a refundable credit in excess of tax liability results in a cash refund. For preferential tax rates which reduce the tax rate on some forms of income such as capital gains, the tax savings depend on the difference between the preferential rate and a taxpayer’s marginal tax rate. By allowing taxpayers to reduce current tax liability by delaying recognition of some income or accelerating some deductions otherwise attributable to future years, a tax deferral shifts the timing of tax payments and, in effect, provides an interest-free “loan” to the taxpayer. The benefit from a deferral is even greater if the taxpayer expects to face a lower tax bracket in the future. A lower-income taxpayer—with no net annual income or with no current tax liability after claiming the standard deduction and any personal exemptions—would not directly benefit from most tax expenditures other than refundable credits. Some techniques have been used to limit the benefits that taxpayers may receive from individual tax expenditures or groups of them. Congress has controlled the amount of revenue forgone for some tax expenditures by adopting provisions to restrict taxpayers’ eligibility for benefits. For example, the mortgage interest deduction is limited to interest on debt up to $1 million to buy, build, or improve first and second homes and up to $100,000 in home equity debt. Aggregate itemized deductions are reduced by 3 percent of the amount of a taxpayer’s adjusted gross income that exceeds a certain threshold, eliminating 3 cents of itemized deductions for each dollar of income above the threshold for higher-income taxpayers. Some tax expenditures, such as tax-exempt private-activity bonds issued by each state, are subject to volume caps limiting the aggregate amount of benefits available. The alternative minimum tax (AMT) also affects tax expenditures and the amount of the revenue loss for the federal government. The AMT is intended to ensure that taxpayers with income over certain thresholds pay some income tax, no matter how much they claim in certain deductions and credits. Under the AMT, taxpayers may have to add back some tax expenditures that they could otherwise claim under the regular tax system, such as deductions for state and local taxes and home equity loan interest, and they may have to include as income certain tax-exempt bond interest that is excluded under the regular tax system. In addition to raising revenue, the federal income tax has long been used as a tool for accomplishing social and economic objectives. The general objectives of tax expenditures are to encourage particular types of activities (such as saving for retirement, promoting home ownership, investing in certain sectors, or funding research and development) and provide economic relief to selected groups of taxpayers (such as the elderly, the blind, and those with children). Another objective of tax expenditures may also be to adjust for differences in individuals’ ability to pay taxes. For example, if two taxpayers have the same income, but one has a catastrophic illness and costly medical bills (or large casualty and theft losses), the other taxpayer is judged better able to pay income taxes. Some tax expenditures may be enacted to compensate for other provisions of the tax code. For example, advocates of reduced tax rates on capital gains often explain the special treatment of capital gains income as offsetting, in part, the assessment of taxes on the nominal, rather than the real, value of capital gains. The rationale and reasons for a particular tax expenditure may change over time. For example, according to the Congressional Research Service (CRS), the income tax code instituted in 1913 contained a deduction for all interest paid. No distinction was made between business and personal interest expenses, although most interest payments at that time represented business expenses. The legislative history does not indicate that the deductibility of mortgage interest was originally intended to encourage home ownership or subsidize the housing industry. However, over time, encouraging home ownership, stimulating residential construction and maintenance, and encouraging families to save and invest in a major financial asset have all been offered as justifications for the mortgage interest deduction. The tax expenditure tool may substitute for a federal spending program in that the federal government “spends” some of its revenue on subsidies by forgoing taxation on some income. Certain activities may be cheaper and simpler to subsidize through the tax code than by setting up a separate program using a different tool. 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. The administrative infrastructure already exists for the government to collect and remit money to over 131 million individual tax filers and 6 million corporations via the tax system administered by the IRS. In concept, the costs to implement an income- based benefit program through the existing tax system could be lower than to set up separate spending programs to deliver these benefits. In some circumstances, tax expenditures may not be the best policy choice to deliver timely benefits or reach intended populations. For programs that seek to provide benefits within a given year, the annual income measure relevant for income tax purposes may not be the best way to target benefits. Relative to spending programs, tax expenditures are limited in their ability to directly provide benefits to nontaxpayers. For example, tax credits must be refundable to reach low-income individuals who do not pay taxes and otherwise would not be required to file tax returns. Tax expenditures generally do not deliver federal resources directly to state and local governments and tax-exempt nonprofit organizations. The charitable contribution deduction provides an incentive for individual and corporate taxpayers to donate to charitable, religious, educational, and health nonprofit organizations. The deduction, in effect, is a federal grant to the donor that reduces the out-of-pocket cost of giving. The itemized deduction for state and local taxes directly increases an individual taxpayer's after-tax income and thus reduces the after-tax price of state and local taxes. State and local governments receive some of the benefit to the extent that taxpayers may be more willing to pay state and local taxes. Tax expenditures are not necessarily an either/or alternative to federal spending and may be used in combination with federal spending and strategies to achieve national objectives. For example, the HOPE and Lifetime Learning tax credits are used with federal education assistance, such as student loans, all of which help individuals fund higher education. Many tax expenditures are comparable to entitlement programs for which spending is determined by rules for eligibility, benefit formulas, and other parameters rather than by Congress appropriating specific dollar amounts each year. With some exceptions, tax expenditures typically make funds (through reduced taxes) available to all qualified claimants, regardless of how many taxpayers claim the tax expenditures, how much they claim collectively, or how much federal revenue is reduced by these claims. Some tax expenditures resemble other policy tools, such as grants or direct loans. A few tax expenditures are administered like grant programs, allowing for some administrative discretion over who receives funds. For the New Markets Tax Credit (NMTC), those seeking the credit must apply to the Community Development Financial Institutions (CDFI) Fund within Treasury and be chosen by a group of evaluators to receive the tax credit. Like a grant program, the NMTC has a maximum amount that can be allocated by CDFI. Tax expenditures in the form of deferrals resemble loans, because they allow taxpayers to postpone the time when income is recognized for tax purposes or to accelerate the deduction of expenses, both of which effectively lower the amount of income currently subject to tax. Deferrals can result in higher taxes in later years when taxpayers recognize deferred income in later tax years or have fewer deductions to claim than they otherwise would have had; the amount of the deferral is, in effect, analogous to a government loan. Tax expenditures, by definition, reduce federal revenue and thus have implications for income tax rates, federal spending, and the federal budget. To obtain a given amount of revenue, tax expenditures require overall statutory tax rates to be higher. Otherwise, revenues forgone through tax expenditures reduce the revenue base available for funding federal spending programs. From a budgetary perspective, most tax expenditures are comparable to mandatory spending for entitlement programs, in that no further action is required to provide resources for tax expenditures. Tax expenditures do not compete overtly in the annual budget process and, in effect, receive a higher funding priority than discretionary spending subject to the annual appropriations process. Revenues forgone through tax expenditures—unless offset by increased taxes or lower spending— increase the unified budget deficit and federal borrowing from the public (or reduce the unified budget surplus available to reduce debt held by the public). As noted previously, both the executive and legislative branches—by Treasury and JCT, respectively—publish annual lists of tax expenditures and the associated revenue loss, but budgetary decisions generally are not based on these lists. Like any spending program, newly proposed tax expenditures and those subject to expiration, to some extent, are subject to scrutiny, but most tax expenditures are not subject to reauthorization. Tax expenditures may be indirectly controlled to the extent that the Congress aims to achieve any revenue target. The tax committees consider tradeoffs between tax expenditures, tax rates, and other parts of the tax code. In concept, eliminating or limiting an existing tax expenditure—like an existing spending program—would free up resources to reduce tax rates, increase federal spending or other tax expenditures, reduce the deficit, or produce some combination thereof. Conversely, adding a new tax expenditure, expanding an existing tax expenditure, or extending an expiring tax expenditure reduces the resources available to reduce tax rates, fund federal spending and tax expenditures, or reduce the deficit. The overall effect on the unified budget position would depend on the extent to which any change in tax expenditures is offset by adjustments to the tax code or other spending programs. Whether gauged in absolute numbers, by revenues forgone, or in comparison to federal spending or the size of the economy, tax expenditures have been substantial over the last three decades. Between fiscal years 1974 and 2004, tax expenditures doubled in number, and the sum of estimated revenue losses associated with tax expenditures tripled, most of which was accounted for by tax expenditures that were used by individual taxpayers. Since 1981 when outlay-equivalent estimates were first available, the sum of the outlay-equivalent estimates for tax expenditures has been similar in magnitude to discretionary spending, and this sum exceeded total discretionary spending for most years during the last decade. As a share of the U.S. economy, the sum of tax expenditure outlay-equivalent estimates remained relatively stable at about 7.5 percent of GDP since the last major tax reform legislation. Summing the individual tax expenditure estimates is useful for gauging the general magnitude of the federal revenue involved, but it does not take into account possible interactions between the individual tax code provisions. Because of this limitation, sums of tax expenditure estimates must be interpreted carefully. The JCT and Treasury estimate the revenue loss from each tax expenditure separately, assuming that the rest of the tax code remains unchanged. Neither JCT nor Treasury adds tax expenditure estimates, because summing them does not take into account possible interaction effects among the provisions. If two or more tax expenditures were estimated simultaneously, the total change in federal revenue could be smaller or larger than the sum of the amounts shown for each item separately as a result of interactions among the tax expenditure provisions. For example, the repeal of an itemized deduction tax expenditure might cause more taxpayers to take the standard deduction instead of itemizing. However, the revenue loss estimate for any single tax expenditure among the itemized deductions does not reflect this potentially sizeable interaction with the standard deduction. Eliminating several itemized deductions at the same time could cause significant numbers of taxpayers to take the standard deduction, and thus, the decrease in revenue could be less than the sum of the estimated revenue loss estimates for each itemized deduction. To demonstrate the magnitude of possible interactions and the potential implications for summing tax expenditures, Treasury’s Office of Tax Analysis illustrated for us the repeal of five itemized deductions. Based on tax year 2002 data, the sum of the five separate tax expenditure estimates, each calculated assuming the rest of the tax code was unchanged, was over $175 billion. Assuming the simultaneous repeal of all five provisions, Treasury estimated the revenue loss after interaction totaled $131 billion—about 25 percent less than the sum of the separate estimates. According to Treasury, this example cannot be generalized given that some groups of tax provisions have substantial interactions and others do not. For all tax expenditures, the magnitude of the difference between the sum of the estimates and an estimate for all tax expenditures simultaneously is not known. Additionally, tax expenditure estimates developed by Treasury and JCT do not take into account possible behavioral responses by taxpayers if a tax expenditure were repealed. For example, if the HOPE scholarship tax credit—a tax credit for the first 2 years of post-secondary education—were eliminated, taxpayers who would have used that tax credit may instead opt for the Lifetime Learning tax credit or other tax subsidies aimed at higher education. In contrast, certain kinds of behavioral responses, such as changes in the timing of transactions, income recognition, or shifts between sectors of the economy, are taken into account when JCT and Treasury prepare revenue estimates for proposed legislation. Potential macroeconomic effects, such as changes to GDP, are not reflected in tax expenditure revenue loss estimates or in revenue estimates for proposed legislation. To some extent, the same kinds of challenges in interpreting tax expenditure estimates also exist in projecting the costs of spending programs. Budget line items generally do not reflect the actual budget savings to be gained by abolishing specific programs or groups of programs. For instance, eliminating all veterans’ benefits would reduce the federal budget by less than the amount currently spent on those programs because spending likely would increase in food stamps, Medicaid, and other entitlement programs. Although interaction effects also occur for spending programs, Treasury officials responsible for developing tax expenditure estimates told us that the bias in summing tax expenditure revenue loss estimates likely is greater than the bias for outlay projections. Whereas historical data are reported for federal budget receipts and outlays, the last available values for tax expenditures remain estimates. Treasury’s last reported re-estimates for past fiscal years reflect legislation enacted, prevailing economic conditions, and the latest taxpayer data available at the time of estimation. Projections of the future costs of tax expenditures are more uncertain than projections for future tax receipts or outlays because it is not known with certainty, even after the fact, how much was spent for any given tax expenditure. Despite the limitations in summing separate tax expenditure revenue loss and outlay-equivalent estimates, these are the best available data to measure the value of tax expenditures and make comparisons to other spending programs. Summing the estimates provides perspective on the use of tax expenditures as a policy tool and represents a useful gauge of the general magnitude of government subsidies carried out through the tax code. The estimates also can be used to compare tax expenditures to federal spending overall and by budget function. Other researchers also have summed tax expenditure estimates to help gain perspective on the use of this policy tool and examine trends in the aggregate growth of tax expenditure estimates over time. Between 1974 and 2004, tax expenditures reported by Treasury more than doubled in overall number from 67 to 146, and while some were dropped, considerably more were added. For 1974, Treasury listed 67 separate exclusions, exemptions, deductions, credits, preferential tax rates, and deferral of tax liability as tax expenditures. In 1986, Treasury reported 115 tax expenditures, and by 2004 Treasury’s list grew to 146 tax expenditures. Figure 2 shows the rise of the overall number of tax expenditures over the last three decades. (App. IV contains a compilation of all tax expenditures reported by Treasury between 1974 and 2004.) Of the 146 tax expenditures listed by Treasury in the President’s fiscal year 2006 budget, 32 percent were on the first list in 1974, 23 percent were added between 1975 and 1986, and 45 percent were added since 1986. Figure 3 shows the duration of tax expenditures listed by Treasury. Of the 67 tax expenditures listed in 1974, 21 had been dropped over the period, leaving 46 remaining on the list in 2004. Since 1974, 143 tax expenditures were added to Treasury’s list, although 43 of them have since dropped from the list over the period. Of the 100 added since 1974 and still reported in fiscal year 2004, 66 were first reported for 1986 or later. The number of tax expenditures reported by Treasury has changed over time for several reasons. Some provisions expired or were repealed; others were merged with another tax expenditure. For example, until expiration on December 31, 1984, state and local governments were allowed to issue tax-exempt obligations to finance the purchase of mass-commuting vehicles for lease to government transit agencies; the Tax Reform Act of 1986 repealed the investment tax credit; and the tax expenditure that provided 5-year amortization for pollution control was merged into the investment tax credit by the Tax Reform Act of 1976. Legislation also added new tax expenditures over time, such as the child tax credit created by the Taxpayer Relief Act of 1997. Some tax expenditures split into additional listings to reflect legislation expanding existing tax expenditures. For example, Treasury began listing the net exclusion of pension contributions and earnings with separate estimates for employer- sponsored defined-benefit and 401(k) pension plans following 2001 legislation increasing the contribution limits for 401(k) accounts. Finally, changes in the baseline used by Treasury to identify tax expenditures may have caused some tax expenditures to drop off its list, while adding new tax expenditure listings. For example, Treasury briefly dropped the exclusion of scholarship and fellowship income from its fiscal year 1982 list because it was not considered a tax expenditure under the baseline that Treasury used that year. As the overall number reported by Treasury doubled, the sum of the estimated revenue loss due to tax expenditures, adjusted for inflation, tripled from approximately $243 billion for 1974 to $728 billion for 2004. Figure 4 shows the sum of Treasury’s revenue loss estimates over the past three decades. From 1974 to 1986, revenue losses increased by nearly two and one-half times from approximately $243 billion for 1974 to $598 billion for 1986 (in 2004 dollars). Over the next 2 years, the sum of the revenue losses decreased by about 28 percent to approximately $433 billion for 1988. From 1989 through 1997, however, revenue losses increased by approximately 16 percent to approximately $547 billion. From 1998 to 2002, the sum of the estimated revenue loss increased by an average of about $41 billion per year, peaking at about $783 billion for 2002. The sum of the revenue loss estimates declined to approximately $728 billion in 2004. The revenue loss estimates do not reflect the outlays for the refundable portion for certain tax credits. Summing these outlays along with the sum of the revenue loss estimates provides a more complete picture of the aggregate cost of tax expenditures throughout the period, as shown in figure 5. The sum of the estimated revenue losses and outlays associated with tax expenditures totaled about $770 billion for fiscal year 2004. Trends in the sum of tax expenditures are due, at least in part, to legislation affecting the number or scope of tax expenditures or modifying tax rates or other basic structural features of the tax code. During this period, tax legislation directly influenced the sum of tax expenditure estimates by repealing or limiting some tax expenditures, enacting new ones, and extending the life of expiring tax expenditures. Even without changes to tax expenditures, legislation affecting tax rates or the tax structure affects the sum of the tax expenditure estimates. When a taxpayer uses a tax expenditure, his or her effective tax rate is reduced, because some part of his or her income remains untaxed or is taxed at a lower rate. When statutory rates increase, a taxpayer’s ability to avoid tax on a portion of income is worth more; consequently, tax expenditures are worth more. Likewise, when rates decrease, tax expenditures are worth relatively less. Figure 6 highlights tax legislation enacted since 1974 that likely influenced the aggregate revenue losses due to tax expenditures. The sum of estimated revenue losses declined following the Tax Reform Act of 1986, primarily because of individual and corporate marginal tax rate reductions which indirectly scaled back the value of all but a few tax credits. The 1986 act, which created the last major tax reform, also eliminated or limited the scope of various tax expenditures directly, for example, by repealing the investment tax credit, phasing out the interest deduction for consumer credit over 5 years, and limiting the expensing of the intangible drilling costs for oil and gas to successful, domestic wells. While materially reducing the number and scope of tax expenditures broadened the tax base, the act resulted in no net change in federal revenue because of the lower tax rates. In contrast, the sum of estimated revenue losses increased following the Omnibus Budget Reconciliation Act of 1993, which directly increased several tax expenditures—for example, extending the EITC to single workers with no children earning $9,000 or less—and indirectly increased the value of other tax expenditures by increasing the top individual income tax rates and adding a third rate. The sum of estimated revenue losses accelerated following the Taxpayer Relief Act of 1997, which expanded several tax expenditures—for example, increasing eligibility for traditional individual retirement accounts—and created an assortment of new tax expenditures, including the child tax credit and postsecondary education tax incentives. The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced tax rates again and also increased the individual AMT exemption. The influence on the aggregate trend is less apparent for legislation expanding or adding tax expenditures while also reducing tax rates. Changes in economic conditions and in the baseline tax system can also affect revenue loss estimates for tax expenditures, making them differ from year to year. For example, rising housing prices may cause the estimated cost of the mortgage interest deduction to increase as homeowners finance larger mortgages or take out equity with home equity loans. In addition, changes in tax expenditure baselines could also cause estimates to differ from year to year. For example, for fiscal years 2003 and 2004, Treasury redefined accelerated depreciation tax expenditures so that they are calculated relative to a replacement cost basis baseline rather than the historic cost basis previously used. This redefinition had the effect of reducing the estimated size of the accelerated depreciation tax expenditures. The sum of estimated revenue losses due to tax expenditures for individual income taxpayers accounted for substantially more of the revenue loss between 1974 and 2004 than corporate tax expenditures, as shown in figure 7. The sum of revenue loss estimates for tax expenditures that arise under the individual income tax increased from approximately $187 billion for 1974 to $487 billion for 1987 (in 2004 dollars). After decreasing to approximately $363 billion for 1988, the sum gradually increased to a high of approximately $688 billion for 2002 and then declined in 2003 and 2004. On average over the entire period, revenue loss estimates for individual income taxpayers accounted for about 83 percent of the sum of revenue loss estimates per year. While estimated revenue losses for all tax expenditures tripled, the sum of revenue loss estimates for corporate tax expenditures increased from approximately $57 billion for fiscal year 1974 to a high of about $116 billion in 1984 (in 2004 dollars). After 1984, the sum dropped back to approximately $57 billion in 1992 and increased slightly over the rest of the period, with some fluctuation between years. In 2004, revenue loss estimates for tax expenditures that arise under the corporate income tax accounted for 11 percent of the sum of revenue losses due to all tax expenditures. At about 10 percent of total federal receipts, corporate income taxes also accounted for a smaller share than individual income taxes. The sum of revenue loss estimates due to individual income tax expenditures is primarily attributable to a small number of large tax expenditures. The fourteen tax expenditures listed in table 2—each with an annual revenue loss estimated at $20 billion or more—accounted for about 75 percent of the sum of revenue losses for fiscal year 2004. Ten of the 14 largest tax expenditures focused entirely on individual taxpayers, and the other 4 were available for individuals and corporations. Most of the largest tax expenditures are long-standing ones, and only 2 of the 14 were added to the tax code since 1986. The child tax credit, enacted in 1997, is among the largest tax expenditures based on its estimated revenue losses alone, not counting associated outlays of $8.9 billion in fiscal year 2004. With revenue losses estimated at $4.9 billion, the EITC does not appear on this list; if $33.1 billion in associated outlays were included, this refundable credit ranks among the largest tax expenditures. Tax expenditure revenue loss estimates reflect federal income tax revenue forgone and do not account for provisions that exclude certain earnings from payroll taxes. For example, the income tax exclusion for health care not only permits the value of health insurance premiums to be excluded from the calculation of employees’ taxable earnings for income taxes but also excludes the value of the premiums from the calculation of Social Security and Medicare payroll taxes for both employees and employers. Some researchers have estimated that these payroll tax revenue losses amount to more than half of the income tax revenue losses. If payroll tax revenue losses were 50 percent of the $102.3 billion in income tax revenue loss estimated by Treasury, the combined revenue loss associated with the exclusion of employer contributions for health insurance premiums would be $153.5 billion in 2004. The sum of tax expenditure outlay-equivalent estimates exceeded the amount of discretionary spending for most years during the last decade, as shown in figure 8. Outlay-equivalent estimates, introduced by Treasury in 1981, allow the value of a tax expenditure to be compared with a direct federal outlay. The sum of the outlay-equivalent estimates reported by Treasury was approximately $853 billion in 2004. Until 1987, the sum of outlay-equivalent estimates for tax expenditures was roughly the same magnitude as discretionary spending. From 1988 through 1995, the sum of tax expenditure outlay-equivalent estimates averaged about $104 billion (in 2004 dollars) less than annual discretionary spending. Beginning in 1996, the sum of tax expenditure outlay-equivalent estimates surpassed discretionary spending and averaged about $114 billion (in 2004 dollars) more than annual discretionary spending through 2003. However, in 2003, the sum of Treasury’s tax expenditure estimates declined markedly, and the sum of tax expenditure outlays fell below discretionary spending in fiscal year 2004. This decline may be due, at least in part, to changes in the way Treasury defined and measured several tax expenditures in these years. Just as the sum of tax expenditure outlay-equivalent estimates increased since the late 1990s, discretionary spending also increased over this period. Between 1996 and 2002, the sum of tax expenditure estimates increased by an average of approximately $46 billion annually, while discretionary spending increased by an average of $21 billion annually (in 2004 dollars). Mandatory spending—larger than the sum of tax expenditure estimates or discretionary spending—consistently rose over the period shown by an average of $43 billion annually (in 2004 dollars). Figure 9 compares tax expenditures and federal outlays as a share of GDP as a way to measure the amount of federal spending through the tax code and other programs relative to the economy. As a share of the U.S. economy, the sum of tax expenditure outlay-equivalent estimates peaked at 10.9 percent of GDP in 1986. Since 1988, the sum of tax expenditure outlays has remained relatively stable at about 7.5 percent of GDP. Over the period shown, mandatory spending also was fairly constant as a share of the economy, at an average of 12.7 percent of GDP. As a share of the economy, discretionary spending declined from 10.1 percent of GDP in 1981 to 6.3 percent in 1999 and 2000, with some fluctuation between the years. In recent years, discretionary spending has grown faster than the economy, increasing to 7.8 percent of GDP in fiscal year 2004. Averaging about 18.0 percent of GDP in the 1980s through the early 1990s, federal receipts steadily rose to 20.9 percent of GDP in 2000 and since declined to 16.3 percent of GDP in fiscal year 2004. With total federal outlays— including mandatory and discretionary spending plus net interest— reaching 19.9 percent of GDP, the federal unified budget deficit amounted to 3.6 percent of GDP ($412 billion) in fiscal year 2004. The on-budget deficit in fiscal year 2004 amounted to 4.9 percent of GDP ($567 billion). Tax expenditures span almost all federal mission areas, but their relative size differs across budget functions. To gauge the relative role of tax expenditures, the sum of tax expenditure outlay-equivalent estimates and federal outlays can be compared to total spending by budget function. For 2004, Treasury reported tax expenditures for 16 of 20 budget functions. Five of the functions accounted for 91 percent of the sum of the tax expenditure outlay-equivalent estimated dollar amounts in 2004— commerce and housing credit; education, training, employment and social services; income security; health; and general government, as shown in figure 10. (See app. III for a list of tax expenditures reported for 2004 by budget function.) For the most part, these same five budget functions accounted for the largest percentage of total outlay-equivalent estimates over time, although the relative size of the estimated outlay-equivalent dollar amounts for the five budget functions varied somewhat over the period shown. For example, the health and the education, training, employment and social services budget functions more than doubled between 1986 and 2002 (in 2004 dollars). The sum of the tax expenditure outlay-equivalent estimates was greater than what the federal government spends in discretionary and mandatory spending for some budget functions. As shown in figure 11, the sum of the tax expenditure outlay-equivalent estimates exceeded federal outlays for three budget functions: energy, commerce and housing credit, and general government. Outlay-equivalent estimates for tax expenditures in the commerce and housing credit budget function totaled $300 billion for 2004, while budget outlays for that function totaled $5 billion. Seven of the 14 largest tax expenditures, listed in table 2 with revenue losses exceeding $20 billion in 2004, were reported under the commerce and housing credit budget function. The mortgage interest deduction—the second largest single tax expenditure in fiscal year 2004—had an outlay- equivalent estimate of $61.5 billion, compared to $45 billion in outlays for the Department of Housing and Urban Development, which is responsible for, among other things, mortgage credit and housing assistance programs. Various tax expenditures for accelerated depreciation and capital gains listed under the commerce and housing credit budget function also provide incentives for a wide range of different investments that can affect other federal mission areas. The general government budget function included two of the largest tax expenditures—the deduction of state and local income and sales tax, and the exclusion of interest on public purpose state and local bonds—which together accounted for about $71.5 billion in tax expenditures outlays. As figure 11 shows, the sum of outlay-equivalent estimates for tax expenditures was nearly the same magnitude as outlays in two budget functions: international affairs and education, training, employment, and social services. Within the education, training, employment, and social services budget function, the sum of outlay-equivalent estimates of the tax expenditures represented 49 percent of the total federal support. This budget function includes two of the largest tax expenditures—the child tax credit and charitable contributions other than for health. The sum of the outlay-equivalent estimates for tax expenditures was substantially less than total outlays in the health and income security budget functions. The income tax exclusion for employer-provided health care—the largest single tax expenditure—accounted for 12 percent of the sum of tax expenditure outlay-equivalent estimates and represented about 27 percent of total federal support in the health function, which includes Medicaid. Outlays in the income security function include mandatory outlays refunded under the EITC and child tax credit. No tax expenditures are reported by Treasury for two budget functions: administration of justice and Medicare. Although tax expenditures represent a substantial federal commitment of resources, little progress has been made in the Executive Branch to increase the transparency of and accountability for tax expenditures. The entire set of tools the federal government can use to address national objectives—including discretionary and mandatory spending, tax provisions, loans and loan guarantees—should be subject to periodic reviews and reexamination to ensure that they are achieving their intended purposes and designed in the most efficient and effective manner. The nation’s current and projected fiscal imbalance provides an additional impetus for engaging in such a review and reassessment. Tax expenditures may not always be efficient, effective, or equitable, and consequently, information on these attributes can help policymakers make more informed decisions as they adapt current policies in light of our fiscal challenges and other overarching trends. In addition, some tax expenditures, at least as currently designed, may serve to exacerbate other key private sector and public policy challenges (e.g., controlling health care costs). To review tax expenditures, information is needed to assess economic efficiency, effectiveness, distributional equity, and administration and compliance costs, although data and methodological challenges may impede studies of some tax expenditures. Over the past decade, the Executive Branch made little progress to integrate tax expenditures in the budget presentation and review processes that apply to spending programs, as we recommended in 1994. Simply put, our nation’s fiscal policy is on an unsustainable course. Long- term simulations by GAO, the Congressional Budget Office (CBO), and others show that over the long term we face large, escalating, and persistent deficits due primarily to known demographic trends and rising health care costs. This unsustainable fiscal path will gradually erode the nation’s economy and increasingly constrain the federal government’s capacity to address emerging challenges and opportunities. The long-term fiscal challenge is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies, including tax expenditures. In addition, the long-term fiscal challenge makes it all the more important to ensure all major federal spending and tax programs and policies—including tax expenditures—are efficient, effective, and relevant. The revenues forgone through tax expenditures either reduce resources available to fund other federal activities or require higher tax rates to raise a given amount of revenue. Our long-term simulations illustrate the magnitude of fiscal challenges we will face in the future. Figures 12 and 13 present these simulations under two different sets of assumptions. In figure 12, we begin with CBO’s August 2005 baseline—constructed according to the statutory requirements for that baseline. Consistent with these requirements, this simulation assumes that discretionary spending grows with inflation for the first 10 years, and that tax cuts which are currently scheduled to expire will expire. After 2015, discretionary spending is assumed to grow with the economy, and revenue is held constant as a share of GDP at the 2015 level. In figure 13, only two assumptions are changed: (1) discretionary spending is assumed to grow with the economy rather than merely with inflation for the entire period (not just after 2015), and (2) all tax cuts which are currently scheduled to expire are made permanent. For both simulations, Social Security and Medicare spending is based on the 2005 Trustees’ intermediate projections, and we assume that benefits continue to be paid in full after the trust funds are exhausted. Medicaid spending is based on CBO’s December 2003 long-term projections under mid-range assumptions. Both of these simulations illustrate that, absent policy changes on the spending or revenue side of the budget, the growth in federal retirement and health entitlements will encumber an escalating share of the government’s resources. Indeed, when we assume that recent tax reductions are made permanent and discretionary spending keeps pace with the economy, our long-term simulations suggest that by 2040 federal revenue may be adequate to pay little more than interest on the federal debt. Neither slowing the growth in discretionary spending nor allowing the tax provisions to expire—nor both combined—would eliminate the imbalance. Although revenues will be part of the debate about our fiscal future, making no changes to Social Security, Medicare, Medicaid, and other drivers of the long-term fiscal gap would require at least a doubling of federal taxes in the future and that seems both unrealistic and inappropriate. Accordingly, substantive reform of Social Security and the major health programs remains critical to recapturing our fiscal flexibility. While Social Security and Medicare dominate the long-term outlook, they are not the only federal programs or activities that bind the future. The federal government undertakes a wide range of programs, responsibilities, and activities that may explicitly or implicitly expose it to future spending. These “fiscal exposures” range from explicit liabilities, such as environmental cleanup and disposal, to the implicit promises embedded in current policy or public expectations, such as assistance following a major disaster. Policymakers may benefit from a better understanding of the long-term costs of decisions when they are made. For large and significant spending programs and tax provisions, consideration of estimates of present values for the long-term commitments implied could facilitate analysis and decisionmaking. While the fiscal exposure concept focuses only on items that may expose the government to future spending, some new or existing tax expenditures may have uncertain or accelerating future growth paths with long-term implications. These would need to be considered concurrently with long-term spending exposures in addressing long-term fiscal sustainability. Confronting the nation’s fiscal challenge will require a fundamental reexamination and reprioritization of the entire set of tools the federal government can use to address national objectives, including major spending and tax policies and programs. To effectively respond to social, economic, and security changes and challenges emerging in the 21st century, the federal government cannot accept what it does, how it does it, who does it, and how it is financed as “givens.” To assist Congress in reexamining the base of government, we issued a report that provides examples of the kinds of difficult choices the nation faces with regard to discretionary spending; mandatory spending, including entitlements; as well as tax policies and compliance activities. The tax policies and programs financing the federal budget can be reviewed with an eye toward the overall level of revenue needed to fund federal operations and commitments, the mix of taxes that should be used, and the extent to which the tax code is being used to promote certain societal objectives. Some tax expenditures may not always be efficient, effective, or equitable, and consequently, information on these attributes can help policymakers make more informed decisions as they adapt current policies in light of our fiscal challenges and other overarching trends. Periodic reviews of tax expenditures could help to establish whether these programs are relevant to today’s needs; if so, how well tax expenditures have worked to achieve their objectives; and whether the benefits from particular tax expenditures are greater than their costs. To measure benefits and costs, information is needed concerning their effects on economic efficiency, effectiveness, distributional equity, and administration and compliance costs. To the extent that periodic reviews show that specific tax expenditures are not effective, efficient, or equitable, those tax expenditures might be eliminated or redesigned, perhaps at a lower cost in revenue forgone. Coordinated reviews of tax expenditures with related federal spending programs could assess the relationships and interactions of programs within similar mission areas and identify which strategies are effective. Policymakers could use such evaluations to reduce overlap and inconsistencies and direct scarce resources to the most effective or least costly methods to deliver federal support. Tax expenditures, if well designed and effectively implemented, can be an effective tool and appropriate to further some federal goals and objectives. For those activities that merit a subsidy (where too little of the activity would otherwise be undertaken), subsidies through the tax code are one option. For example, a tax expenditure for medical insurance would improve economic efficiency if, absent a subsidy, too few workers would purchase insurance and the tax expenditure encouraged workers to insure in a cost-effective manner. Because the benefits from research may not fully accrue to the firms that bear the costs of research, a tax expenditure aimed at spurring private-sector investment in research and development may be an appropriate response assuming it stimulates additional research whose benefits exceed the social costs associated with the forgone revenues. However, studies we and others have done raise concerns about the efficiency, effectiveness, or equity of some tax expenditures and about how tax expenditures relate to other federal activities aimed at the same mission area. While tax expenditures may be intended to improve economic efficiency, poor targeting or design may introduce additional economic inefficiencies. For example, the income tax exclusion of employer-paid health insurance premiums, by shifting a portion of the costs to all taxpayers, reduces the after-tax cost of insurance for the beneficiary. The income tax exclusion is credited with increasing health care coverage for employees, and the risk pooling under group health insurance generally allows employees to obtain insurance at lower costs than in the individual insurance market. However, this tax benefit also leads people to obtain more coverage than they would otherwise and increases the demand for health care by enabling those insured to obtain services at discounted prices. Some researchers believe that the unlimited availability of the exclusion for employer-provided health insurance has led to excessive use of health care services, which, in turn, has helped to drive up health care prices faster than the overall price level. Capping the exclusion at the average premium cost has been suggested as one option to improve the economic efficiency of this tax expenditure and reduce the associated revenue loss; another option suggested is replacing the tax exclusion with a tax credit to improve equity since the tax savings per dollar of premium would be the same for all taxpayers. In another example, the mortgage interest deduction encourages home ownership by lowering the costs of borrowing for taxpayers who itemize their deductions. However, by doing so, the deduction encourages households to invest more in housing and less in other assets that might contribute more to the nation’s productivity and economic capacity. According to CBO’s Budget Options, limiting the deductibility of interest to $500,000 of mortgage debt might still provide taxpayers with a sizable incentive to become homeowners and could boost investment in businesses and education. Tax expenditures may not be an effective way to achieve federal goals if targeting them to entities or activities meant to receive the benefits is difficult, if they subsidize activities that would have been undertaken without their stimulus, or if they serve to exacerbate other key private sector and public policy challenges. For example, the income tax exclusion of employer-paid health insurance premiums reduces the after-tax cost of insurance for the beneficiary. However, the exclusion offers no benefit to workers whose employers do not offer health benefits or who purchase their own insurance. Further, this tax benefit also leads people to obtain more comprehensive coverage than they would otherwise and could increase the demand for health care to the extent that it shields those insured from the full costs of health care, complicating efforts to moderate health care spending. The exclusion also tends to favor higher-income workers more likely to have employer- sponsored coverage. In another example, individual retirement accounts (IRAs) also receive preferential tax treatment with $7.5 billion in estimated revenue losses in fiscal year 2004. Contributions may be tax-deductible depending on the IRA type, and earnings generally are not taxable until distribution and not taxable at all in some cases. Although the tax benefits indeed seem to encourage individuals to contribute to these kinds of accounts, the amounts contributed may not be totally new saving. Some contributions may represent amounts that would have occurred without the tax incentives or amounts shifted from taxable assets or financed by borrowing. In a 1996 symposium examining universal deductible IRAs available in the early 1980s, researchers reached three widely divergent conclusions: (1) yes, most contributions represented new saving, (2) no, most IRAs contributions were not new saving; and (3) maybe, about 26 cents of each dollar contributed may have represented new saving. More recent research examining the universal IRA experience estimated that at most 9 cents of each dollar contributed represented new saving. Since 1986, Congress has restricted IRA eligibility for higher-income taxpayers and increased the contribution limits, and the overall effect of IRAs on personal saving remains subject to considerable debate. Although tax expenditures, by design, result in individuals with similar incomes and expenses paying differing amounts of tax depending on whether they engage in tax-subsidized activities, tax expenditures still may raise equity concerns. Some tax expenditures benefit mainly upper- income taxpayers because they are most likely to itemize and because the value of tax expenditures is generally greatest for those in higher tax brackets. Tax expenditures also can contribute to mission fragmentation and program overlap, and this, in turn, creates the potential for duplication and service gaps. Though sometimes necessary to meet federal priorities, mission fragmentation and program overlap can create an environment in which programs do not serve participants as efficiently and effectively as possible. Like spending programs, tax expenditures may reduce government effectiveness to the extent that they duplicate or interfere with other federal programs. For example, in the higher education mission area, the federal government helps students and families save and pay for the costs of postsecondary education through tax expenditures and longer- standing federal financial aid programs, consisting of grants, loans, and work-study income. Since the 1990s, the federal government has offered multiple tax incentives to help families pay for post-secondary education, including the nonrefundable Lifetime Learning and HOPE tax credits, deductions for qualifying post-secondary expenses and interest on student loans, and two tax-preferred ways to save for future education expenses. The tax-preferred saving vehicles interact with the traditional federal aid system and can affect the net federal assistance received. Further, some tax filers do not appear to make the most effective use of certain education- related tax incentives, and we have found that some people who appear eligible for the tuition deduction and/or the tax credits did not claim them. One reason may be that the differing income phaseouts and interactions among the tax credits and deductions are difficult for taxpayers to understand; CBO, JCT, IRS’s National Taxpayer Advocate, Treasury, and others have suggested ways to consolidate the education tax credits and deductions. Others have also questioned the efficiency, effectiveness, and equity of other tax expenditures and suggested ways to design and better target specific provisions. In December 2004, the IRS National Taxpayer Advocate designated the complexity of the Internal Revenue Code, including the complexity of reporting requirements related to tax expenditures, as the most serious problem facing taxpayers and the IRS. The IRS National Taxpayer Advocate also recommended consolidating the various types of retirement saving vehicles and creating uniform rules regarding early withdrawals, plan loans, and portability. In its January 2005 report to the Senate Finance Committee, JCT staff presented various options to improve tax compliance and reform tax expenditures. Options include repealing some tax expenditures and restructuring others to simplify the law or achieve the intended purpose in a more fair or efficient way. In its February 2005 budget options compendium prepared for the House and Senate Budget Committees, CBO listed several options to eliminate or restructure tax expenditures. Options include further limiting the tax benefit of itemized deductions to the 15 percent rate for higher-bracket taxpayers and capping itemized deductions for state and local taxes and charitable contributions to the amount exceeding 2 percent of adjusted gross income. Finally, in December 2004 for the Senate Budget Committee, CRS updated its biennial compendium on tax expenditures. This volume includes for each tax expenditure: JCT’s revenue loss estimate, the legal authorization, a description of the tax provision, its impact including distribution of benefits when available, the rationale at the time of adoption, assessment summarizing the arguments for and against the provision, citations to relevant research. According to CRS, congressional budget decisions will take into account the full spectrum of federal programs only when tax expenditures are considered in conjunction with direct spending programs. Inadequate or missing data and difficulties in quantifying the benefits of some tax expenditures can impede studies of their efficiency, effectiveness, and equity. A key challenge is that data necessary to assess how often a tax expenditure is used and by whom generally would not be collected on tax returns unless IRS needs the information to know the correct amount of taxes owed or is legislatively mandated to collect or report the information. For example, tax exclusions—including those for employer- provided health insurance and pensions which are among the largest tax expenditures—generally are not reported on individual taxpayers’ returns. 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. For example: In our 2002 report on three tax expenditures meant to encourage employment of the disabled among other economically disadvantaged workers, we could not determine the amounts used to hire, retain, and accommodate workers with disabilities. We found that information on the work opportunity and disabled access credits was not available from tax data because tax returns provided only the total amount of credits reported, and employers could claim the work opportunity credit for employing other types of workers and claim the disabled access credit for expenditures made to accommodate customers with disabilities. Also, information regarding use of the barrier removal deduction for providing transportation or architectural accommodations was not available in IRS databases. As we reported in 2003, for one of the seven Liberty Zone tax benefits, the business employee credit, IRS was in the process of collecting but was not planning to report information about the number of taxpayers claiming the credit and the amount of credit claimed. IRS was also not planning to collect or report information about the use of the other six benefits, and taxpayers do not report these benefits as separate items on the existing returns. For example, taxpayers added the amount of depreciation they are allowed under the Liberty Zone special depreciation allowance benefit to other depreciation expenses and report their total depreciation expenses on their returns. IRS officials said that they do not need information on each specific benefit claimed to properly target their enforcement efforts. Further, IRS’s financial management system does not currently have cost accounting capabilities. As a result, comparisons of the costs of administering existing or proposed tax expenditures with similar administrative costs for spending programs may be impossible. Regarding taxpayer compliance costs, although IRS is working to develop improved estimates of taxpayer compliance burden, it is not yet clear whether this modeling effort will provide estimates of additional compliance costs that may result from particular tax expenditures. According to IRS officials, IRS seeks to collect information necessary to determine whether taxpayers have accurately reported their income and calculated the correct amount of tax liability. By focusing on information essential to administering the tax code, IRS aims to ensure that taxpayers are not burdened unnecessarily by record keeping and reporting, and IRS can minimize its own administrative costs for data collection and processing. For tax expenditures recorded on particular lines on tax forms, such as deductions and credits for individual taxpayers, data on the use of these tax expenditures are available. IRS Statistics of Income Division publications detail the number of individual tax returns on which taxpayers claimed each deduction or credit, the total amounts claimed, and the distribution of claims among taxpayers by income level. 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. For example: Limited data are available on the prevalence and use of business-owned life insurance, and GAO has reported that more comprehensive data could be useful in assessing the tax-favored treatment of this investment. Data on the amount of tax-free income that businesses received from death benefits could help explain the potential effect of changes to the tax treatment of policies on tax revenues. Businesses holding the policies or insurance companies that sold them could provide this and other data. Several agencies, including Treasury and the Securities and Exchange Commission, already collect some financial information from businesses and insurers and could be tasked to collect additional data for tax policy purposes. In the higher education area, the Department of Education (Education) is unable to analyze the use of higher education tax credits or their effects because it lacks access to individual taxpayer data needed to identify users of the credits. Treasury has access to taxpayer data but has not used these data for evaluating the education tax credits since their implementation in 1998. In 2002, GAO recommended that Education and Treasury collaborate in studying the impact of tax credits and student aid programs on postsecondary attendance, choice, completion, and costs. A key first step would be identifying opportunities for, and limits to, data sharing and develop a plan to address data needs, but little action has been taken. In the case of the empowerment zone, enterprise community, and renewal community programs, the lack of tax benefit data limits the ability of the Department of Housing and Urban Development (HUD) and the Department of Agriculture (USDA) to administer and evaluate the overall programs. We recommended that HUD, USDA, and IRS collaborate to (1) identify the data needed to assess the use of the tax benefits and the various means of collecting such data; (2) determine the cost-effectiveness of collecting these data, including the potential impact on taxpayers and other program participants; (3) document the findings of their analysis; and, if necessary, (4) seek the authority to collect the data, if a cost-effective means is available. When data on the cost and use of tax expenditures are available or can be reasonably estimated and other relevant data are available, economic analysis can be useful in evaluating whether a tax expenditure is efficient, effective, or equitable. Econometric modeling analysis can estimate how a tax expenditure affects the prices and quantities of targeted goods and services and determine how taxpayers’ incomes are affected. Although isolating and quantifying the outcomes associated with tax expenditures is challenging—just as it is for spending programs, research results are useful in demonstrating how particular tax expenditures work or providing insight on ways to refine their design. For example, research has generally shown that the EITC effectively increases recipients’ participation in the labor force, particularly for single parents, and lifts millions of recipients out of poverty. Some tax expenditures are enacted on a temporary basis, specifically to provide an opportunity for evaluating their effects before they are extended. For example, the research tax credit, enacted on a temporary basis in 1981 and extended 11 times as of 2004, was substantially modified in 1989 after researchers showed the original credit formula undercut the incentive it was intended to provide to undertake additional research spending. In some cases, economic research has not yielded definitive results or was limited by data and methodological issues. For example, although the various tax expenditures aimed at encouraging saving for, among other things, retirement, education, and health care have resulted in substantial sums being placed in these tax preferred accounts, economists disagree about whether tax incentives, such as for IRAs, are effective in increasing the overall level of personal saving. In the case of the research credit, GAO reported in 1996 that studies done at that time provided mixed evidence on the amount of spending stimulated and used publicly available data that were not a suitable proxy for tax return data. To fully assess the value to society of the research tax credit, researchers need to look at more than just the amount of spending stimulated per dollar of revenue cost. Comparisons should include (1) the total benefits gained by society from research stimulated by the credit and (2) the estimated costs to society resulting from the collection of taxes required to fund the credit. The social benefits of the research conducted by individual companies include any new products, productivity increases, or cost reductions that benefit other companies and consumers throughout the economy. Although most economists agree that research spending can generate social benefits, the effects of the research on other companies and consumers are difficult to measure. Ultimately, evaluation results could be used to identify how well tax expenditures are working, to both identify ways to better manage individual tax expenditures and decide how best to ensure prudent stewardship of taxpayers’ resources. Whether in time of deficit or surplus, reexamining both the spending and tax sides of the budget is essential to ensure the reasonableness, relevancy, and sustainability of existing programs and position the nation for the future. In the case of the EITC, Treasury and IRS are using evaluation results to identify ways of reducing erroneous claims, while maintaining participation among eligible claimants and minimizing taxpayer and IRS’s administrative burden. Additional evaluations of other tax expenditures may identify opportunities to retarget or eliminate ineffective or outdated tax expenditures. Tax expenditures, unless well designed to correct market failures, can distort economic decisions in ways that reduce economic performance from what it otherwise could be and thereby lower our future economic well-being. If a tax expenditure or group of tax expenditures is reduced or eliminated, any resulting increase in tax revenues could be offset if policymakers deem that to be appropriate fiscal policy. In any event, in order to raise a given amount of federal revenue, tax rates must be raised higher than they otherwise need to be due to revenue losses from tax expenditures. Thus, the net change after tax rate adjustments could, depending on overall congressional priorities and preferences, result in tax reductions for many taxpayers in place of the preferential treatment for some taxpayers. According to a recent estimate, a broad-based income tax system— eliminating basically all credits, deductions, special rates, exclusions for employer-provided fringe benefits and employee contributions to retirement account as well as eliminating the AMT—-could raise about the same amount of revenue as the current income tax system while lowering tax rates by about one-third. Although OMB and Treasury in 1994 supported expanding federal reviews of tax expenditures, the Executive Branch made little progress over the past decade to integrate tax expenditures in the budget presentation and to incorporate tax expenditures under review processes that apply to spending programs, as we recommended in 1994. Even though the sum of tax expenditure outlay-equivalent estimates is about the same magnitude as discretionary spending overall and greater than outlays in some budget functions, this is not readily visible to policymakers and the public because tax expenditures are not integrated in the budget presentation. Since their initial efforts to outline a framework for evaluating tax expenditures and preliminary performance measures, OMB and Treasury have largely ceased to make progress and have retreated from setting a schedule for evaluating tax expenditures. One of the key impediments to moving forward in conducting reviews of tax expenditures’ performance is the continuing lack of clarity about the roles of OMB, Treasury, IRS, and departments or agencies with outlay program responsibilities. So far, GPRA plans and reports are underutilized as a way to provide more information about the performance of tax expenditures and their contributions relative to spending programs. Tax expenditures are not subject to annual budget reviews, and OMB has not generally subjected them to scrutiny under PART in tandem with spending programs sharing common, crosscutting goals. Integrating tax expenditure costs in the annual budget presentation is crucial to providing a comprehensive picture of federal resources to facilitate reexamining the base. As a start in acting on our 1994 recommendation, OMB began presenting revenue loss sums for tax expenditures alongside outlays and credit activity for each budget function in the fiscal year 1998 budget. These summary tables were a useful starting point in highlighting the relative magnitude of tax expenditures across mission areas. However, OMB discontinued the reporting practice after the fiscal year 2002 budget, and instead, the Analytical Perspectives contains Treasury’s list of tax expenditures with associated revenue loss estimates for each one. Isolating tax expenditure cost information in a supplemental volume, however, provides a less comprehensive picture for policymakers and the public to compare all of the policy tools used within a mission area, such as health care or energy, because all the tools are not displayed together in the budget. OMB has demonstrated that it is feasible to display tax expenditure totals alongside spending programs in each budget function. Such a display is a first step in providing the public and policymakers with a more useful and accurate picture of the extent of federal support and activities. GAO also recommended in 1994 that the budget presentation include, to the extent possible, information to highlight for policymakers and the public the effectiveness, distributional equity, and economic efficiency for all federal resources allocated in a mission area. In the tax expenditure chapter in Analytical Perspectives, OMB added a section outlining possible performance measures developed by Treasury, which could be used to present information about the performance of tax expenditures. Although this overview was initially introduced in the 1997 budget and expanded in the 1999 budget, no performance information is actually displayed. OMB states that the measure examples provided are “illustrative” in nature, acknowledges that the performance measure discussion “although broad, is nonetheless incomplete,” and noted that many tax expenditures are not explicitly cited. The Chief Financial Officers Act, as expanded by the Government Management Reform Act of 1994, required federal agencies to prepare annual audited financial statements beginning in fiscal year 1996. OMB Circular A–136 Financial Reporting Requirements requires agencies to combine the annual GPRA program performance report with the financial statements and other information in a combined performance and accountability report. In accordance with generally accepted accounting principles, the basis on which federal agencies are required to prepare their financial statements, tax expenditures may be presented as other accompanying information. The Federal Accounting Standards Advisory Board (FASAB), which promulgates federal accounting standards, recognized that tax expenditures, which can be large in relation to spending programs that are measured under federal accounting standards, may not be fully considered in entity reporting. FASAB based its views, in part, on the fact that, in some cases, the association of tax expenditures with particular programs is not clear and the information is available elsewhere. The Board agreed to permit reporting entities to present, as other accompanying information, information on tax expenditures that the reporting entity considers relevant to its programs, if suitable explanations and qualifications are provided. As a result, tax expenditure amounts, which in some cases are larger than similar spending programs, are not required to be disclosed to the public as part of federal agencies’ financial statements nor are they disclosed in the consolidated financial statements of the federal government. Similarly, OMB’s guidance for the performance and accountability reports does not require reporting of tax expenditure information in agencies’ reports. Reporting such information would ensure greater transparency of and accountability for tax expenditures. OMB has not designed and implemented a structure for conducting reviews of tax expenditures’ performance, as we recommended in 1994. Our recommendation was consistent with language in the Senate Committee on Government Affairs’ Report on GPRA, which specified that the Director of OMB was to establish an appropriate framework for periodic analyses of the effects of tax expenditures in achieving performance goals. To significantly increase the oversight and analysis of tax expenditures, the committee report also called for a schedule for periodic tax expenditure evaluations. The ultimate goal of designing a structure for conducting performance reviews of tax expenditures was to begin developing and presenting performance information in the federal budget that would help demonstrate the relative effectiveness, efficiency, and equity of federal outlays and tax expenditure efforts within a mission area. In our 1994 report, we emphasized that in designing the structure for tax expenditure performance reviews, OMB should consider the roles of OMB, Treasury, and departments or agencies with outlay program responsibilities in assessing the performance of tax expenditures and their relationship and interaction with related spending programs; and which tax expenditures and outlay programs are related or interact and should be jointly considered. GAO recommended that OMB and Treasury conduct case studies of the proposed review structure to identify (1) successful methods agencies devise for reviewing tax expenditures’ performance, (2) how best to report the results of these reviews, and (3) how to ensure that adequate resources are available for such reviews. Although OMB, working with Treasury, took a number of steps consistent with our recommendation, it has not resolved the roles of OMB, Treasury, and departments or agencies with outlay program responsibilities; established a schedule for reviewing tax expenditures; or addressed lessons learned from tax expenditure case study reviews that Treasury performed. If the Executive Branch cannot define roles and set firm plans, it will continue to face additional challenges in developing objective, measurable, and quantifiable performance measures for tax expenditures that support federal missions and goals. Defining roles of agencies. One of the key impediments to moving forward in conducting reviews of tax expenditures’ performance is the continuing lack of clarity about the roles of OMB, Treasury, IRS, and departments or agencies with outlay program responsibilities. According to officials at OMB, it is difficult to determine which agencies in addition to Treasury and IRS have jurisdiction over particular tax expenditures. For example, one OMB official noted that tax expenditures meant to encourage savings were not the purview of any single agency. OMB officials also stated that OMB does not have the expertise or resources to conduct its own comprehensive analyses of tax expenditures, so individual agencies should take responsibility for identifying tax expenditures that affect their missions, with Treasury’s Office of Tax Analysis leading efforts to evaluate tax expenditures. Without clarification on the roles of federal agencies, inaction, overlap or inconsistency in evaluating tax expenditures can occur. For example, in 2002 we reported that gaps existed in monitoring the relative effectiveness of Title IV grants and loans and the HOPE and Lifetime Learning tax credits in promoting postsecondary education. The lack of collaboration between the Department of Education and the Treasury left little information available to help Congress weigh the relative effectiveness of grants, loans, and tax credits. Although data and methodological challenges make it difficult to isolate the impact of these tools, some academic researchers have used statistical techniques and research designs to mitigate these challenges. We recommended in 2002 that the departments develop a plan to share data and collaborate to provide Congress with evidence about the impact of higher education tax credits and student aid, but little action has been taken to implement the recommendation. To define the roles of federal agencies in reviewing tax expenditures, OMB, working with Treasury and other federal agencies, will need to exercise judgment in resolving how to address tax expenditures spanning mission areas. In some cases, Treasury could take the lead, such as in evaluating tax expenditures that broadly support investment and saving, or other agencies could work with Treasury to evaluate tax expenditures that directly affect their mission areas. For example, an evaluation of the various energy supply tax expenditures might involve both Treasury and the Department of Energy in assessing their effects on increasing production as well as on energy security and the environment. Establishing a schedule for evaluations. Periodic reviews of tax expenditures are also impeded because OMB has not developed a schedule for such reviews. In its 1997 GPRA report and again in the fiscal year 1999 budget, OMB set the expectation that the Executive Branch would lay out a schedule for tax expenditure evaluations. Beyond three initial pilot studies in 1997, however, no schedule has been set for further evaluations or case studies to explore methods and resource needs for measuring and reporting tax expenditure performance. As the roles of federal agencies are clearly defined, OMB and Treasury, working with other agencies, would be positioned to establish a schedule for tax expenditure evaluations. Opportunities exist to develop a strategic approach to the selection and prioritization of areas in allocating scarce evaluation resources. In our January 2004 report on OMB’s PART, we recommended that OMB target PART assessments based on such factors as the relative priorities, costs, and risks associated with related clusters of programs and activities and that OMB select similar programs for review in the same year to facilitate comparisons and tradeoffs. Similar considerations would be useful in setting a schedule for tax expenditure evaluations. Testing the evaluation framework. Although OMB outlined an initial framework for tax expenditure analysis in its May 1997 GPRA report to the President and Congress, OMB has not taken steps to address lessons learned from tax expenditure case study reviews that Treasury performed. OMB’s framework focused on the methodology that could be used to assess the performance of tax expenditures. OMB emphasized that developing a framework that is comprehensive, accurate, and flexible to reflect the objectives and effects of the wide range of tax expenditures would be a significant challenge. The initial framework for evaluating tax expenditures was expected to follow the basic structure for performance measurement—inputs, outputs, and outcomes. For tax expenditures, the primary input is the revenue loss. The outputs are the quantitative or qualitative measures of goods and services, or changes in investment and income, produced by the tax expenditures. Outcomes, in turn, were defined as the changes in the economy, society, or environment that the tax expenditures aim to accomplish. In 1997, Treasury did three pilot evaluations of selected tax expenditures to test the evaluation methods that OMB had described in its framework for tax expenditure analysis. In addition to seeking to learn lessons about applying the framework, the pilots were also intended to help identify resource needs for evaluating tax expenditures. Treasury selected one pilot each to be done by the individual, corporate, and international units within its Office of Tax Analysis. Results from the three tax expenditure pilots—the exclusion for worker’s compensation benefits, the tax credit for non-conventional fuels, and the tax exclusion for certain amounts of income earned by Americans living abroad—were summarized alongside each tax expenditure’s description in the tax expenditure chapter of the Analytical Perspective volume of the fiscal year 1999 budget. Although OMB originally expected to complete additional evaluations to refine the tax expenditure framework and improve performance measures, no further pilot evaluations have been completed. In reporting the results of these pilots, Treasury said that much of the data needed for thorough analysis was not available and that in at least one case, it was difficult to identify a clear purpose for the tax expenditure. Treasury did not discuss the resources that would be needed to continue doing such evaluations. However, OMB officials we interviewed reiterated that the data availability issues raised in the 1997 pilots remain a major challenge, and data constraints limit the assessment of the effectiveness of many tax expenditures. To improve the data available to assess the effects of some major tax expenditures, principally those aimed at personal savings, Treasury and IRS are developing a data set that is to follow a sample of individual income taxpayers over at least 10 years, beginning with tax year 1999. The new data set aims to capture the changing demographic and economic circumstances of individual taxpayers for use in analyzing the effects of changes in tax law over time. In addition to the panel sample, OMB reported in the fiscal year 2006 budget that it is working with Treasury’s Office of Tax Analysis and other agencies to improve data available for assessment of saving-related tax expenditures. No time frame was given in the 2006 budget for when any results will be reported. The challenges in producing credible performance information and the ability of federal agencies to produce evaluations of their programs’ effectiveness are not unique to tax expenditures. As our work on GPRA and PART implementation shows, the credibility of performance data has been a long-standing weakness. Developing and reporting credible information on outcomes achieved through federal programs remains a work in progress. In past reports, we have identified several promising ways agencies can maximize their evaluation capacity. For example, careful targeting of federal evaluation resources on key policy or performance questions and leveraging federal and nonfederal resources show promise for addressing key questions about program results. Other ways agencies might leverage their current evaluation resources include adapting existing information systems to yield data on program results, drawing on the findings of a wide array of evaluations and audits, making multiple use of an evaluation’s findings, mining existing databases, and collaborating with state and local program partners to develop mutually useful performance data. Congressional expectations for reviews of tax expenditures in connection with agencies’ reviews of related outlay and other programs generally have not been met. Enacted in 1993, GPRA is designed to inform congressional and executive decisionmaking by providing objective information on the effectiveness and efficiency of federal programs and spending. GPRA requires agencies to measure performance toward the achievement of annual goals and report on their progress in annual program performance reports. Through the strategic planning requirement, GPRA requires federal agencies to consult with the Congress and key stakeholders to regularly reassess their missions and strategic goals as well as the strategies and resources they will need to achieve their goals. Although GPRA offers a promising opportunity for the Executive Branch to develop useful information about the results of tax expenditures, agencies are not using their GPRA strategic plans and annual performance plans and reports to assess tax expenditures and their performance relative to spending programs contributing to the same strategic goals and objectives. Without integrating tax expenditures that have a direct bearing on federal missions and goals, policymakers may not have complete information to fully evaluate whether the government is achieving results or how the performance of tax expenditures interact with or compare to related spending programs. The Senate Governmental Affairs Committee Report on GPRA stated that tax expenditures should be taken into consideration in a comprehensive examination of government performance. The report stated that a schedule for periodically assessing the effects of specific tax expenditures in achieving performance goals should be included in the annual performance plans and that annual performance reports would subsequently be used to report on these tax expenditure assessments. In addition, the report noted that these assessments should consider the relationship and interactions between spending programs and tax expenditures and the effects of tax expenditures in achieving federal performance goals. Although GPRA expanded the supply of performance information generated by federal agencies, evaluating crosscutting federal efforts continues to be a challenge. GPRA requires the President to include in his annual budget submission a federal government performance plan. Congress intended that this plan provide a single cohesive picture of the annual performance goals for the fiscal year. The governmentwide performance plan could help Congress and the Executive Branch address critical federal performance and management issues, including redundancy and other inefficiencies in how we do business. However, this provision has not been fully implemented, and the current agency-by-agency focus of the budget does not have a broad, integrated perspective of planned performance on governmentwide outcomes. As envisioned by Congress, the governmentwide plan could relate and address the contributions of alternative federal strategies, including tax expenditures, to governmentwide goals. Agencies’ annual performance plans and reports could highlight crosscutting program efforts and provide evidence of the coordination of those efforts. We have previously recommended that OMB fully implement GPRA’s requirement to develop a governmentwide plan to provide a more cohesive picture of the federal government’s goals and strategies. Prior to a 2003 revision, OMB’s Circular A-11 guidance on GPRA reporting stated that descriptions should be provided for use of tax expenditures in annual performance plans when achievement of program or policy goals is dependent upon these governmental actions and annual performance reports must include the results of any assessment of how specific tax expenditures affect achieving its performance goals. However, the circular also stated that few agencies were responsible for such analyses. In addition, as part of a broader A-11 revision update, OMB streamlined its GPRA guidance in 2003 and no longer describes tax expenditures as part of guidance on performance plans and performance reports in the circular. According to OMB, it is up to individual agencies to decide whether to address tax expenditures in their GPRA reports and that many agencies focus on outlay programs over which they have more direct control. OMB officials told us that some agencies see tax expenditures as closely related to what they do and some do not, or agencies might not have enough knowledge about tax expenditures to consider them carefully. Our review of selected GPRA Performance and Accountability reports indicated the acknowledgement of tax expenditures in achieving federal performance goals varied by agency. For example: The Department of Energy (DOE) and HUD both acknowledged tax expenditures or tax policy as factors that affect agency goals. However, the DOE’s fiscal year 2004 report provided no further discussion on how the tax expenditures contributed to achieving the agencies’ performance goals. HUD’s fiscal year 2004 report acknowledged the tax incentives for renewal communities, empowerment zones, and enterprise communities as helping to achieve its objective of providing capital resources to improve economic conditions in distressed communities. As discussed previously, the outlay-equivalent value for tax expenditures amounts to more than other spending in the energy as well as the commerce and housing credit mission areas. The fiscal year 2004 reports released by the Department of Commerce (Commerce), the Department of Veterans Affairs, and the Department of Health and Human Services (HHS) do not mention tax expenditures at all, even though tax expenditures exist under the different mission areas related to these departments. For instance, several large tax expenditures, such as capital gains and accelerated depreciation, are listed by Treasury as related to the Commerce mission area, but it is unclear how, if at all, these tax expenditures relate to Commerce’s performance goals. Also, the income tax exclusion for employer- provided health care, the largest single tax expenditure, clearly intersects with HHS's mission to assure access to health care. Treasury’s fiscal year 2004 report explicitly identified a few tax expenditures—the New Markets Tax Credit and a new health coverage tax credit—as related to achieving its strategic objective to stimulate U.S. economic growth. In the context of its strategic objective to improve and simplify the tax code, Treasury reported on its efforts to, among other things, simplify the EITC and consolidate the higher education tax benefits. Treasury also reported on its efforts to improve determination of EITC eligibility and educate taxpayers about this provision. Treasury did not include information about tax expenditures as other accompanying information in the financial statement in its 2004 report. Tax expenditures have not been incorporated into Executive Branch budget reviews, as we recommended in 1994. We recommended that OMB use information on outlay programs and tax expenditures to make recommendations to the President and Congress about the most effective methods for accomplishing federal objectives. We concluded that better targeting by Congress and the Executive Branch of all federal spending and subsidy programs could save resources and increase economic efficiency through (1) better coordination of spending programs with tax expenditures; (2) reduction of overlap and inconsistencies among all federal subsidy programs; and (3) encouragement of trade-offs among tax expenditures, outlays, and loans. The congressional budget process is the annual vehicle through which Congress articulates both an overall fiscal stance—overall targets for spending and revenue—and its priorities across various broad categories. The process provides the overall constraints for spending and revenue actions by Congress for each year and the rules of procedure that can be used to constrain new entitlement and tax legislation not assumed in the annual budget resolution. The conflicts and uncertainties entailed in budgeting and policymaking are often mitigated by focusing decisions on incremental changes in resources each year. As a result, this incremental process focuses disproportionate attention on proposed changes to existing programs and proposals for new programs, with the base of programs often being taken as “given.” Moreover, the process routinely examines only the one-third of federal spending subject to the annual appropriations process. Unlike discretionary spending programs, which are subject to periodic reauthorization and annual appropriation, tax expenditures—like entitlement programs—are permanent law and are generally not subject to a legislative process that would ensure systematic annual or periodic review. In addition, the budget rules that were grounded in statute—including discretionary spending caps, pay-as-you-go (PAYGO) limits on mandatory spending and tax cuts—and enforced by executive actions if violated, expired at the end of fiscal year 2002. Before their expiration, PAYGO procedures restricted Congress’ ability to add new tax expenditures or expand existing ones unless offsetting funds could be raised. Because tax provisions are not as visible in the budget as spending programs, there is an incentive for policymakers to use tax provisions rather than spending programs to accomplish programmatic ends. However, both have a negative effect on the government’s “bottom-line.” Reinstituting budget enforcement mechanisms, such as discretionary spending caps, PAYGO discipline on both the spending and tax side, and fiscal benchmarks, could help the President and Congress sort out the many claims on the federal budget, including tax expenditures. Within the Executive Branch, OMB has not used its PART process, which is central to the Executive Branch’s budget and performance integration initiative, to systematically review tax expenditures and promote joint and integrated reviews of tax and spending programs sharing common, crosscutting goals. OMB describes PART as a diagnostic tool meant to provide a consistent approach to assessing federal programs as part of the executive budget formulation process. It applies 25 questions to all “programs” under four broad topics: (1) program purpose and design, (2) strategic planning, (3) program management, and (4) program results (i.e., whether a program is meeting its long-term and annual goals) as well as additional questions that are specific to one of seven mechanisms or approaches used to deliver the program. PART is designed to be evidence-based, drawing on a wide array of information, including authorizing legislation, GPRA strategic plans and performance plans and reports, financial statements, inspectors general and GAO reports, and independent program evaluations. Drawing on available performance and evaluation information, the PART questionnaire attempts to determine the strengths and weaknesses of federal programs with a particular focus on individual program results and improving outcome measures. Since the fiscal year 2004 budget cycle, OMB has applied PART to 607 programs (about 60 percent of the federal budget), and given each program one of four overall ratings: (1) “effective,” (2) “moderately effective,” (3) “adequate,” or (4) “ineffective” based on program design, strategic planning, management, and results. A fifth rating, “results not demonstrated,” was given—independent of a program’s numerical score— if OMB decided that a program’s performance information, performance measures, or both were insufficient or inadequate. Over the next 2 years, OMB plans to assess nearly all remaining Executive Branch spending programs. Whereas OMB, through its development and use of PART, has provided agencies with a powerful incentive for improving data quality and availability on the spending side, relatively little progress has been made in evaluating the effectiveness of tax expenditures. So far, OMB has used PART to address tax expenditures in only two cases—the EITC compliance initiative and the New Markets Tax Credit (NMTC). For the EITC, which has outlays for the refundable portion, the direct federal spending PART instrument was used to evaluate IRS’ initiative to improve the payment accuracy rate for the EITC—and not the refundable EITC itself. OMB rated the compliance initiative as “ineffective” in the fiscal year 2004 budget because data showed no progress in reducing the high rates of erroneous payments. The review did not evaluate the effects of the EITC on workforce participation or examine its contribution relative to other federal programs aimed at reducing poverty. The NMTC, which is administered like a grant by CDFI, was evaluated as part of OMB’s crosscutting review of community and economic development programs. OMB rated the NMTC as “adequate” and reported in 2005 that CDFI had established meaningful long-term and annual performance measures but that data were not yet available to evaluate the effectiveness of the NMTC or establish baselines for the performance measures. We have urged a more comprehensive, consistent, and integrated approach to evaluating all programs relevant to common goals—encompassing spending, tax expenditures, and regulatory programs—using a common framework. Such an analysis is necessary to capture whether a program complements and supports other related programs, whether it is duplicative and redundant, or whether it actually works at cross-purposes to other initiatives. OMB officials we interviewed said that OMB would need Treasury’s assistance to determine what information or criteria to include in a PART instrument tailored to examine tax expenditures. As of July 2005, OMB said that it was planning to review the health insurance tax credit program next year but that it has not decided whether the PART review will be limited to administration or will also cover the program’s tax policy purpose. As we move forward in shaping government for this century, the federal government cannot accept all of its existing programs, policies, functions, and activities as “givens.” Outmoded commitments and operations constitute an encumbrance on the future that can erode the capacity of the nation to better align its government with the needs and demands of a changing world and society. Reexamining the base of all major existing federal spending and tax programs, policies, functions, and activities by reviewing their results and testing their continued relevance and relative priority for our changing society is an important step in recapturing our fiscal flexibility and bringing the panoply of federal activities into line with 21st century trends and challenges. The decisions we face involve difficult choices about the appropriate size and role of the federal government and how to finance the federal government. The revenues forgone through tax expenditures reduce resources available to fund other federal activities or they require higher tax rates to raise a given amount of revenue. Reviewing their results and testing their continued relevance and relative priority is an important step in the process towards fiscal responsibility and national renewal. Such a fundamental review of major programs, policies, and activities, including tax expenditures, can serve the vital function of updating the federal government’s approach to meet current and future challenges. Regular and systematic evaluation will be necessary to inform policy decisions about the efficiency, effectiveness, and equity of tax expenditures or whether they are the best tool for accomplishing federal objectives within a functional area. Beginning the governmentwide reexamination process now would enable decisionmakers to be more strategic and selective in choosing areas for review over a period of years. Reexamining selected parts of the budget base over time may make the reviews more feasible and less burdensome, and it would allow decisionmakers to focus on all federal efforts—discretionary spending, mandatory spending, and tax expenditures—sharing common goals. Unfortunately, over a decade has passed since Congress encouraged systematic reviews of tax expenditures and since we made recommendations to facilitate such reviews and to display information on tax expenditures in the federal budget in a manner that enables policymakers to look at resource commitments across related outlays and tax expenditures. Although specific tax expenditures, such as the EITC and Liberty Zone tax benefits, have received varying degrees of scrutiny, efforts to date have not provided the Congress and others with an integrated perspective on the extent to which programs and tools— including tax expenditures—contribute to national goals and position the government to successfully meet 21st century demands. In addition, the lack of a requirement to disclose tax expenditures in agencies’ annual performance and accountability reports may result in important performance and cost related data not being fully considered with other federal resources allocated to achieve similar objectives. Although challenges must be overcome to provide systematic reviews of tax expenditures, these challenges cannot be addressed absent effective leadership within the Executive Branch. Accordingly, we are making several recommendations to OMB. To ensure that policymakers and the public have the necessary information to make informed decisions and to improve the progress toward exercising greater scrutiny of tax expenditures, we recommend that the Director of OMB, in consultation with the Secretary of the Treasury, take the following four actions: resume presenting tax expenditures in the budget together with related outlay programs to show a truer picture of the federal support within a mission area; develop and implement a framework for conducting performance reviews of tax expenditures. In developing the framework, (1) determine which agencies will have leadership responsibilities to review tax expenditures, how reviews will be coordinated among agencies with related responsibilities, and how to address the lack of credible performance information on tax expenditures; (2) set a schedule for conducting tax expenditure evaluations; (3) re-establish appropriate methods to test the overall evaluation framework and make improvements as experience is gained; and (4) to identify any additional resources that may be needed for tax expenditure reviews. develop clear and consistent guidance to Executive Branch agencies on how to incorporate tax expenditures in strategic plans, annual performance plans, and performance and accountability reports, to provide a broader perspective and more cohesive picture of the federal government’s goals and strategies to address issues that cut across Executive Branch agencies; and require that tax expenditures be included in the PART process and any future such budget and performance review processes so that tax expenditures are considered along with related outlay programs in determining the adequacy of federal efforts to achieve national objectives. We provided a draft of this report to OMB, Treasury, and IRS for their review and comments. We received written comments from OMB’s Associate Director for Economic Policy in a letter dated September 2, 2005. These comments are reprinted in app. II along with our analysis of certain issues raised by OMB. OMB disagreed with our recommendations and several of our findings, and also raised concerns about our use of Treasury’s tax expenditure estimates. Where appropriate, we made changes in our report in response to these comments. The Secretary of the Treasury did not submit comments, instead deferring to OMB. IRS staff provided a technical correction that we incorporated. In commenting on our report, OMB raised concerns about our use of tax expenditure estimates developed by Treasury and reported in the annual federal budget. For example, OMB commented that we accepted uncritically the concept of tax expenditures first advanced in the 1960s and said that we ignored limitations about the “volume” of total tax expenditures. To the contrary, the background section of our draft report, as well as several pages in app. III, clearly identified issues related to the tax expenditure concept, including that characterizing individual provisions as tax expenditures is a matter of judgment, and that disagreements exist about classifying what should be included in the income tax base. Pursuant to the Congressional Budget Act of 1974, the term tax expenditure, as our draft stated, has been used in the federal budget for three decades, and the tax expenditure concept—while not precisely defined—is nevertheless a valid representation of one tool that the federal government uses to allocate resources. Regarding the “volume” of tax expenditures, we acknowledged throughout our draft report limitations in the methodology of summing the individual tax expenditures. To provide an example of the extent that interaction effects among tax expenditure estimates can affect summing them, at our request, Treasury calculated total tax expenditures for five itemized deductions that took these effects into account; we included this information in our draft report. As our report stated, tax expenditure estimates—both those published in the budget as well as those produced by JCT—are the best and only data available to measure the value of tax expenditures and make comparisons to other spending programs. In our opinion, summing the estimates provides perspective on the use of tax expenditures as a policy tool and represents a useful gauge of the general magnitude of government subsidies carried out through the tax code. OMB also stated that we reported that more attention should be given to tax expenditures due to the severity of the nation’s long-term fiscal imbalance and stated that the Administration rejects any attempt to address the long-term fiscal imbalance with tax increases. To the contrary, we believe that tax expenditures, like other federal programs and activities, should be reevaluated as to their effectiveness and continued relevance as part of a periodic reexamination of what the federal government does and how it does business. Although the long-term fiscal gap heightens the need to ensure resources are not wasted, this reexamination would be appropriate regardless of the fiscal position. Further, OMB’s implication that focusing more attention on tax expenditures would automatically increase taxes is unfounded. As our report clearly stated, for any given level of revenue, the revenues forgone through tax expenditures require higher tax rates to obtain a given amount of revenue. Thus, if the evaluations of tax expenditures we call for lead to reducing or eliminating some tax expenditures, the net change after rate adjustments could, depending on overall congressional priorities and preferences, result in tax reductions for many taxpayers. We adjusted sections of our report to reinforce the point that reviewing tax expenditures is consistent with good stewardship of taxpayers’ resources and does not automatically result in tax increases depending on other related changes. At the same time, our current and projected fiscal imbalance serves to reinforce the need for reassessing all activities. We also added a recent estimate calculated by the Department of the Treasury for the President's Advisory Panel on Federal Tax Reform which showed that a tax system where basically all tax expenditures were eliminated could raise the same amount of revenue as the current tax system while lowering tax rates by about a third. OMB also stated that information on tax expenditures is not useful for budgeting and that tax expenditures have never been included in the congressional budget process. To the contrary, the tax expenditure list is legally required under the 1974 Congressional Budget Act and, before the expiration of the Budget Enforcement Act in 2002, PAYGO procedures restricted Congress’ ability to add new tax expenditures or expand existing ones unless offsetting funds could be raised. Whereas OMB favors reporting tax expenditures separately from the rest of the budget, we believe an integrated presentation is also useful to show the relative magnitude of tax expenditures compared to spending and credit programs across mission areas. This is not a recommendation to equate tax expenditures with outlays. We are recommending that OMB focus on integrating tax expenditures in the President’s budget presentation to show a truer picture of federal support in a mission area and on including tax expenditures under budget and performance review processes that apply to related spending programs. As our report stated, OMB began presenting tax expenditure sums alongside outlays and credit activity for each budget function in the federal budget from fiscal year 1998 through fiscal year 2002, but has discontinued the practice. Finally, OMB commented that it would be unwise to follow our recommendations for the conceptual and methodological reasons mentioned above, as well as for other practical reasons. We address OMB’s comments on our recommendation to resume including tax expenditures in the budget together with related outlay programs in the paragraph above. Regarding our recommendation to develop a framework for conducting performance reviews of tax expenditures, OMB stated that it has some potential promise but it is clearly a job for Treasury because no other agency has access to the data that would be needed to conduct such an analysis. However, we are not recommending that OMB be responsible for conducting the actual reviews, just for developing and overseeing the implementation of a framework for conducting the performance reviews. OMB would not need to have access to taxpayer data to manage the process. In addition, we recognize the challenges in using taxpayer data, which is the reason we recommend that OMB work in consultation with Treasury to develop and implement the framework. Also, our report recognizes the scarcity of evaluation resources, and we suggest factors that would be useful in taking a strategic approach to selecting and prioritizing tax expenditure evaluations. To make this point more apparent in our report, we added a fourth requirement to our recommendation to identify any additional resources that may be needed for tax expenditure reviews. OMB said that our recommendation to develop clear and consistent guidance to Executive Branch agencies on how to incorporate tax expenditures in GPRA reports would be counterproductive because agencies do not administer the tax code, and they should not be saddled with responsibility for something they do not control. OMB misstated our recommendation; this report does not recommend that agencies be responsible for administering parts of the tax code. As the tax expenditure chapter in OMB’s Analytical Perspectives volume of the fiscal year 2006 budget states, tax expenditures may also contribute to achieving goals identified in Federal agencies annual and strategic plans for their programs and activities. The aim of our recommendation was to provide a more cohesive perspective of the government’s programs and strategies—including tax expenditures—to address common federal goals. As our report states, in passing the Government Performance and Results Act, the Senate Governmental Affairs Committee called for inclusion of tax expenditures in the GPRA process so that more and better information would be available on the performance of tax expenditures themselves and the effects of tax expenditures would be considered in achieving federal performance goals. Our recommendation is consistent with this intent. Regarding our recommendation to require tax expenditures to be included in the PART process and any future such budget and performance review processes, OMB stated that it has no current plans to implement any of the recommendations in this report, but stated that other tax expenditures may be evaluated with the PART in the future. OMB also stated that the Department of the Treasury manages the tax code, so any new PARTs for tax expenditures would generally mean more PARTs for Treasury. Within the Executive Branch, major responsibility for management of the tax code was given to the Department of the Treasury. Given that the Administration is aiming to assess nearly 100 percent of federal outlay programs under PART, Treasury would be facing less scrutiny than other agencies to the extent that tax expenditures are not similarly evaluated under PART. Our recommendation merely calls for bringing tax expenditures in line with the performance management attention PART gives to outlay programs. Further, if our second recommendation to develop an evaluation framework for tax expenditures is implemented, OMB would be better positioned to target crosscutting reviews of related clusters of programs and activities. We are sending copies of this report to the relevant congressional committees and other interested parties. Copies of this report will also be made available to others upon request. In addition, the report will also be available at no charge on GAO’s Web site at http://www.gao.gov. If you or your staff have any questions about this report, please contact Mike Brostek at (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made major contributions to this report are listed in appendix VI. A decade ago, we examined the growth in tax expenditures and examined opportunities to focus policymakers’ attention on tax expenditures. To assist the Congress in reexamining the base of federal programs and policies critical to achieving fiscal discipline in the budget as a whole, this report updates our 1994 work. Specifically, this report describes (1) how tax expenditures have changed over the past three decades in reported number and aggregate size and in comparison to federal spending, revenue, and the economy; and (2) the progress that has been made since 1994 in how the Executive Branch scrutinizes tax expenditures. To meet each of our objectives, we relied on past GAO work, agency and congressional reports, and relevant tax expenditure literature. In addition, we interviewed agency officials from the Department of the Treasury’s Office of Tax Analysis; the Internal Revenue Service’s Office of Research, Analysis, and Statistics; the Office of Management and Budget (OMB); congressional staff from the Joint Committee on Taxation (JCT); and experts on tax policy to obtain a greater understanding of information gained through our literature review and to corroborate findings. To identify how tax expenditures have changed over the past three decades in number and size in terms of aggregate revenue loss and outlay- equivalents, we analyzed tax expenditure estimates developed by Treasury and reported by OMB in the Federal Budget’s Special Analyses, Appendixes, and Analytical Perspectives for fiscal years 1974 to 2004. Tax expenditure estimates are reported for individual and corporate taxpayer groups and categorized by budget function. We chose the tax expenditure estimates reported in the budget for our analysis because Treasury develops (1) revised estimates based on changes in tax policy and economic activity for the year prior to the reported fiscal budget year (i.e., retrospective estimates), and (2) outlay-equivalent estimates that facilitate comparison to federal spending. Even though Treasury’s estimates are retrospective, the final reported numbers are still estimates and may not reflect additional policy changes. Although the tax expenditure concept can also be applied to other kinds of taxes, such as excise taxes, this report only covers tax expenditures for the federal income tax system. We determined the number of tax expenditures for each fiscal year by adding the number of items in the list of tax expenditures reported by Treasury for each fiscal year. In certain fiscal years, Treasury reported estimates for select tax expenditures as two line items on their list, such as the expensing of exploration and development costs, which was split out as two tax expenditures, one pertaining to oil and gas and one for other fuels between fiscal years 1980 and 1995. To be consistent with Treasury’s reporting of these tax expenditures in years when they were listed as only one item, we summed the revenue loss estimates in the years they were listed as two tax expenditures and counted them as one. To determine the number of distinct tax expenditures across fiscal years, we reviewed the names and descriptions for each tax expenditure reported by OMB in the Budget’s Special Analyses, Appendixes, and Analytical Perspectives for fiscal years 1974 to 2004. We conducted two independent reviews to verify that our list contained only distinct tax expenditures across fiscal years. To assist in our review, we also relied on the descriptions reported in the Congressional Research Service’s compendiums on tax expenditures and legislative histories of certain tax expenditures, as needed. App. IV contains our compilation of all tax expenditures reported by Treasury between 1974 and 2004. We aggregated tax expenditure revenue loss estimates to measure growth over time. We also summed the revenue loss estimates by their reported corporate and individual basis to see how the amounts differed between the two taxpayer groups. We converted all sums for each fiscal year into constant dollars to adjust for inflation using the chain price indexes reported in the fiscal year 2006 federal budget. While summing tax expenditure estimates provides a useful perspective, aggregate numbers should be interpreted carefully due to interactive effects between tax expenditures and potential behavioral changes. To identify how tax expenditures have changed over the past three decades in comparison to federal spending, revenue, and the economy, we summed the outlay-equivalent estimates for each fiscal year and compared them to the federal budget position in aggregate. We used historical data on spending drawn from OMB historical tables and compared them to the sums for tax expenditure outlay-equivalent estimates in dollar value and as a percentage of GDP. We also used outlay-equivalent estimates to compare tax expenditure trends over time by budget function. Finally, we used historical data on spending by budget function from OMB historical tables and compared them to the sum of tax expenditures by budget functions for fiscal year 2004. We worked with Treasury officials to verify any discrepancies we found in using the tax expenditure estimates and modified our data accordingly. To determine the amount of progress since 1994 in how the federal government scrutinizes tax expenditures, we examined actions taken to implement our earlier recommendations to OMB intended to encourage more informed policy debate about tax expenditures and to stimulate joint review of related tax and spending programs. We recommended (1) developing a structure for conducting reviews of tax expenditures’ performance (2) conducting case studies to assess performance review structure (3) presenting tax expenditures in the annual budget, and (4) incorporating tax expenditures into the annual budgetary review process. We reviewed relevant literature, interviewed relevant agency officials and tax policy experts, and relied on previous GAO work to determine the progress that has been made in implementing our recommendations. We reviewed efforts to include tax expenditures under the Government Performance and Results Act’s statutory framework for strategic planning, performance measurement, and program evaluation. We also considered activities to include tax expenditures under OMB’s Program Assessment Rating Tool process. To describe how tax expenditures are measured and reported, we reviewed, but did not verify, the procedures used by the Joint Committee on Taxation and Treasury to estimate the magnitude of revenues forgone through tax expenditures or, in Treasury’s case, their outlay-equivalent values as well. As described in app. III, JCT and Treasury use different conceptual approaches to identify the provisions of the tax code they label as tax expenditures. In addition, their estimating models, macroeconomic assumptions, and choice of data cause their revenue loss estimates to differ somewhat. We conducted our work between August 2003 and July 2005 in accordance with generally accepted government auditing standards. The agency comments and evaluation section of this report discusses our overall comments on the Office of Management and Budget’s letter dated September 2, 2005. The following are our additional comments on issues raised by OMB. 1. See the agency comments and evaluation section of this report. 2. While we believe that the nation’s current and projected fiscal imbalance provides an additional impetus for engaging in such a review and reassessment, we believe tax expenditures should be reviewed and evaluated for efficiency and effectiveness even if there were no fiscal imbalance. We did not suggest that extra attention to tax expenditures would eliminate the long-term fiscal imbalance. As our report stated, substantive reform of Social Security and the major health programs remains critical to recapturing our fiscal flexibility. 3. Our report cites several examples of changes in the presentation of tax expenditures over time. For example, starting with the fiscal year 1999 budget, OMB began including a section outlining possible performance measures and issues in evaluating tax expenditures. This section was a first step in responding to congressional expectations for the Executive Branch to provide information about how tax expenditures meet their objectives and affect the performance of other federal programs. 4. We do not take for granted that tax expenditures are similar to spending programs. We devote a section of our background to describing how tax expenditures differ from, may substitute for, and work in conjunction with other spending programs to achieve policy objectives. Also, see the agency comments and evaluation section of this report. 5. In our report, we recommend adding useful comparisons to spending programs to the budget document, while not detracting from or changing in any way how the tax expenditure lists can be used to think about tax policies. 6. To the contrary, throughout our draft report we note and even emphasize the limitations in the methodology of summing the individual tax expenditures. In fact, to ensure that summing limitations of tax expenditures were clearly acknowledged, we discussed the limitations in (1) the introduction of our methodology, (2) a footnote in the Results In Brief section, (3) the section devoted to explaining the limitations which precedes our presentation of the trends in tax expenditures over time, and (4) a footnote for all 10 figures where we summed the tax expenditure estimates. In addition, we report a quantitatively significant example of interaction effects of tax expenditure estimates, which was developed by Treasury at our request. The example shows that the revenue loss calculation assuming the simultaneous elimination of several itemized deductions would be less than the sum of the revenue loss estimates for each itemized deduction, each calculated assuming the rest of the tax code was unchanged. As our report stated, tax expenditure estimates produced by Treasury and JCT are the best and only available data to measure the value of tax expenditures and make comparisons to other spending programs. In our view, summing the estimates provides perspective on the use of tax expenditures as a policy tool and represents a useful gauge of the general magnitude of government subsidies carried out through the tax code. Our report also cites several other researchers who have summed tax expenditure estimates to help gain perspective on the use of this policy tool and examine trends in the aggregate growth of tax expenditure estimates over time. 7. In this report, we provide a number of examples of studies we and others have done of tax expenditures; our reviews often are at the request of Congress, and OMB examined two tax expenditures under the Administration’s PART initiative. We also provide illustrations of the major legislation that has affected tax expenditures since the late 1970s. However, we stand by our statement that tax expenditures are not subject, or effectively subject, to several major processes that apply to outlay programs that increase the likelihood of reviews and, perhaps more importantly, increase the quantity and quality of information available to policymakers in determining whether and how to modify tax expenditures. Developing such enhanced information for policymakers and displaying it in a manner that facilitates their understanding of the total federal effort to address functionally related issues, e.g., ensuring adequate housing or stimulating economic development, is the thrust and intent of our report and recommendations. 8. We disagree with OMB’s characterization that the current tax expenditure presentation is “more than adequate” for the public and policymakers. We realize that the current budget volume is not organized by separate budget functions; however, OMB had previously presented revenue loss sums for tax expenditures alongside outlays and credit activity for each budget function in the federal budget from fiscal year 1998 through fiscal year 2002. As we state in our report, these summary tables were a useful starting point in highlighting the relative magnitude of tax expenditures and related outlay programs across mission areas. In addition, our current recommendation gives OMB latitude on how to present them with other outlay programs with similar purposes. Further, Congress has shown significant interest in reviewing all tools within a mission area. For example, recent congressionally-requested studies we conducted have reviewed all tools—including tax expenditures—used in the post-secondary education and energy areas. Also, see comment 2 as well as the agency comments and evaluation section of this report. 9. We disagree with the opinion that OMB has implicitly expressed that it would not have a leadership role regarding our second recommendation. First, we are not recommending that OMB be responsible for conducting the actual reviews, just to develop and oversee the implementation of a framework for conducting the performance reviews. OMB would not need to have access to taxpayer data to manage the process. Secondly, we recognize the challenges in using taxpayer data, which is the reason we recommend that OMB work in consultation with Treasury to develop and implement the framework. Third, taxpayer data may not be the only source of performance information on tax expenditures, which is why we recommend that the framework address the lack of credible performance information on tax expenditures. Finally, our report recognizes the scarcity of evaluation resources and we suggest taking a strategic approach to select and prioritize tax expenditure evaluations based on such factors as the relative priorities, costs, and risks associated with related clusters of programs and activities and that OMB select similar programs for review in the same year to facilitate comparisons and tradeoffs. To make this point more apparent in our report, we added a fourth element to our recommendation that OMB and Treasury in developing a framework for evaluating tax expenditures are to identify any additional resources that may be needed for tax expenditure reviews. 10. OMB misstated our recommendation. This report does not recommend that agencies be responsible for administering parts of the tax code. As we state in our report, in passing the Government Performance and Results Act, the Senate Governmental Affairs Committee called for inclusion of tax expenditures in the GPRA process so that more and better information would be available on the performance of tax expenditures themselves and the effects of tax expenditures would be considered in achieving federal performance goals. Our recommendation is consistent with this intent. Also, see the agency comments and evaluation section of this report. 11. Our recommendation aims to bring tax expenditures in line with the performance management attention PART gives to outlay programs. Our report discussed the two cases where OMB has applied PART to tax expenditures—the EITC compliance initiative and the New Markets Tax Credit. Within the executive branch, the Department of the Treasury has major responsibility for managing programs implemented through the tax system. Given that over the next 2 years the Administration plans to assess nearly all remaining executive branch outlay programs, Treasury would be facing relative less scrutiny than other agencies to the extent that the tax expenditure tool is not similarly evaluated under PART. Although OMB disagreed with our recommendations as a whole, we are encouraged that OMB is still considering how other tax expenditures could be evaluated with PART in the future. In moving forward, PART reviews of tax expenditures in isolation might be revealing, but we would urge a more comprehensive and crosscutting approach to assessing all tools—including tax expenditures—related to common goals. To understand the trends in the size of tax expenditures, it is helpful to understand how tax expenditures are measured and reported annually. This appendix explains the baselines used to distinguish tax expenditures from other provisions in the tax code and provides an explanation of the different methods that are used to measure tax expenditures. The Congressional Budget Act of 1974 defines tax expenditures as “those revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability. Both the congressional Joint Committee on Taxation (JCT) and the Department of the Treasury’s Office of Tax Analysis annually compile a list of tax expenditures and estimates of their cost each year. The Department of the Treasury’s (Treasury) tax expenditure estimates are included in the annual federal budget by the Office of Management and Budget (OMB). While, in general, the tax expenditure lists published annually by JCT and Treasury are similar, they differ somewhat in the number of tax expenditures reported and the estimated revenue loss for particular expenditures. Part of this difference arises because the organizations use different income tax baselines to determine tax expenditures. To determine the tax code provisions that satisfy the definition of a tax expenditure, the existing tax law must be compared or measured against an alternative set of tax rules that represent a baseline. The Congressional Budget Act did not define a specific baseline tax structure. As a result, the Treasury and the staff of the JCT have used judgment to define the different baselines that they use to develop lists of tax expenditures. Before the fiscal year 1983 budget, there were few differences between the Treasury and JCT tax expenditure lists because both organizations used a baseline patterned on a comprehensive income tax, which was deemed the “normal” baseline. JCT has used this baseline consistently over time in producing its tax expenditure list, while Treasury has modified its normal baseline over time and provided alternative baselines. In general, the normal income tax law baseline developed by both Treasury and JCT represents a broad-based income tax on individuals and a separate income tax on corporations. The normal baseline includes income from all sources, including wages and salaries, fringe benefits and other forms of employee compensation, interest income, dividends, realized capital gains, and net income from non- corporate businesses such as sole proprietorships and partnerships. The normal baseline generally allows for personal exemptions, deductions for costs incurred to earn income, and a standard deduction. Currently, the normal baselines used by both Treasury and JCT differ somewhat. Treasury’s normal baseline excludes several tax expenditures that are included in the normal baseline used by JCT and leads to several tax expenditures being reported by JCT only. For instance, the exclusion of Medicare hospital insurance benefits is included in the JCT list but this provision is not included in the federal budget tax expenditure list because Treasury views the exclusion of government benefits received in kind as part of its normal baseline. Additional examples of specific tax expenditures reported by only JCT or Treasury can be found at the end of this appendix in table 2. In the fiscal year 1983 budget, Treasury introduced the concept of a reference baseline. The reference baseline used by Treasury is also patterned on a broad-based income tax, but it is closer to existing law because tax expenditures by definition are limited to special exceptions that serve programmatic functions, such as national defense, income security, and education. Under Treasury’s reference baseline, two conditions are necessary for a provision to qualify as a tax expenditure: (1) The provision must be “special” in that it applies to a narrow class of transactions or taxpayers and (2) There must be a general provision to which the special provision is a clear exception. The set of general tax rules in the existing tax code is used as the standard by which various provisions are determined to be special. Whereas accelerated depreciation was considered a special rule exception under the normal baseline, these provisions were not considered tax expenditures under the reference baseline, because accelerated depreciation was considered to be the general treatment for the depreciation of business assets. The preferential tax rate for capital gains was included in Treasury’s tax expenditure list based on the general tax code rule that income from any source is considered taxable. For fiscal year 1983, Treasury began to report estimates using the reference baseline for some tax expenditures and then reinstituted reporting estimates for the normal baseline in fiscal year 1985. This reporting practice has continued to the present. In recent years, Treasury modified treatment of certain provisions under its normal and reference baselines and introduced two supplemental baselines. In the 2005 and 2006 budgets, Treasury excluded the reduced tax rate on dividends and capital gains that have already been taxed under the corporate income tax from the reference law baseline because it believes that since current law taxes these forms of corporate income twice, it is an inappropriate baseline to use. Also, in the 2004, 2005, and 2006 budgets, Treasury changed how it computed the accelerated depreciation tax expenditure under the normal baseline by using a measure of economic depreciation rather than straight-line depreciation as the baseline depreciation method, which was used in prior years. The measure of economic depreciation is generally faster than the straight-line method, so the tax expenditure estimates for accelerated depreciation for fiscal years 2002, 2003, and 2004 (from the 2004, 2005, and 2006 budgets) are smaller than what they would have been if the straight-line depreciation method were used. In addition, in the 2004 budget, Treasury began reporting two supplemental baselines, as discussed in figure 14. Both Treasury and JCT provide estimates of revenue loss, which is the amount of revenue that the government forgoes as the result of each special provision in the tax code. Revenue loss is estimated for each tax expenditure separately by comparing the revenue raised under current law with the revenue that would have been raised if the single provision did not exist, assuming that taxpayer behavior and all other tax and spending provisions remain constant. A revenue loss estimate does not represent the amount of revenue that would be gained if a particular tax expenditure were repealed, since repeal of the expenditure would probably change taxpayer behavior in some way that would affect revenue. Treasury and JCT tax expenditure lists will also differ because each organization uses a different de minimis amount, which is the minimum amount of revenue loss threshold for Treasury and JCT to report a tax expenditure. JCT excludes tax expenditure estimates that result in revenue losses that are less than $50 million over its 5-year projected period. For instance, the tax exemption for certain small insurance companies was not included in JCT’s January 2005 list of tax expenditures because the estimated revenue loss was below its de minimis amount. Treasury rounds all yearly estimates to the nearest $10 million and excludes tax expenditures with estimates that round to zero in each of the 7 years that it reports tax expenditure estimates. JCT and Treasury estimates of revenue loss also differ somewhat due to different economic and technical assumptions. For instance, JCT and Treasury use different sources for macroeconomic assumptions incorporated in their revenue loss estimates. JCT uses CBO macroeconomic assumptions in its tax expenditure projections and Treasury uses assumptions based on consultations with OMB, and the Council of Economic Advisers, the same assumptions used for the President’s budget. In addition to projecting future revenue losses, Treasury also reports re-estimates for the past fiscal year, which incorporate changes in tax policy and reflect more up-to-date economic and taxpayer data. Table 3 compares tax expenditure reporting by JCT and Treasury. In addition to revenue loss estimates, Treasury also measures tax expenditures in terms of their outlay-equivalent value, which allows the cost of a tax expenditure to be compared with a direct federal outlay, were each to provide the same benefit to the taxpayer. JCT does not produce outlay-equivalent estimates. The underlying economic assumptions used for the outlay-equivalent and revenue loss estimates are the same. However, to estimate outlay-equivalents, Treasury will increase—“gross up”—the revenue loss estimate by the average marginal tax rate that applies to the relevant taxpayers (the taxpayers that take the particular credit or deduction or earn the income that is excluded from tax). The result is an estimate of the amount of direct spending that would be needed to leave the relevant taxpayer with the same amount of benefit, after he or she paid tax on the amount received through the spending, as the taxpayer would get from the tax provision itself. For example, the outlay-equivalent estimate for the housing and meal allowances for military personnel tax expenditure reflects the additional pre-tax income that military personnel would have to be paid to raise their income after federal taxes by the amount of the benefits, so that it can be compared with other defense outlays on a consistent basis. An exception to this general rule of increasing the revenue loss estimate is made for tax expenditures that are believed to reduce the price of particular goods and services. In this case no gross up is made because a spending program that led to the same price reduction would not increase the tax liability of the taxpayer. For instance, revenue loss estimates for accelerated depreciation on rental housing and state prepaid tuition do not differ from the outlay-equivalent estimates for these tax expenditures. Outlay-equivalents can also differ from revenue loss estimates because they are calculated based on an even flow of virtual payments over the year to make the estimates comparable to actual outlay programs. Even for those tax expenditures that do not require a calculated adjustment, differences between the revenue losses and outlay-equivalents can occur solely because of differences in timing factors. Although revenue loss estimates can be affected by the collection patterns of the corporate and personal income taxes, the cash flow of direct spending programs can differ widely from the annual tax collection cycle. Of the 146 tax expenditures reported in the fiscal year 2006 budget, 91 were “grossed up” for the outlay-equivalent estimate with the implied rate varying across different provisions. Just as there is debate over which tax provisions should be listed as tax expenditures, tax experts do not always agree on whether specific tax expenditures should be grossed up or not. It may not be apparent to observers why the outlay-equivalent and revenue loss estimates are the same for some tax expenditures and why they differ for other tax expenditures. Other estimates of tax expenditures produced by JCT and Treasury also may differ from revenue loss estimates. These supplemental estimates are discussed in figure 15. Although there are differences between how Treasury and JCT develop and measure tax expenditures, the sum of revenue loss estimates from each list has followed relatively the same trend in the past. Figure 16 compares the sum of revenue loss estimates for JCT and Treasury since the last comprehensive tax reform, when the Tax Reform Act of 1986 was adopted. Since fiscal year 2002, the trends in the sums of the two sets of revenue loss estimates have diverged. Since the fiscal year 2004 Budget, Treasury’s estimates of dividends and capital gains tax expenditures are lower than JCT’s, at least in part, because Treasury changed its definition of the tax expenditures to reflect the reduced tax rates only on dividends and capital gains from sources other than corporate equity. Treasury also redefined the accelerated depreciation tax expenditures under the normal baseline to reflect depreciation relative to a replacement cost basis, rather than the historic cost basis previously used. Table 4 lists the tax expenditures and their associated revenue loss estimates that were reported by both Treasury and JCT for fiscal year 2004. The table details the number and size of tax expenditure estimates between the two lists. For example, in the National Defense budget function, the revenue loss estimate for the exclusion of benefits and allowances to armed forces personnel was estimated at $2.5 billion by Treasury and $2.7 billion by JCT. two tax expenditures not listed by Treasury. To identify how tax expenditures have changed over the past three decades in number and size, in terms of aggregate revenue loss, we analyzed the list of tax expenditures reported by the Department of the Treasury (Treasury) in the Budget’s Special Analyses, Appendixes, and Analytical Perspectives for fiscal years 1974 to 2004. The tax expenditures reported by Treasury during this period are listed in table 6. Adjusted gross income (AGI): All income subject to taxation under the individual income tax after subtracting above-the-line deductions, such as certain contributions for individual retirement accounts and alimony payments. Personal exemptions and the standard or itemized deductions are subtracted from AGI to determine taxable income. Alternative Minimum Tax (AMT): A separate tax system that applies to both individual and corporate taxpayers. It parallels the regular individual income tax system but with different rules for determining taxable income, different tax rates for computing tax liability, and different rules for allowing the use of tax credits. Baseline: A benchmark for measuring the budgetary effects of proposed changes in federal revenues or spending. Or, a benchmark for identifying and measuring exceptions to the basic provisions of the tax structure. CBO baseline: CBO’s estimate of spending, revenue, the deficit or surplus, and debt held by the public during a fiscal year under current laws and current policy. For revenues and mandatory spending, CBO projects the baseline under the assumption that present laws continue without change. For discretionary spending subject to annual appropriations, CBO is required to adjust the current year’s discretionary budget authority to reflect inflation, among other factors. Comprehensive income tax baseline: This baseline, also called Haig- Simons income, is the real, inflation adjusted, accretion to wealth arising between the beginning and ending of the year. It includes all accretions to wealth, whether or not realized, whether or not related to a market transaction, and whether a return to capital or labor. Inflation adjusted capital gains would be included in comprehensive income as they accrue. Consumption tax baseline: A broad-based consumption tax is a combination of an income tax plus a deduction for net saving. Many current tax expenditures related to preferential taxation of capital income and savings would not be considered tax preferences under a consumption tax (e.g., capital gains), but preferences unrelated to broad-based saving or investment incentives would remain tax preferences under a consumption baseline. Normal income tax baseline: The Budget Act did not specify the baseline income tax against which tax preference provisions should be measured, and deciding whether provisions are exceptions from the normal baseline is a matter of judgment. The normal income tax baseline is meant to represent a practical and broad-based income tax that reflects the general and widely applicable provisions of the current federal income tax. For the individual income tax, the Joint Committee on Taxation’s (JCT) normal tax baseline includes one personal exemption for each taxpayer, one for each dependent, the standard deduction, the existing tax rate schedule, and deductions for investment and employee business expenses. Itemized deductions that are not necessary for the generation of income but exceed the standard deduction level are classified as tax expenditures. Very similar in scope to JCT’s normal income tax baseline, Treasury's baseline is patterned on, but allows several major departures from, a comprehensive income tax, where income is defined as the sum of consumption and the change in net wealth during a given period. Reference tax law baseline: The reference baseline is closer to existing tax law and is also patterned on, but still allows several major departures from, a comprehensive income tax. Thus fewer tax provisions are considered tax preferences under the reference tax baseline than under the normal tax baseline. These include the lower tax rate for certain corporations, preferential rates on capital gains, accelerated depreciation, deferral of tax on income from controlled foreign corporations, etc. Budget function: One of 20 broad categories into which budgetary resources are grouped so that all budget authority and outlays can be presented according to the national interests being addressed. There are 17 broad budget functions, including national defense, international affairs, energy, agriculture, health, income security, and general government. Three other functions—net interest, allowances, and undistributed offsetting receipts—are included to complete the budget. De minimis rule: The level of revenue loss below which a revenue loss estimate is not reported for a tax preference. Direct loans: A disbursement of funds by the government to a nonfederal borrower under a contract that requires the repayment of such funds with or without interest. Discretionary spending: Outlays controlled by appropriation acts, other than those that fund mandatory programs. Entitlement authority: Authority to make payments (including loans and grants) for which budget authority is provided in advance by appropriations acts to any person or government if, under the provisions of the law containing such authority, the U.S. government is obligated to make the payments to persons or governments who meet the requirements established by law. Government Performance and Results Act (GPRA): Enacted in 1993, GPRA, also known as the Results Act, intends to improve the efficiency and effectiveness of federal programs by requiring federal agencies to develop strategic plans, annual performance plans, and annual program performance reports. Grants: A federal financial assistance award making payment in cash or in kind for a specified purpose. The federal government is not expected to have substantial involvement with the state or local government or other recipient while the contemplated activity is being performed. Gross domestic product (GDP): The value of all final goods and services produced within the borders of a country such as the United States during a given period. The components of GDP are consumption expenditures (both personal and government), gross investment (both private and government), and net exports. Mandatory spending: Also known as direct spending. Mandatory spending includes outlays for entitlement authority (for example, the food stamp, Medicare, and veterans’ pension programs), payment of interest on the public debt, and nonentitlements such as payments to the states from Forest Service receipts. By defining eligibility and setting the benefit or payment rules, the Congress controls spending for these programs indirectly rather than directly through appropriations acts. Tax expenditure: A revenue loss attributable to a provision of the federal tax laws that grants special tax relief designed to encourage certain kinds of behavior by taxpayers or to aid taxpayers in special circumstances. The Congressional Budget and Impoundment Control Act of 1974 lists six types of tax expenditures: exclusions, exemptions, deductions, credits, preferential tax rates, and deferral of tax liability. Preferential tax rates: A reduction of the tax rate on some forms of income, such as capital gains. Tax credit: An amount that offsets or reduces tax liability. When the allowable tax credit amount exceeds the tax liability, and the difference is paid to the taxpayer, the credit is considered refundable. Otherwise, the difference can be (1) allowed as a carryforward against future tax liability, (2) allowed as a carryback against past taxes paid, or (3) lost as a tax benefit. Tax deduction: An amount that is subtracted from the tax base before tax liability is calculated. Deductions claimed before and after the adjusted gross income line on the Form 1040 are sometimes called “above-the-line” and “below-the-line” deductions, respectively. Tax deferral: A provision allowing taxpayers to reduce current tax liability by delaying recognition of some income or accelerating some deductions otherwise attributable to future years. This can increase the taxpayer’s future tax liability, as the deferred income is eventually recognized, or reduce the deductions available on future income. Tax exclusion: An item of income that would otherwise constitute a part of the taxpayer’s gross income, but is excluded under a specific provision of the tax code. Exclusions generally do not appear on the U.S. Individual Income Tax Return (Form 1040), and excluded income is not reflected in total reported income. Tax exemption: A reduction in taxable income offered to taxpayers because of their status or circumstances. Tax expenditure revenue loss estimate: The measure of the revenue cost of each tax expenditure. The revenue cost is the difference between tax liability under current law and the tax liability that would result if taxes were recomputed without that tax expenditure. Revenue cost estimates assume (1) economic behavior does not change, and (2) all other tax expenditures remain in the code unchanged. Tax expenditure outlay-equivalent estimate: The amount of budget outlays that would be required to provide the taxpayer the same after-tax income as would be received through the tax provision. The outlay- equivalent measure allows the cost of a tax preference to be compared with a direct federal outlay, were each to provide the same benefit to the taxpayer. Unified budget: A comprehensive budget in which receipts and outlays from federal funds and trust funds are consolidated; generally a cash or cash equivalent measure in which receipts are recorded when received and expenditures are recorded when paid, regardless of the accounting period in which the receipts are earned or the costs incurred. In addition to the individual named above, MaryLynn Sergent, Assistant Director, as well as Eric Gorman, Edward Nannenhorn, Anne Stevens, and Lynn Wasielewski made key contributions to this report. Other individuals also contributing to this report included Ellen Grady, Susan Irving, Shirley Jones, Donna Miller, Amy Rosewarne, and William Trancucci. 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Summary: Numerous federal programs, policies, and activities are supported through the tax code. As described in statute, tax expenditures are reductions in tax liabilities that result from preferential provisions, such as tax exclusions, credits, and deductions. They result in revenue forgone. This report, done under the Comptroller General's authority, is part of an effort to assist Congress in reexamining and transforming the government to meet the many challenges and opportunities that we face in the 21st century. This report describes (1) how tax expenditures have changed over the past three decades in number, size, and in comparison to federal revenue, spending, and the economy, and (2) the amount of progress made since our 1994 recommendations to improve scrutiny of tax expenditures. Whether gauged in numbers, revenues forgone, or compared to federal spending or the size of the economy, tax expenditures have represented a substantial federal commitment over the past three decades. Since 1974, the number of tax expenditures more than doubled and the sum of tax expenditure revenue loss estimates tripled in real terms to nearly $730 billion in 2004. The 14 largest tax expenditures, headed by the individual income tax exclusion for employer-provided health care, accounted for 75 percent of the aggregate revenue loss in fiscal year 2004. On an outlay-equivalent basis, the sum of tax expenditure estimates exceeded discretionary spending for most years in the last decade. For some budget functions, the sum of tax expenditure estimates was of the same magnitude as or larger than federal spending. As a share of the economy, the sum of tax expenditure outlay-equivalent estimates has been about 7.5 percent of gross domestic product since the last major tax reform legislation in 1986. All federal spending and tax policy tools, including tax expenditures, should be reexamined to ensure that they are achieving their intended purposes and designed in the most efficient and effective manner. The nation's current and projected fiscal imbalance serves to reinforce the importance of engaging in such a review and reassessment. Although data and methodological challenges exist, periodic reviews of tax expenditures could establish whether they are relevant to today's needs; if so, how well they have worked to achieve their objectives; and whether the benefits from specific tax expenditures are greater than their costs. Over the past decade, however, the Executive Branch made little progress in integrating tax expenditures into the budget presentation, in developing a structure for evaluating tax expenditure outcomes or in incorporating them under review processes that apply to spending programs, as we recommended in 1994. More recently, the Administration has not used its Program Assessment Rating Tool process to systematically review tax expenditures or promote joint reviews of tax and spending programs sharing common goals.