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.