Tax Expenditure

A tax expenditure is revenue deliberately forgone through deductions, credits, exclusions, or preferential tax rates. Governments could collect this revenue directly but choose to forgo it, achieving policy goals through the tax code rather than explicit spending. The cost to the public is the same; only the accounting differs.

The equivalence principle

A government can subsidise home-ownership in two ways. It can write a cheque to every homeowner for £2,000 per year (a direct expenditure budget item), or it can allow homeowners to deduct mortgage interest from taxable income, reducing their tax bills by about £2,000 (a tax expenditure). The fiscal cost to the government is identical: £2,000 forgone per recipient. The economic effect is identical: homeowners are £2,000 better off, funded by higher taxes on others or higher deficits.

Yet the two appear completely different in the budget. One is listed as spending and must be voted on explicitly, often with sunset dates and mandatory review. The other is embedded in tax code and persists unless actively repealed—a subtle but powerful difference in political durability.

A tax expenditure is, fundamentally, a substitution of implicit subsidy for explicit spending. The government achieves the same fiscal outcome through the tax system instead of direct appropriations.

Common tax expenditure forms

Deductions subtract amounts from taxable income before calculating tax. A mortgage interest deduction, a charitable contribution deduction, or a business expense all reduce the base on which tax is calculated, lowering the tax owed. The benefit is proportional to the taxpayer’s marginal rate: a 50% taxpayer saves 50p per pound deducted; a 20% taxpayer saves 20p. This is regressive: wealthy taxpayers, in higher brackets, receive larger subsidies per pound of eligible spending.

Credits are subtracted directly from tax liability, not income. A child tax credit worth £1,000 reduces tax by £1,000 regardless of bracket. Credits are therefore more uniform in their subsidy, though they can be designed to phase out as income rises.

Exclusions exempt certain income from taxation altogether: employer contributions to health insurance, owner-occupied housing imputed rent (in some countries), certain foreign earned income, or investment income on retirement accounts. These permanently exclude flows from the tax base.

Preferential rates apply lower tax rates to specific income types. Long-term capital gains are often taxed at lower rates than wages; qualified dividends receive preferential treatment; some jurisdictions tax corporate income at lower rates in certain sectors. The subsidy is the difference between the preferential rate and the standard rate, applied to the taxed amount.

Why use the tax code instead of direct spending?

Tax expenditures are politically durable. Once embedded in code, they are easier to maintain than direct spending, which must be reauthorised annually. A deduction or credit can persist indefinitely unless Congress or Parliament explicitly repeals it—a high political bar. Direct spending, by contrast, requires annual appropriations, making it a frequent target for budget cuts.

Tax expenditures are also less visible. They reduce revenue rather than increase spending, so they don’t swell the published budget. This obscures the true size of government outlays and can allow more redistribution to occur without formal debate. Some view this opacity as a feature (reducing political conflict); others see it as a bug (enabling spending without scrutiny).

Tax expenditures also benefit groups with political leverage. Mortgage deductions, capital gains preferences, and business deductions benefit property owners, investors, and entrepreneurs—constituencies with organisational capacity to lobby for their preservation. Benefits for the poor, channelled through tax credits, are more visible and more vulnerable to cuts during fiscal crises.

The cost to public finance

The revenue cost of tax expenditures is massive. In the United States, major tax expenditures total over $1.5 trillion annually—roughly 7% of GDP and nearly half of federal tax receipts. In the UK, tax expenditures are estimated at £100–200 billion per year, also a major fiscal item. Few countries have comprehensive inventories of their tax expenditures, and fewer still reduce them systematically.

The cost falls on other taxpayers. Tax expenditures are funded by either higher tax rates on the general population, higher deficits, or lower spending elsewhere. A mortgage interest deduction for homeowners means higher income tax for renters and lower income for public services. The incidence is real and economically significant, yet politically invisible.

Inefficiency and incidence problems

Tax expenditures are often inefficient tools for achieving policy goals. A deduction is worth more to high-income taxpayers than low-income ones, since the value depends on the marginal tax rate. If the goal is to help poor families, a credit of fixed amount is superior; if the goal is to incentivise behaviour (like charitable giving), a deduction might distort choices inefficiently.

Many tax expenditures subsidise activities people would undertake anyway. A mortgage interest deduction exists in part to encourage home ownership, yet most homeowners would buy homes at lower interest rates regardless. The deduction produces substantial deadweight loss: it reduces the tax base, requiring higher rates elsewhere, inflating deadweight loss across the entire tax system.

The tax incidence of tax expenditures is also often regressive. Deductions and credits for middle-class and wealthy consumption (homes, education, investments) are funded by broad-based taxation that hits all income levels. The net effect is a transfer from lower-income to higher-income groups, even if intended otherwise.

Measuring and controlling tax expenditure

Governments increasingly publish estimates of tax expenditure costs, recognising them as implicit spending. The United States publishes an annual “tax expenditure budget” alongside the regular budget, quantifying major deductions, credits, and preferences. The UK Office for Budget Responsibility (OBR) and other revenue bodies do similar work.

Yet control mechanisms remain weak. Tax expenditures lack automatic sunset dates; they are not evaluated against explicit spending programmes; and their costs are often underestimated, since budget estimates assume static behaviour whilst taxpayers respond to incentives.

Some jurisdictions have enacted “base broadening” reforms, narrowing deductions and preferences in exchange for lower overall tax rates. This can raise revenue, reduce deadweight loss, and simplify the code. However, such reforms face fierce opposition from beneficiaries and often fail or are reversed after a few years.

See also