There are currently more than 150 tax expenditures, also known as tax breaks, which can take the form of exemptions, deductions, credits, and preferential rates written into the individual and corporate tax codes. In 2016, those breaks exceeded $1.5 trillion. To put that in perspective, that’s more than the government spends on Social Security, Medicare, or defense.
As lawmakers discuss tax reform, these tax expenditures are a key part of the discussion. Many economists believe that eliminating some or all tax breaks would benefit the economy by removing market distortions and simplifying the code.
Here are six of the most expensive individual tax breaks that may figure prominently in the debate and together account for more than 50 percent of annual tax expenditures:
- Exclusion of employer contributions for medical insurance and care ($341 billion in 2016). The single largest tax expenditure in the code may be one you are not even aware of. The premiums that employers pay for their employees’ healthcare are exempt from federal income and payroll taxes. While this tax break benefits a wide swath of Americans by reducing the after-tax cost of health insurance, it is worth more to taxpayers in higher tax brackets than to those in lower brackets.
- Preferential treatment of dividends and capital gains ($196 billion). Income from capital gains (the profit from the sale of a property or investment) and qualified dividends are taxed at a lower rate than other forms of income. Defenders argue that such preferential rates encourage the sort of investment and risk-taking that spur economic growth, but critics note that they disproportionately benefit the wealthy and encourage tax avoidance.
- Exclusion of pension contributions and earnings ($178 billion). Contributions to pension or retirement plans — for example, contributions to 401(k)s and IRAs — are not taxed as income when they are received but instead taxed in the future when the employee withdraws the funds.
- Deduction for State and Local Taxes ($91 billion). State and local taxes, including state income taxes, personal property taxes, local real estate taxes, and general sales taxes, can be deducted from federal tax payments. While anyone who itemizes their taxes can claim this deduction, critics argue that the benefits are unevenly distributed, as wealthier individuals and those who live in areas with higher tax burdens receive more of the benefits.
- Earned Income Tax Credit ($64 billion). This tax credit is primarily available to low-income working parents. The credit is refundable which means that if the total value of the credit is more than a family’s total tax liability, the difference is returned as a tax refund by the IRS. Research shows that the EITC encourages people to work and that recipients use the credit to cover essential costs.
- Deduction of Home Mortgage Interest ($61 billion). If you’re a homeowner, you probably know that interest paid on your mortgage can be deducted from taxable income. This deduction is intended to encourage home ownership, but some findings show that rather than increasing homeownership, it mainly encourages buying larger homes or second homes.
A recent analysis by the Tax Policy Center looked to see how low tax rates could be slashed without increasing the national debt if all of expenditures were eliminated. And, as lawmakers continue to consider overhauling the tax system, they should keep in mind key principles that will help grow the economy — not our national debt.
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