How Specifications of the Reference Tax System Affect CBO’s Estimates of Tax Expenditures

The Congressional Budget Act of 1974 (the Budget Act) 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.” Tax expenditures thus arise from provisions (exclusions, deductions, tax credits, and preferential rates) in the federal tax system that grant special tax treatment for certain types of income, activities, or groups. In turn, those provisions cause government revenues to be lower than they would be if the provisions did not exist.

Tax expenditures have a large effect on the federal budget. On the basis of estimates prepared by the staff of the Joint Committee on Taxation (JCT), the Congressional Budget Office estimates that the value of all tax expenditures in the individual and corporate income tax systems totaled $1.6 trillion, or 7.8 percent of gross domestic product, in fiscal year 2019. That amount was equal to nearly half of all federal revenues, exceeded all discretionary outlays, and totaled about 60 percent of all mandatory spending in the federal budget, which includes spending on Social Security and Medicare.

To identify and measure tax expenditures, the normal tax structure in which such provisions represent special treatment must first be defined. That normal tax structure is known as the reference tax system—the underlying framework of tax laws and administrative practices in which tax expenditures are analyzed. Thus, a reference tax system reflects a particular conceptual basis for taxation as well as other features necessary to implement and administer the tax code.

This report outlines how the specifications of the reference tax system used by CBO affect the agency’s estimates of tax expenditures. Before the Budget Act became law, both the Treasury and JCT produced estimates of tax expenditures. Although the Budget Act subsequently required CBO to report on tax expenditures, it did not establish a specific framework for identifying or measuring them. As a result, there is no single, consistent definition of the reference tax system or its features that is universally used when analyzing tax expenditures. The specifications of such a system can therefore vary, which has led analysts to disagree about the appropriate specifications for the reference tax system and the resulting estimates of tax expenditures.