“Tax Expenditures”, when used by the federal government, refers to the loss of tax revenue as a result of exemptions, exclusions, deductions and credits contained in the US tax code. It is effectively a government subsidy provided through the tax code to both individuals and businesses.
US individual taxes are reduced each year by many tax expenditures. Some of the larger ones include the deductibility of mortgage interest, state and local taxes and charitable contributions.
The US corporate tax code also contains a wide variety of exemptions, exclusions, deductions, accounting methods and credits that greatly reduce the tax payments made by American businesses.
Each year, the US Treasury Department prepares a “ Tax Expenditure Report” that estimates the value of all the tax expenditures contained in the US tax code. The most recent report covers fiscal year 2017 and outlines 168 separate exemptions, exclusions, deductions and credits available to both individuals and corporations. This report itemizes 1) total tax expenditures, 2) corporate tax expenditures reflected in corporate tax returns, and 3) individual tax expenditures flowing through individual tax returns.
Remember that a large number of businesses are structured as sole proprietorships, partnerships, S Corps and LLC’s. All of these businesses flow their income through to the individual owners, who then pay tax through their individual tax returns.
To determine the total value of tax expenditures benefiting US businesses, The Informed Vermonter took all the exemptions, deductions and credits that apply to corporations and tracked them through the report on individual tax returns, thereby measuring the total tax expenditures available to businesses.
In 2017, total tax expenditures for businesses was $266 billion, of which $217.2 billion went to corporations and $48.8 billion went to LLC’s, S-Corps and other flow-through business entities (see chart below).
To put this is perspective, total corporate tax receipts in 2017 were only $299.1billion. The various exemptions, exclusions, deductions and credits in the corporate tax code basically reduced corporate taxes by 42% in 2017. Some of the largest tax “loopholes” are described below.
- Deferral of income from controlled foreign corporations. In the baseline tax code, US tax is calculated on all income, both foreign and domestic. To avoid double taxation, any foreign tax paid on income becomes a tax credit for US tax purposes. Over the years, this baseline tax system has been eroded to the point where only foreign income actually transferred in cash back to the USA was subject to tax. By allowing companies to avoid paying any tax at all on foreign income, the US basically subsidized foreign investment by US corporations. This tax expenditure was $107 billion in 2017 and totaled almost $1.5 trillion over the last ten years. A similar provision for financial service firms was another $16 billion in 2017.
- R&D expenditures & R&D tax credits. In the baseline tax system, research and development expenditures are capitalized and amortized over time to reflect the long-term benefits. To motivate high levels of R&D spending, the tax code now allows companies to expense R&D upfront, thereby reducing their taxable income on a dollar-for-dollar basis. Tax credits are available for companies that increase R&D spending above predetermined baseline levels. R&D tax expenditures were $19.8 billion in 2017.
- Accelerated depreciation of machinery and equipment. In the baseline tax system, investments in machinery and equipment are depreciated over a period corresponding to their useful life. To incentivize investment, the tax code allows businesses to expense their investments over a much shorter time period, thereby reducing their taxable income. Accelerated depreciation generated $44.3 billion of tax expenditures in 2017.
- Deduction for US production activities. The baseline tax system generally would tax all income under the regular tax rate schedule. It would not allow preferentially low (or zero) tax rates to apply to certain types or sources of income. In contrast, the tax code allows for a deduction equal to a portion of taxable income attributable to domestic production. This tax expenditure was $13.5 billion in 2017.
- Deferred gains for like-kind exchanges. The trouble with accelerated depreciations is capital gains. If you write down the value of an asset faster than its useful life and then sell it, you are likely to have a capital gain. To avoid the tax on capital gains, the tax code allows the deferral of the gain if the proceeds of the sale are invested in similar equipment or machines. This tax expenditure was $7.7 billion in 2017.
Tax Reform Act
The 2018 Tax Reform and Jobs Act materially changed some of these tax expenditures and the impact won’t be seen or known until the next Tax Expenditure Report is published next year. Two changes are worthy of note.
First, for the next five years, the Tax Reform Act permits businesses to write-off 100% of capital investments in the year incurred. This is accelerated depreciation on steroids and will serve to increase tax expenditures.
Second, the taxation of foreign income has been materially changed. There is now a minimum tax on the income of the foreign subsidiaries of US companies. It is all very complex, but for simplicity lets call it a 10.5% tax. Subject to this minimum tax, foreign income can now be repatriated to the US parent with no additional tax. There is a one-time, mandatory tax on all foreign accumulated earnings and profits (“E&P”) since 1986. There is an estimated $2-3 trillion dollars of accumulated earnings sitting in off-shore accounts. The one-time tax is 15.5% on E&P held in cash and cash equivalents and 8% on any residual amounts. Companies can pay this tax over 8 years in installments.
The Tax Reform Act of 2018 reduced corporate tax rates to 20%. As noted above, some of the exemptions, exclusions and deductions have been altered, but largely remain in place. As a result, the effective tax rate for corporations, which was just about 20% before the Tax Reform Act, will be significantly lower and tax receipts from corporations and businesses will be greatly reduced.
Tax Expenditures Are Subsidies: Tax expenditures represent government spending via the tax code. There is no economic difference between reducing a corporation’s tax bill by $1 million or granting a corporation a $1 million cash grant. The real difference is transparency. The recipient of a grant is reported. The recipient of the tax cut is not.
Corporate Welfare Is A Big Expense: As noted above, total business tax expenditures in 2017 were $266 billion. Corporate grants, direct subsidy payments, loans and loan guarantees can be measured in the tens of billions annually. In total, US businesses are getting over $300 billion a year in handouts from the federal government.
Note: Federal Business Tax Expenditures Fiscal Year 2017 ($ millions)
|Tax Expenditure Corporate||Individual Flow Through||Total|
|-Deferral of Income from controlled foreign corporations||107,200||—||107,200|
|-Deferred taxes of financial firms on certain overseas income||16,080||—||16,080|
|-Inventory property sales source rules exemption||3.320||—||3,320|
|Total International Income||126,600||—||126,600|
|General Science, Space & Technology|
|-Credit for increasing R&D activities||10,520||980||11,500|
|Total Science, Space & Technology||18,140||1,690||19,830|
|-Expensing of exploration & development costs||(470)||(180)||(650)|
|-Excess of percentage over cost depletion: fuels||350||90||440|
|-Enhanced oil recovery credit||220||50||270|
|-Energy production credit||1,190||400||1,590|
|-Energy investment credit||1,390||460||1,850|
|-Temporary 50% expensing for refining costs||(1.380)||—||(1,380)|
|-13 other deductions, exemptions & credits||850||330||1,180|
|Natural Resources & Environment|
|-Excess of percentage over cost depletion: minerals||120||20||140|
|-Exclusion of interest on bonds for water, sewage…||130||290||420|
|-Expensing of multi-period timber growing costs||210||130||340|
|-Tax incentive to preserve historic structures||430||70||500|
|-Industrial CO2 capture tax credit||190||—||190|
|-4 other deductions, exemptions & credits||90||120||210|
|Total Natural Resources & Environment||1,170||630||1,800|
|Commerce & Housing|
|-Accelerated depreciation for machinery & equipment||28,810||15,490||44,300|
|-Deduction for US production activities||9,930||3,570||13,500|
|-Credit for low income housing investment||7,890||420||8,310|
|-Deferred gains from like-kind exchanges||6,000||1,690||7.690|
|-Exemption of credit union income||2,918||—||2,918|
|-Exclusion of life insurance death benefits||2,870||11,880||14,750|
|-Exemption of insurance income earned by tax-exempt org.||720||—||720|
|-Exclusion of interest on mortgage subsidy bonds||350||800||1,150|
|-Exclusion of interest on rental housing bonds||320||740||1,060|
|-Accelerated depreciation of rental housing||360||1,730||2,090|
|-Depreciation of non-rental housing||(3,860)||(4,940)||(8,800)|
|-Graduated corporate income tax rates||1,550||—||1,550|
|-5 other deductions, exemptions & credits||570||3,260||3,830|
|Total Commerce and Housing||58,428||36,640||93,068|
|-4 deductions, exemptions & credits||200||160||360|
|Community & Regional Development|
|-New markets tax credit||1,430||30||1,460|
|-7 other deductions, exemptions & credits||530||820||1,350|
|Total Community & Regional Development||1,960||840||2,800|
|Education, Training, Employment & Social Services|
|-Work opportunity tax credit||1,001||319||1,320|
|-Exclusion of interest on bonds of non-profit education facilities||690||1,560||2,250|
|-5 other deductions, exemptions & credits||470||770||1,240|
|Total Education, Training, Employment & Social Services||2,161||2,649||4,810|
|-Tax credit for orphan drug research||2,240||40||2,280|
|-Exclusion of interest on hospital construction bonds||1,031||2,349||3,380|
|-Special Blue Cross/Blue Shield tax benefits||590||—||590|
|-Special ESOP rules||1,960||120||2,080|
|Total Income Security||1,960||120||2,080|
|-Credit for certain employer contributions to Social Security||490||550||1,040|
|Total Social Security||490||550||1,040|
|-Expensing of multi-period production costs||20||290||310|
|-Capital gains treatment of certain income||—||1,360||1,360|
|-5 other deductions, exemptions & credits||50||380||430|
|TOTAL CORPORATE TAX EXPENDITURES||217,190||48,848||266,038|
Source: US Treasury Tax Expenditure Report, 2017 Tax Year