A tax expenditure is a provision in the tax code that reduces what a taxpayer owes, and in doing so, reduces how much revenue the federal government collects. Think of it as government spending delivered through the tax system instead of through a traditional program. Rather than writing you a check, the government lets you keep money you would otherwise owe in taxes. The most familiar examples include deductions for mortgage interest, tax credits for children, and the fact that your employer’s contributions to your health insurance aren’t counted as taxable income.
How Tax Expenditures Work
The federal tax code starts from a baseline: a set of rules about what counts as income, what rates apply, and when taxes are due. Any provision that carves out an exception to that baseline is a tax expenditure. These exceptions take several forms:
- Exclusions let you leave certain income off your tax return entirely, like employer-paid health insurance premiums.
- Deductions reduce the amount of income subject to tax, like the deduction for state and local taxes.
- Credits directly reduce the tax you owe, dollar for dollar. The Child Tax Credit is a well-known example.
- Preferential rates tax certain income at lower rates than ordinary income. Long-term capital gains, for instance, are taxed at rates well below what most workers pay on wages.
- Deferrals let you postpone paying tax until a later year, as with contributions to a traditional 401(k).
Each of these has the same net effect on the federal budget as writing a check would. If the government gives a $1,000 grant to encourage homeownership, that costs the Treasury $1,000. If it instead lets a homeowner deduct $1,000 in mortgage interest, the Treasury loses the same revenue. The mechanism differs, but the budget impact is similar.
The Largest Tax Expenditures
Tax expenditures are not small. According to U.S. Treasury estimates covering 2025 through 2034, the five largest provisions will cost the federal government trillions in forgone revenue over that decade:
- Exclusion of employer-paid health insurance: roughly $3.9 trillion. When your employer pays part of your health insurance premium, that compensation is not taxed as income. This is the single most expensive tax expenditure in the code.
- Exclusion of imputed rental income: about $2.2 trillion. If you own your home, you effectively “pay rent” to yourself, but that value is never taxed. Renters don’t get an equivalent break.
- Defined contribution retirement plans: about $2.1 trillion. Contributions to 401(k)s and similar employer plans grow tax-deferred, and employer matches are excluded from income.
- Capital gains preferences: roughly $1.8 trillion. Profits from selling investments held longer than a year are taxed at lower rates than wages.
- Deduction for state and local taxes: about $974 billion. Taxpayers who itemize can deduct certain state and local taxes from their federal taxable income.
These five provisions alone account for more than $10 trillion in reduced federal revenue over a decade. Hundreds of smaller tax expenditures exist alongside them, covering everything from electric vehicle credits to tax-free college savings plans.
Why Governments Use Tax Breaks Instead of Direct Spending
If a tax credit has the same budget cost as a spending program, why choose one over the other? Several practical reasons push policymakers toward the tax code.
Administration is often simpler. Delivering a small benefit to millions of people through a new government program requires building infrastructure: application portals, verification systems, staff. Delivering the same benefit through the tax return piggybacks on a system that already reaches most households. The IRS is already processing the returns, so adding a line item is cheaper than standing up a new agency.
Behavioral economics also plays a role. Research suggests people respond more strongly to keeping money they already have (through a lower tax bill) than to receiving an equivalent payment. A $2,000 reduction in taxes owed feels like avoiding a loss, while a $2,000 government check feels like a gain. Even though the dollar amounts are identical, the tax break may be more effective at encouraging the desired behavior, whether that’s buying a home, saving for retirement, or investing in solar panels.
Politics matter too. Tax expenditures don’t show up in the annual budget the way traditional spending does. They aren’t subject to the same yearly appropriations process, which means they tend to be more durable once enacted. A direct spending program can be cut in next year’s budget cycle, but a tax deduction often stays in the code for decades with little formal review. Legislators who want to promote a policy goal without appearing to increase government spending frequently prefer the tax route.
How Tax Expenditures Are Tracked
Federal law requires the Treasury Department to publish a “tax expenditure budget” as part of the president’s annual budget proposal. This document lists every provision the Treasury considers a tax expenditure and estimates how much revenue each one costs.
The estimates have important limitations. Each provision is measured independently, assuming the rest of the tax code stays the same. Because provisions interact with each other, you can’t simply add up individual estimates to get a grand total. Repealing two provisions at once might raise more or less revenue than the sum of their separate estimates suggests.
Treasury also reports two types of figures: a current revenue effect (the annual cash-flow impact) and a present value estimate that accounts for the time value of money. The present value approach is particularly useful for deferrals like retirement plan contributions, where the government collects the tax eventually, just years later.
Who Benefits Most
Tax expenditures tend to deliver larger benefits to higher-income households, a pattern researchers call the “upside-down subsidy.” The reason is structural. A deduction, for example, is worth more to someone in a higher tax bracket. If you’re in the 37% bracket, a $10,000 deduction saves you $3,700. If you’re in the 12% bracket, the same deduction saves you $1,200. The person with more income gets a bigger subsidy for the same activity.
Higher-income households are also more likely to use tax expenditures in the first place. They’re more likely to own homes (and claim mortgage interest deductions), hold investments (and benefit from capital gains rates), and have employer-sponsored retirement plans. Lower-income households, many of whom take the standard deduction and have no investment income, often don’t benefit from these provisions at all.
One proposed reform that surfaces regularly is converting deductions into flat-rate credits. If every taxpayer got a 15% credit instead of a deduction, the benefit per dollar spent would be the same regardless of income. This would eliminate the upside-down effect, though it would also reduce the tax break for higher earners who currently benefit from it.
Why Tax Expenditures Matter for Tax Reform
Every dollar of revenue lost to a tax expenditure is a dollar that must be made up through higher tax rates, more borrowing, or less spending on other programs. This is why tax expenditures sit at the center of nearly every serious tax reform proposal. Eliminating or scaling back tax expenditures would broaden the tax base, meaning more income gets taxed. A broader base allows the same revenue to be raised at lower rates, or more revenue to be raised at current rates.
Reducing tax expenditures also simplifies the code. Fewer special provisions means fewer forms, fewer calculations, and fewer opportunities for taxpayers to structure their finances around tax considerations rather than economic ones. When the tax system treats all income the same way, people and businesses make decisions based on what’s actually productive rather than what generates the best tax outcome.
The political challenge is that every tax expenditure has a constituency. The mortgage interest deduction is backed by homeowners and the real estate industry. Employer health insurance exclusions are defended by employers and insurers. Retirement plan tax breaks have broad public support. Eliminating any single provision creates visible losers, even if the overall reform would leave most people better off. That tension is why tax expenditures, once created, rarely disappear.