Responses to Tax Incentives in a Complex and Uncertain Tax Law : Before the Senate Committee on Finance

Responses to Tax Incentives in a Complex and Uncertain Tax LawEric Toder

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Eric Toder's testimony before the Senate Finance Committee on how tax law complexity limits the effectiveness of tax incentives.

Chairman Baucus, Ranking Member Hatch, and members of the Committee:

Thank you for inviting me to testify today on taxpayer responses to incentives in the individual and corporate income taxes. I will limit my comments to a discussion of how tax incentives might affect behavior, what the available evidence does and does not tell us, and how the increased complexity of the tax code affects responses to these incentives. I will not address the important questions of whether the behaviors that tax incentives encourage add to or subtract from economic efficiency or how tax incentives alter the distribution of income.

The tax code can be viewed conceptually as consisting of two types of provisions – 1) general rules and 2) exceptions to those rules. The general rules define what is to be taxed (the tax "base" or bases), the rates at which taxes should be applied (flat or graduated), the taxpaying unit (single individuals, couples, corporations), and rules for adjusting the tax base to account for family size. The exceptions consist of provisions that allow special exemptions, deductions, tax credits, preferential tax rates, or deferrals of recognition of income for selected activities or categories of taxpayer.

There is considerable dispute about which provisions should be viewed as part of the normative or baseline tax system and which provisions are exceptions, or "tax expenditures". For example, the baseline tax system is a broad-based income tax, while some economists would prefer a consumption-based system that allows deferral of liability until income is consumed. Under such an alternative baseline, deferral of tax on income accrued within qualified retirement plans would no longer be a tax expenditure. Nonetheless, the Congressional Budget Act of 1974 required both the Office of Management Budget (OMB) and the Congressional Budget Office to prepare annual lists of these tax expenditures and estimates of their revenue losses. The Joint Committee on Taxation (JCT) has assumed responsibility for preparing these estimates on the Congressional side. Every year, both OMB and JCT release updated estimates of tax expenditure provisions.

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