Thursday, July 14, 2011

Budget Solution: "Cut Spending AND Cut Tax Expenditures!" I understand the first one, but what does the second one mean? You are going to hear it a lot. I try to explain it here for you...

There is a two word phrase that has been used a lot recently in the Federal budget debate-- "Tax Expenditures". It has been used like this: "We need to reduce government spending AND reduce tax expenditures in the tax code". The first one is self-evident and needs no explanation.  However, the second one I think passes by people and most believe it is a similar in meaning or related to reducing govt spending.

When the Congress taxes your income it is tax revenue for them.  If Congress decides to grant a tax deduction, your taxable income decreases by the amount of the allowable deduction. As a result the tax revenue to the Federal govt will be less than it otherwise would have been...Quick Simplistic Example:

Assumptions: You are single and rent an apartment.  You do your taxes and you calculate you have a taxable income of $150,000 . Using the  IRS tax tables for 2010 you would owe $35,709 in Federal income tax.  Write your check and be done with it.

Now assume you are still single BUT you own a home and last year you paid $10,000 in interest on the loan you took out to buy the house.  As the tax code is presently written, when you do your taxes you can now subtract that $10,000 from the $150,000. Your taxable income is $140,000.  NOW, your Federal tax bill will be $32,909---$2,800 LESS because of the interest deduction you were allowed to take.

Congress considers this $2,800 a "Tax Expenditure"---tax revenue they otherwise would have received if the interest deduction did not exist.  Instead of being revenue for them to spend, they are "expending" it back to you.

When a politician/pundit talks of reducing "tax expenditures", they are referring to eliminating (or reducing) various tax deductions or tax credits that are currently allowed.  In effect you would be paying a larger tax bill--$2,800 in our example.  BUT your TAX RATE did not increase by eliminating this deduction, only your income that is subjected to tax increased.

Reducing or eliminating the interest you pay on a home mortgage is just one area Congress is looking at to raise more revenue without raising taxes. 

Whether you agree or disagree with how the term is used/interpreted, I hope this brief explanation helps you better understand it when you hear it.
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