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In 1967, the tax expenditure concept was created by Stanley Surrey, then Assistant Secretary of the Treasury, as a means to elucidate the political use of tax breaks for means that were usually accomplished through direct spending programs. Secretary Surrey argued that members of Congress were using tax policy not as means to raise and collect revenue but as a ``vast subsidy apparatus to reward favored constituencies or subsidize narrow policy areas (Surrey 1973, p. 6). Tax expenditures alter the horizontal and vertical equity of the basic tax system by allowing exemptions, deductions, and credits to specialized groups or activities. Historically, the U.S. income tax system has been used to promote social and economic goals. Since the initial adoption of the income tax, numerous provisions have been labeled as “tax loopholes” or “tax breaks.” These terms were used to identify a tax evasion not foreseen by Congress but discovered by tax lawyers. There is a second category of long-standing tax provisions that were adopted deliberately by Congress as “tax preferences” and were not unintended escape routes for income tax evasion. The tax expenditure concept takes the next step, recognizing that these “tax preferences” are really government spending programs and, consequently, public assistance administered through the tax code. The Congressional Budget and Impoundment Act of 1974 (CBA) officially codified and defined tax expenditures as "those revenue losses attributable to provisions of the Federal tax laws which allow a special credit, a preferential rate of tax, or a deferral of tax liability.” There are three main types of tax expenditures: exclusions, deductions, and credits (less frequent are preferential tax rates and deferrals of tax liability). The difference between exclusions, deductions, and credits relates to where each provision factors into the calculation of income and tax liability. Exclusions are those items excluded from gross income, which means they never enter into the "top line" calculation of the taxpayer's tax base. Deductions are those items that may be subtracted from gross income in computing taxable income. Credits are allowed against the tax rates imposed by the tax code, thereby reducing an individual’s tax liability. Refundable credits provide a payment to the individual even if all of her tax liability is eliminated.

The Congressional Joint Committee on Taxation (hereafter JCT) annually estimates tax expenditures in terms of revenues lost to the U.S. Treasury for each special tax provision included in the U.S. tax code. A provision has traditionally been listed as a tax expenditure if it departs from the normal income tax structure and if it results in more than a de minimis revenue loss ($50 million). Under the JCT methodology, the normal tax structure for an individual includes the following: one personal exemption for each taxpayer and one for each dependent, the standard deduction, the existing tax schedule, and deductions for investment and employee business expenses. Most tax benefits to individual taxpayers can be classified as exceptions to "normal income tax law" and therefore qualify as tax expenditures. Each annual tax estimate is a function of subtracting two predicted streams of revenues: predicted revenues under current law from predicted revenue under new and expanded tax provisions.