Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Tax Expenditures Skew Federal Budgets
Transcript
- Lucas: When we talk about government spending, we usually picture the Appropriations Committee chopping up bills for defense, education, or infrastructure. But there is a second, quieter ledger that runs parallel to that, one that costs just as much but never gets a vote in the traditional sense. Luna: You mean tax expenditures? The things we call loopholes when they benefit us and credits when they benefit corporations? Lucas: Exactly. And I use the word 'expenditure' deliberately here because economists treat them that way. When the Treasury forgoes two hundred billion dollars in revenue to subsidize renewable energy, it is mathematically identical to writing a check for two hundred billion dollars to a private company. It is money the government does not collect, which means it cannot spend elsewhere. Luna: Right, so it is a subsidy disguised as a deduction. But why do politicians love this mechanism so much compared to actual line-item spending? Lucas: Because it looks like lower taxes. If you pass a new spending bill, you have to raise revenues somewhere else to balance it out eventually. But if you expand a tax credit, you can claim you are cutting taxes while simultaneously directing that money exactly where you want it. It is fiscal stealth. Luna: It feels less accountable too. You don't get an inspector general watching over a tax break the same way you would over a grant program. Lucas: That is the core tension we are looking at today. Let us look at the Child Tax Credit expansion debates from last year. When lawmakers proposed making it fully refundable, they weren't just changing who paid taxes; they were creating a massive social safety net program hidden inside the Internal Revenue Code. Luna: And the cost was roughly two hundred billion dollars annually, which is more than the entire budget for many federal agencies combined. Lucas: Precisely. And yet, when that provision expired, the backlash wasn't framed as 'spending cuts.' It was framed as 'tax increases' for families. That framing shift is entirely due to the vehicle being used. We need to understand how these provisions actually work in practice, not just in theory. Luna: So let us start with the corporate side. What is the most significant tax expenditure for businesses right now? Lucas: The Research and Development tax credit is probably the biggest driver of innovation policy. It allows companies to deduct a percentage of their R&D spending from their tax liability. On paper, it is supposed to encourage innovation by lowering the cost of failure. Luna: But doesn't it also just reward companies that were already going to spend heavily on research anyway? Like the big tech firms? Lucas: That is the classic economic critique. If I am building a new software platform, and the government says I get ten percent back on those costs, I might still build it. The credit lowers my effective tax rate, but it doesn't necessarily change my decision to invest. It becomes pure profit enhancement rather than behavioral modification. Luna: So it functions more like a bonus for successful incumbents than a lifeline for startups. Lucas: Exactly. Startups rarely have enough taxable income to use non-refundable credits anyway. They burn cash. So the R&D credit disproportionately benefits established players who can offset their profits. It is a wealth transfer mechanism disguised as an innovation incentive. Luna: That seems inefficient. Why not just give them a direct grant if the goal is to spur innovation? Lucas: Because grants require oversight. Grants mean you have to decide which projects win. Tax credits are automatic. If you meet the criteria, you get the money. It is politically easier to distribute money invisibly than to pick winners and losers publicly. Luna: So the inefficiency is the feature, not the bug. It avoids political friction by hiding the allocation process. Lucas: Spot on. And this brings us to the housing market, which is another massive bucket for tax expenditures. The mortgage interest deduction is arguably the largest single tax break for homeowners. Luna: I know that one well. It caps at seven fifty thousand in debt, right? Which means it mostly helps people buying expensive homes. Lucas: It helps people buying expensive homes, yes. And it inflates home prices. Because buyers know they get a tax break on interest, sellers can charge more. The government subsidizes the purchase price indirectly. It is a regressive subsidy in terms of distribution because higher-income households save more on their taxes due to marginal rates. Luna: So the richer you are, the bigger your tax break on your mortgage. That sounds like a policy designed to widen the wealth gap. Lucas: It certainly has that effect. And it distorts the housing market away from rentals and toward ownership. We spend hundreds of billions a year encouraging people to buy houses, which drives up construction costs and land values. If we eliminated that deduction and put the money into a first-time buyer grant, we might actually help entry-level buyers instead of subsidizing luxury real estate. Luna: But no one wants to touch the mortgage interest deduction because everyone loves owning a home. It is politically toxic to suggest removing it. Lucas: True. Which is why it persists. But let us look at the environmental side, which is growing fast. The Inflation Reduction Act introduced a slew of clean energy tax credits. Luna: Like the credits for buying electric vehicles or installing solar panels? Lucas: Yes. And these are structured differently. Some are refundable, meaning if you don't owe taxes, you still get the cash. That is crucial for middle-class adoption. But they are also capped and phase-out based on income. It is a targeted approach to behavior change. Luna: Does it work? Are people actually switching to EVs because of the credit, or did they want one anyway? Lucas: Sales data shows a spike during the rollout periods. The uncertainty around the credit expiration causes sales to dip. That suggests the credit is marginally effective. It pushes some hesitant buyers over the line. But again, we have to ask: is the cost worth the emission reduction? Luna: That is the hard part. Calculating the return on investment for a tax credit is messy. You don't get a clear metric like you would with a public works project. Lucas: Right. With a bridge, you know how much it cost and you can measure traffic flow. With a tax credit, you see a drop in revenue and hope for a long-term societal benefit. It is a bet, not a guarantee. Luna: And sometimes those bets go wrong. Like the production tax credits for biofuels that ended up supporting corn ethanol despite mixed environmental results. Lucas: A perfect example. The policy intent was good, but the implementation favored a specific industry lobby. Now we have decades of infrastructure built around a fuel source that may not be as green as promised. That is the risk of tax expenditures. Once they are embedded in the code, they become permanent fixtures of the economy. Luna: So we end up with a system where special interests embed their subsidies into the tax code, making them harder to remove than direct spending programs. Lucas: Much harder. Direct spending requires annual renewal. Tax expenditures are often permanent unless actively repealed. They accumulate like sediment. Over thirty years, you have hundreds of billions locked into outdated incentives. Luna: It makes me think about the complexity of filing taxes. All these forms exist just to track whether you qualify for these various expenditures. Lucas: The compliance cost is enormous. Small businesses spend thousands of dollars hiring accountants to navigate the R&D credit rules. That is money spent on bureaucracy rather than production. It is a deadweight loss that rarely gets discussed. Luna: So the argument for simplification isn't just about fewer pages in the tax code. It's about economic efficiency. Lucas: Exactly. If you broadened the base and lowered the rates, eliminating most of these expenditures, you could reduce the statutory corporate tax rate significantly. That is what supply-side economists advocate for. Lower rates, fewer loopholes. Luna: But then you lose the ability to use the tax code for social engineering. You can't target specific behaviors easily. Lucas: No, you can't. And some argue that is a good thing. Government should raise revenue neutrally and spend it transparently through the budget process. Using the tax code as a policy lever is opaque and undemocratic. Luna: It feels like we are stuck in the middle. We can't move to full transparency because the entrenched interests fight it, but we can't keep the current system because it's unfair and complex. Lucas: We are definitely stuck. But understanding the mechanics helps you see where the money is actually going. When you hear 'tax cut,' ask yourself: who specifically benefits? Is it a broad rate cut, or is it a targeted credit for a specific industry? Luna: That is a vital question for voters. Most people don't realize their 'tax savings' might just be a subsidy for a corporation they have no connection to. Lucas: Right. And that disconnect is why trust in fiscal institutions is so low. People feel the system is rigged, and often, the data supports that feeling when you look at the top five tax expenditures. Luna: Okay, before we dive deeper into the legislative hurdles, I want to pause for a moment about how this show exists. Lucas: Yeah, sure. We have had listeners ask about the model lately. Luna: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that is literally what funds making this many of these episodes. Lucas: It keeps us independent. No ads, no sponsors dictating topics. Just a small group of supporters who value deep economic analysis. Luna: If that resonates with you, checking out that link is the best way to support the work directly. Lucas: Back to the policy gridlock. Why is reform so difficult even when everyone agrees the system is broken? Luna: Because every tax expenditure has a constituency. Remove the mortgage interest deduction, and you anger homeowners. Remove the R&D credit, and you anger tech. There is no winner in a reform bill. Lucas: Correct. It is a game of musical chairs where everyone refuses to leave their seat. The only way out is a comprehensive overhaul, which requires bipartisan cooperation that currently does not exist. Luna: So we are left with incremental changes. Small tweaks to existing credits rather than structural reform. Lucas: Until the next crisis forces a re-evaluation. Or until the revenue shortfall becomes undeniable. Right now, the deficit is large enough that every dollar of forgone revenue matters more than it did twenty years ago. Luna: Which puts pressure on lawmakers to either raise taxes or cut expenditures. Both are painful. Lucas: They are. And that pain is likely to define fiscal policy for the next decade. We will see more debates over refundable credits, more scrutiny of corporate incentives, and perhaps a slow move toward transparency. Luna: Will we ever get to a point where tax expenditures are treated exactly like spending bills? Subject to sunset clauses and regular reviews? Lucas: Some experts argue we should. It would force accountability. But until then, we have to read between the lines of the tax code to understand the true shape of government spending. Luna: And that is probably the most important skill for any modern investor or voter. Understanding where the money goes, not just where it comes from. Lucas: Absolutely. The ledger tells the whole story. You just have to know how to read it.