Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Tax Expenditures Skew Federal Budgets
Transcript
- Lucas: If you open the federal budget document today, October twenty-eighth, two thousand twenty-six, you see a list of appropriations. You see money going to defense, to education, to infrastructure. It feels linear. But there is a shadow side to that ledger, a parallel universe of spending that never actually touches a government agency. These are tax expenditures. Luna: Right, so it’s money the government chose not to collect rather than money it chooses to spend. That distinction matters because it makes the scale of federal support look completely different depending on which column you’re looking at. Lucas: Exactly. And the sheer size of it is staggering. When we talk about the deficit, we usually focus on the gap between revenue and outlays. But if you add back the major tax expenditures, the effective size of the federal government shrinks dramatically in terms of actual resource allocation. The Congressional Budget Office estimates that tax expenditures cost roughly one point five trillion dollars annually. That is larger than the entire defense budget. Luna: One point five trillion dollars is a number that sounds abstract until you realize it could fund every non-defense discretionary program for years. Why do we treat a tax break like a check written to a contractor? Lucas: Because politically, it is easier. Writing a check requires an appropriation bill, committee hearings, and a vote. A tax expenditure is baked into the code. You don’t need to pass new legislation to give someone a benefit; you just leave a loophole in place. It is passive governance. And the biggest beneficiary of this passive governance is not the poor, or even the middle class, but homeowners with large mortgages. Luna: The mortgage interest deduction. That has been a staple of American housing policy since nineteen thirteen, hasn't it? Lucas: Since nineteen thirteen. And it remains one of the single largest tax expenditures in the United States. In recent CBO estimates, the mortgage interest deduction costs around two hundred and thirty billion dollars a year. Here is the thing that most listeners don’t grasp: the value of that deduction scales with your marginal tax rate and the size of your loan. So a person earning three hundred thousand dollars who takes out a seven hundred thousand dollar mortgage gets a vastly larger subsidy than a first-time homebuyer with a standard loan. Luna: It effectively subsidizes luxury housing while doing almost nothing for affordability for the average worker. It’s a wealth transfer disguised as a home ownership incentive. Lucas: Precisely. And it distorts the entire housing market. Developers know that high-income earners have access to this massive tax break, so they build larger homes with higher price tags, assuming the buyer can deduct the interest. It pushes prices up. If you eliminated the deduction tomorrow, you wouldn’t crash the market, but you would remove a significant artificial bid on property values. The question is, why haven’t we touched it? Luna: Because everyone owns a home now, or wants to. Even renters pretend to be future owners. It’s the American Dream wrapped in a tax shelter. Who is going to volunteer to kill that dream? Lucas: No one. And that is the trap of tax expenditures. They become entrenched. But the mortgage interest deduction isn’t the only one. There is another giant hiding in plain sight, one that affects almost every single employed listener in this country. The employer-sponsored health insurance exclusion. Luna: You mean the fact that employers don’t pay taxes on the health benefits they provide? That is huge. I’ve seen estimates that it costs nearly three hundred billion dollars a year. Lucas: That is correct. And like the mortgage deduction, it is regressive. It provides the greatest benefit to those with the highest tax rates. If you make fifty thousand dollars, the value of that exclusion is modest. If you make five hundred thousand dollars, the tax savings on a comprehensive family health plan are enormous. It encourages over-insurance. People get gold-plated plans because they aren’t paying for them with after-tax dollars. It drives up healthcare costs industry-wide. Luna: So we are subsidizing inefficient healthcare consumption through the tax code. It’s a double whammy. We pay for the system indirectly through lost revenue, and then we pay again when bills arrive because the market is distorted. Lucas: Exactly. And here is where the fiscal drag comes in. As healthcare costs rise, the value of that exclusion rises with it. It creates a feedback loop. The more expensive healthcare becomes, the bigger the tax break, which keeps demand high, which keeps prices high. It is a closed loop of inefficiency that the federal budget supports without ever showing it as a line item. Luna: This makes me wonder about the political viability of reform. If you can’t touch the mortgage deduction or the health exclusion, how do you actually reduce the deficit? Do you just raise income taxes across the board? Lucas: That is the classic debate. Broaden the base, lower the rates. Many economists argue that if you eliminated these major deductions, you could significantly lower top marginal tax rates while raising more revenue. It would simplify the code. But the political math is brutal. The groups benefiting from these tax expenditures are organized, vocal, and wealthy. The beneficiaries of efficiency gains—future generations, or the poor—are diffuse and quiet. Luna: So we are stuck with a system that rewards lobbying power over economic logic. Is there any precedent for successful reform? Did we ever actually fix something like this? Lucas: There was a moment in the late eighties. The Tax Reform Act of nineteen eighty-eight did a lot of work to broaden the base and lower rates. It cut dozens of loopholes. But it didn’t touch the big ones—the mortgage interest deduction and the health exclusion remained intact. Since then, the trend has been toward adding new credits rather than removing old ones. We keep building onto the house instead of renovating it. Luna: It’s like adding rooms to a foundation that is already cracking. You just make the structural problems worse. What about state-level experiments? Have any states tried to limit these kinds of federal spillovers? Lucas: Not really, because the federal tax code preempts so much of state taxation. States are largely forced to conform to federal definitions of income. So even if a governor hates the mortgage interest deduction, their state can’t easily decouple from it without creating chaos for their residents. It locks states into the federal framework. Luna: That explains why local governments are so desperate for grants. They can’t control the levers that matter most. They are just trying to survive within a system designed by Washington decades ago. Lucas: Right. And this brings us back to the present day. In October twenty-twenty-six, we are seeing pressure on entitlements like Social Security and Medicare. Those are the visible parts of the budget. But the invisible part—the tax expenditures—is growing faster in real terms because healthcare costs continue to climb. The gap between what we spend directly and what we spend indirectly is widening. Luna: So the deficit problem isn't just about spending too much. It's about taxing too little on the wrong things. We are starving the treasury of efficient revenue sources while giving away billions to the wealthy through complex codes. Lucas: Yes. And the irony is that many of these tax expenditures were originally created with good intentions. The mortgage deduction was meant to encourage stability. The health exclusion was a wartime wage-control measure that got stuck. But good intentions don’t age well. They calcify into permanent privileges. Luna: Calcified privileges. I like that phrase. It implies they are hard to move and likely to cause injury if you try. Lucas: Very likely. Which is why reform is so difficult. But it is not impossible. Look at the child tax credit expansion during the pandemic. For a brief window, we saw how direct payments could be structured differently than traditional tax breaks. It showed that the government could target aid more precisely without relying on the blunt instrument of the tax code. Luna: But that was temporary. Once the emergency ended, the politics faded. Can we sustain a narrative that tax reform is necessary for long-term stability, not just short-term crisis management? Lucas: That is the challenge. Fiscal literacy among voters is low. Most people don’t know that the mortgage interest deduction exists, let alone its cost. If you can’t educate the public on the trade-offs, you can’t build the coalition needed to change the law. So we are left with incrementalism. Maybe we cap the deduction. Maybe we phase it out for high earners. Small steps. Luna: Small steps that still face massive headwinds. It feels like we are treading water while the tide rises. What should our listeners take away from this today? Just that the budget is bigger than we think? Lucas: I hope they take away that transparency matters. When you hear politicians talk about 'spending cuts,' ask them which tax expenditures they plan to eliminate. Because if they aren’t willing to touch the mortgage deduction or the health exclusion, their promises are likely empty. Real fiscal responsibility requires confronting the shadow budget. Luna: And realizing that sometimes the best way to save money is to stop giving it away through the back door. Before we go, I want to pause for a second on how this show works. Lucas: Yeah, quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. No ads, just us talking about the economics that affect your life. If walking through the economy with us has made something click, consider supporting us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Luna: It really does help keep the lights on and the research sharp. Thanks for listening. Now, back to the numbers. Lucas: Let’s look at one final data point. The Joint Committee on Taxation recently analyzed the distributional effects of eliminating the top ten tax expenditures. The result was stark. The top one percent would see their average tax liability drop by less than two percent, while the bottom half of earners would see no change at all. The burden of maintaining these loopholes falls disproportionately on the middle class, who bear the brunt of other tax increases needed to balance the books. Luna: So the status quo isn’t just inefficient. It’s inequitable. We are asking the people who contribute the least to extract the most from the system to maintain the privileges of the few. Lucas: That is the core tension. Economics is rarely just about efficiency. It is always about who wins and who loses. And right now, the tax code is rigged to protect the winners while ignoring the losers. Until we acknowledge that, we will keep running deficits that we cannot explain, let alone solve. Luna: A fair assessment. It forces us to ask whether we want a government that spends openly, or one that hides its priorities behind a maze of exemptions. Lucas: Exactly. And as we move into the next quarter, watch for any bipartisan proposals that address the base-broadening issue. It might be the only path left. Thanks for tuning in.