Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / The Hidden Cost of Tax Expenditures
Transcript
- Lucas: If you walk through the economy with us, you probably know that about thirty percent of the federal budget doesn't show up as a check written to a contractor or a salary paid to a civil servant. It shows up as money we didn't collect from you. Luna: Right, and most people don't even realize that losing tax revenue is treated as spending by the Congressional Budget Office. It's a ghost in the machine. Lucas: Exactly. Today we're looking at tax expenditures. These are provisions in the tax code that lower your bill—like the mortgage interest deduction or the preferential rate on long-term capital gains—and economists treat them as if the government gave you a check for that exact amount. It changes how we view the national debt because it hides spending behind a loophole. Luna: It makes sense mathematically, but politically they feel totally different. One feels like support, the other feels like waste. Lucas: That is the central tension. Let's start with the biggest item on the books: the mortgage interest deduction. It costs the federal government roughly one hundred billion dollars a year. That is not a typo. That is more than what the entire Department of Education spends annually. Luna: One hundred billion? I always thought housing subsidies were smaller. Why does it cost so much? Lucas: Because it's uncapped for primary residences up to seven hundred fifty thousand dollars in debt. And here is the kicker: it only helps people who itemize their deductions. So it disproportionately benefits higher-income households who own expensive homes, while renters and first-time buyers get nothing. It's a subsidy for wealth accumulation, not affordability. Luna: So it actually widens the gap between homeownership and renting, rather than helping entry-level buyers break in. Lucas: Precisely. Now, compare that to the second largest tax expenditure: the exclusion of employer-sponsored health insurance premiums from taxable income. This one is tricky because it's buried in payroll taxes. If you buy health insurance with after-tax dollars, you pay income tax on that money. But if your employer buys it for you, that money is tax-free. This accounts for nearly two hundred billion dollars in lost revenue every single year. Luna: Two hundred billion tied to employment. That seems like a huge anchor on labor mobility. If I change jobs, do I lose that benefit immediately? Lucas: You might. And that creates what economists call 'job lock.' People stay in jobs they hate or under-employ themselves just to keep that tax-advantaged coverage. It distorts the labor market in a way that direct spending never could. The government isn't paying for your doctor visits directly; it's just refusing to tax the transaction, which artificially inflates the price of care. Luna: So the government is essentially subsidizing healthcare costs without ever touching the hospital bills. That's a strange way to run a system. Lucas: It is. And then we have capital gains. When you sell an asset like stock or real estate for a profit after holding it for more than a year, you pay a lower tax rate than ordinary income. Currently, the top rate is twenty percent versus thirty-seven percent for wages. This costs over one hundred billion dollars annually. It incentivizes holding assets rather than earning labor income. Luna: Which means if you work hard for a salary, you pay more than someone who waits ten years for their investment portfolio to grow. Is that really considered fair by the architects of the tax code? Lucas: The argument was originally about preventing double taxation and encouraging risk-taking in new businesses. But today, it mostly benefits those who already have capital to invest. It shifts the burden onto wage earners. We're seeing a divergence where the wealthy pay effective tax rates lower than middle-class teachers or nurses. That's a structural feature of our current fiscal policy. Luna: It feels like we've built a financial system that rewards patience and wealth over effort and time. How does this impact the actual deficit numbers? Lucas: It masks the true size of government. If you counted tax expenditures as direct spending, the federal budget would be significantly larger. You can't cut a program that doesn't exist on a spreadsheet. Politicians love tax expenditures because they can claim they are cutting taxes while simultaneously claiming they are funding social programs. It's a fiscal sleight of hand. Luna: So we have a budget that looks balanced on paper, but it's actually bloated with hidden liabilities that no one votes on. Lucas: Correct. And because these provisions are embedded in the Internal Revenue Code, they require an act of Congress to change. Usually, that means raising taxes, which is political suicide. Direct spending cuts are easier to frame as efficiency improvements. Removing a tax break is framed as taking away a right. Luna: But aren't those rights actually privileges granted by the state? Like the mortgage deduction. You don't have a constitutional right to deduct interest. Lucas: No, you don't. But once a subsidy becomes entrenched, it creates a constituency. Homeowners vote. Investors donate. They fight tooth and nail to keep those loopholes. Meanwhile, the general fund gets squeezed to make up the difference, leading to higher marginal rates elsewhere or increased borrowing. Luna: It's a self-reinforcing cycle. The more we rely on tax breaks, the less revenue we have, so we need more breaks to stimulate growth, which reduces revenue further. Lucas: Spot on. And this brings us to a specific case study from the last quarter. The Corporate Average Effective Tax Rate has dropped below eighteen percent for the largest s and p five hundred companies, despite statutory rates being higher. Why? Because of R&D credits, depreciation schedules, and offshore deferral mechanisms. These are all tax expenditures. Luna: Eighteen percent. That sounds incredibly low compared to what my local business pays in property and payroll taxes. Lucas: It is. And local governments don't have these tools. They rely on property taxes and sales taxes. So we have a federal system that encourages corporate profitability through complex accounting tricks, while local schools and infrastructure crumble because the revenue stream is too narrow and rigid. Luna: That disparity between federal flexibility and local rigidity is something I haven't heard discussed enough. It explains a lot about municipal bond yields. Lucas: It does. Now, before we go deeper into the mechanics of how this affects your personal portfolio, I want to take a brief pause to talk about how this show exists. It's something we discuss internally quite often. Luna: Yeah, we try to keep things transparent here. What's the situation with the funding model right now? Lucas: We operate entirely without advertisements. A small group of listeners supports us monthly through buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. — and that contribution literally covers our production costs. It keeps us independent and allows us to dive into topics like this without any commercial pressure. Luna: It really does make a difference. Knowing that our audience values this depth of analysis is what keeps the lights on and lets us research these angles thoroughly. Lucas: Exactly. And it ensures we can continue producing daily episodes for free. Anyway, let's get back to the data. When you remove these tax expenditures, the theoretical base broadens. Could we lower statutory rates and still raise the same revenue? Luna: Theoretically yes, but practically it requires a consensus that rarely happens. Who decides which loopholes close? Lucas: That's the political question. Economists generally agree that a broader base with lower rates is more efficient. It reduces distortion. If everyone paid fifteen percent on everything, including capital gains and health benefits, the market would allocate resources based on productivity, not tax avoidance strategies. Luna: But eliminating the mortgage deduction overnight would crash the housing market. There's no transition plan that works without hurting millions of people. Lucas: True. That's why reforms are usually gradual. Phase out the benefit for homes above a certain value, or cap the deduction. But even small changes face fierce opposition. We see this in the debate over the State and Local Tax deduction, which caps the SALT deduction at ten thousand dollars. It was intended to limit the subsidy for high-tax states, but it was portrayed as a punishment for working in cities like New York or San Francisco. Luna: So the framing matters as much as the math. If you call it a 'deduction,' it sounds like a reward. If you call it a 'spending program,' it sounds like a liability. Lucas: Naming it correctly is half the battle. When we recognize that the health insurance exclusion is effectively a subsidy, we can ask whether it should be capped or shifted to a direct payment system. Maybe we give everyone a fixed credit instead of letting employers exclude millions in pre-tax dollars. Luna: A fixed credit would level the playing field. Low-income workers who don't itemize currently get zero benefit from the exclusion. A credit would help them too. Lucas: Yes. It transforms a regressive subsidy into a progressive benefit. That is the kind of structural fix that could stabilize the budget while improving equity. But it requires admitting that the current system is broken. Luna: Admitting it is the hard part. Once we accept that tax breaks are spending, the whole conversation about fiscal responsibility changes completely. Lucas: It does. We stop asking 'how much did we spend?' and start asking 'what did we choose not to collect?' Both numbers matter equally to the treasury. Ignoring one just gives you a false sense of security. Luna: I think that's the key takeaway for our listeners. Look past the headline deficit number. Look at the revenue foregone. That's where the real policy decisions live. Lucas: Exactly. And as we move into the next quarter, watch how these tax expenditures interact with inflation adjustments. Many deductions are indexed for inflation, meaning they grow automatically without congressional approval. It's a silent driver of long-term fiscal drift. Luna: Silent and growing. It's almost like compound interest, but for government waste. Lucas: A perfect analogy. Next time you file your taxes, or look at your W-two, remember that the line items reducing your liability are also line items adding to the national debt. The choice between a deduction and a grant is purely political, but the economic impact is identical. Luna: And recognizing that link might be the first step toward demanding a tax code that actually serves the public interest, rather than just optimizing for the highest bidder. Lucas: Hopefully. Until next time, keep questioning the baseline.