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Everyone in Washington loves tax credits and deductions. Politicians tout them as a painless way to help families pay for green energy, buy homes or lower the cost of healthcare. They’re also politically irresistible: No one wants to be accused of “raising taxes” by trimming perks that voters now consider to be entitlements.
But for all their popularity, “tax expenditures” — what budget experts call feel-good policies like the mortgage-interest deduction or education credits — are among the most corrosive and costly features of the federal tax code. New evidence backs up this skepticism.
Economists have long known that tax expenditures make our taxes unnecessarily complicated, distort pragmatic economic decision making and mostly benefit hand-selected political constituencies. My Mercatus Center colleague Jack Salmon and I have spent time demonstrating that most tax expenditures don’t offer broad-based relief but rather narrow carve-outs that erode critical tax revenue while tilting the scales toward the special interests that sell whatever we’re nudged into buying.
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Tax expenditures stand in sharp contrast to a neutral tax system — one that taxes income and consumption consistently and only once, trusts individuals to make buying decisions without manipulation and leaves resource allocation to markets. Special-interest tax credits should ultimately be terminated.
A new study by Indiana University’s Bradley Heim looks at the issue from a different perspective: Do the largest individual tax incentives actually achieve their goals, and are they cost-effective?
Heim defines cost-effectiveness this way: For every dollar of tax revenue the government gives up, do we see at least a dollar’s worth of additional activity result in the targeted area? If not, the expenditure is wasteful and it would be better to subsidize the activity directly or, better yet, to lower tax rates across the board and stop micromanaging economic life through the tax code.
Some provisions do actually pass Heim’s test. Although Salmon and I believe the charitable deduction should be reformed, it’s been shown to encourage genuine new giving.
Not surprisingly, Heim finds that retirement-savings tax breaks in employer-based 401(k) plans have historically been effective. This isn’t new knowledge. In the 1990s, research demonstrated that these accounts generated several dollars of additional savings for every dollar of lost tax revenue, making them pro-growth.
The finding dovetails with what Salmon and I argue: Provisions that remove the double taxation of savings, including 401(k)s, are not loopholes but essential features of a well-designed tax system. When we stop double- or triple-taxing savings, of course people will save more.
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On the other hand, Heim finds that many of the most expensive tax expenditures fail miserably.
Deducting the interest on mortgage payments has virtually no effect on whether someone buys a house. It mostly leads to larger mortgages and bigger homes for wealthier households. That’s a subsidy for the upper middle class.
Also failing are education credits, such as the American Opportunity Tax Credit. Decades of research show no measurable impact on college enrollment or completion rates. Colleges surely pocket some of the subsidies through higher tuition, but students are not attending in greater numbers. Here again, tax revenue vanishes with almost nothing to show for it.
The exclusion of employer-sponsored health insurance (ESHI) payments is the single largest individual tax break, costing in excess of $3 trillion over the next decade. Most employees would take the insurance their employers offer with or without this incentive. It ends up inflating the size and cost of plans, driving up health spending, making it more necessary to insure through one’s employer and entrenching workers in their current jobs.
Salmon and I would argue to terminate these three expenditures on the basis that they’re destructive special-interest tax breaks.
Interestingly, Heim finds that tax deductions for the self-employed to buy health insurance raise coverage rates and, hence, are cost-effective. Yet this deduction is not a healthy, neutral fix for saving or investment — it’s more like an attempt to level the health-coverage playing field between the self-employed and employees. If we got rid of the ineffective ESHI tax break, we wouldn’t need this other one, either.
The implications are clear: Tax credits and deductions are generally not harmless ways to help taxpayers. They are costly, distortionary privileges captured by industries and interest groups. They complicate the tax code, mask the true size of government and fail to deliver the promised bang for the buck.
Worse still, they drain revenue in a fiscal environment where the United States is already loaded down by a debt of $37 trillion and rising — making them anything but free gifts from the government. They are wasteful, and that’s the last thing the country can afford. If politicians were serious about tax reform and fiscal responsibility, they would start by eliminating any tax expenditures that fail the tests of neutrality or cost effectiveness.
Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University. This article was produced in collaboration with Creators Syndicate.
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Ideas expressed in the piece
Tax expenditures represent some of the most corrosive and costly features of the federal tax code, despite their political popularity among Washington politicians who view them as painless ways to help families. Rather than providing broad-based relief, these provisions primarily serve as narrow carve-outs that benefit hand-selected political constituencies while eroding critical tax revenue and distorting economic decision-making.
A neutral tax system that taxes income and consumption consistently, trusts individuals to make purchasing decisions without government manipulation, and leaves resource allocation to markets would be superior to the current system of targeted incentives. Most tax expenditures fail basic cost-effectiveness tests, where the government should see at least one dollar of additional targeted activity for every dollar of foregone tax revenue.
While certain provisions like charitable deductions and retirement savings accounts in 401(k) plans demonstrate genuine effectiveness by encouraging new behavior, many of the most expensive tax expenditures fail dramatically. The mortgage interest deduction has virtually no impact on homebuying decisions but primarily subsidizes larger mortgages and homes for wealthier households, while education credits show no measurable impact on college enrollment or completion rates.
The exclusion for employer-sponsored health insurance, costing over $3 trillion in the next decade, inflates plan sizes and costs while entrenching workers in their current jobs without meaningfully increasing coverage rates. These failures demonstrate that tax expenditures function as destructive special-interest breaks rather than effective policy tools, complicating the tax code while masking government’s true size and draining revenue during a period of mounting national debt exceeding $37 trillion.
Different views on the topic
Tax expenditures serve as essential policy instruments that governments use strategically to achieve important social objectives, including transferring resources to lower-income taxpayers and promoting economic development and growth. These provisions function as legitimate alternatives to direct spending programs, allowing policymakers to accomplish similar budget policy objectives through the tax system rather than traditional outlays[1].
Rather than being mere special-interest giveaways, tax expenditures represent targeted tools designed to encourage beneficial behaviors and assist specific groups that Congress wishes to support[2]. They effectively incentivize citizens and firms to engage in socially desirable activities such as saving for retirement, purchasing homes, and making investments that promote economic growth[3][4].
The tax expenditure framework recognizes the functional similarity between direct government spending and tax-based assistance, acknowledging that both approaches can deliver identical monetary benefits to taxpayers[3]. This flexibility allows governments to choose the most efficient delivery mechanism for achieving policy goals, whether through direct subsidies or tax relief.
Tax expenditures provide governments with an important part of their policy toolbox that can be effective in providing incentives when properly designed and implemented[3]. The revenue loss calculations help policymakers evaluate the relative merits of achieving specific public goals through tax benefits versus direct outlays, enabling more informed decisions about resource allocation and program design[1].
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