Why Tax Incentives Hurt More Than Help

What if that mortgage interest deduction you've been counting on is actually making your dream home more expensive? Or if the tax credit for your child's college tuition is secretly inflating their education costs? Welcome to the paradoxical world of well-intentioned tax policies, where good ideas often lead to unintended—and costly—consequences.

In a recent episode of The Earmark Podcast, I explored this issue with Scott Hodge, President Emeritus and Senior Policy Advisor at the Tax Foundation, a leading independent tax policy think tank.

Our conversation revealed how tax policy has a huge impact on everyone – both as professionals and as taxpayers. As Scott put it, "In so many ways our daily lives are ruled by taxes, whether it's how we get our health care to the kind of house or car we buy, so many elements of our daily lives are wrapped up in taxes, whether we know it or not."

As accounting and tax professionals, we must be aware of the hidden costs of well-intentioned tax policies in healthcare, housing, and education, where tax incentives can paradoxically drive up prices, ultimately harming the consumers they aim to help. This isn't just an academic exercise—it's a call to action for our profession.

The Paradox of Well-Intentioned Tax Policies

Let's look at three areas where well-meaning tax incentives have led to unexpected and often counterproductive outcomes.

Consider the healthcare system. The way it operates today, with the majority of Americans receiving health insurance through their employers, stems from tax policies dating back to World War II. During this time, individual income taxes were very high. Employers found offering health benefits, which were not taxed, to be a more competitive way to compensate their employees. This paved the way for what is known as a "third-party payer system," where healthcare providers are more answerable to insurance companies and employers rather than patients. The outcome? A disconnect between consumers and the actual cost of healthcare leads to a rise in medical expenses.

We see a similar paradox in the housing market with the mortgage interest deduction. Designed to make homeownership more accessible, it often has the opposite effect. Scott noted, "A lot of economic research shows that the mortgage interest deduction is built into the price of homes." In competitive markets like Washington, New York, and California, this can make housing less affordable—the exact opposite of its intended purpose.

Perhaps most surprising is how tax incentives affect higher education. Those tuition tax credits we often recommend to clients? They might be padding university coffers more than easing student debt. Scott used a vivid analogy to illustrate.

"Imagine going to Best Buy to buy a television set,” Scott says. “And the sales clerk knows everything about your finances—how much your parents make, how much your house is worth, etc. They can price that television based on your finances, and you wouldn’t have a whole lot of negotiating power, would you?" This is essentially what happens when students apply to universities with tax credits in hand.

The Economic Theory Behind Tax Effects

Scott laid out a fundamental principle that explains why many tax incentives fall short: "If government's trying to subsidize something or incentivize it, it's the sellers of the good that tend to capture the value of that credit or deduction."?

Consider the electric vehicle tax credit, a hot topic in many client conversations. As Scott pointed out, "Obviously the automakers know what the value of that $7,500 credit is. And so they're going to bake that into the price." When advising clients on the potential savings of purchasing an electric vehicle, we need to consider that the sticker price may already reflect much of the tax credit's value.

Conversely, when it comes to tax increases or tariffs, the burden typically falls on consumers. Scott explained, "Let's say we were going to try to disincentivize imports so we increase tariffs by 10% across the board. Well, that's going to get passed on to consumers through a 10% increase in prices across the board." The takeaway? We need to be careful about using the tax code to incentivize and discourage behaviors because either way, we can see some unintended consequences.

Challenges of Tax Reform and the Role of Education

Given the paradoxes and economic principles we discussed, it's clear that our current tax system often falls short of its intended goals. However, as Scott emphasized, "In order to get to tax reform, we're going to have to do a lot of educating on the unintended consequences of these things."

Scott outlined three key attitude changes needed for successful tax reform:

1. Taxpayers must be willing to give up credits and deductions for a simpler, more effective system.
2. Corporations should stop viewing tax departments as profit centers.
3. Lawmakers need to find better ways to deliver benefits than through the tax code.

These mindset shifts are challenging because they often go against ingrained habits and perceptions. Many struggle to understand the trade-off between higher tax rates with more deductions versus lower tax rates with fewer deductions. As Scott explained using the mortgage interest deduction example, "That mortgage interest deduction is a great thing for me. But I understand that it actually makes housing less affordable and less available for everyone. So maybe if we phased it out, we'd all be better off."

This is where our role as educators becomes crucial. When a client comes to us excited about a new tax credit, we need to help them see the bigger picture. By consistently providing this kind of nuanced advice, we're not just helping our clients make better decisions; we're contributing to a more informed public discourse on tax policy.

By explaining how a seemingly beneficial tax credit might be "baked into the price" of goods or services, we can help shift the conversation toward more effective policy solutions.

The challenges of tax reform are significant, but so is our potential impact. We need to arm ourselves with in-depth knowledge and fresh perspectives to lead in this arena. That's why I encourage you to listen to the full episode of the Earmark Podcast featuring Scott Hodge. You'll gain valuable insights into the economic principles driving tax effects and practical strategies for advising clients on these complex issues.