How a Tax Credit Can Actually Lead to Higher Tax Burdens

September 29, 2009

Suppose two guys are trying to take your wallet on the street corner. The first guy distracts you by just saying, “here’s a hundred dollars I’d like to give to you.” You say, wow, thanks. Five seconds later while you are still thanking that “generous” man who gave you $100, his accomplice snatches your wallet out of your pocket. Now you’re out the $200 in your wallet and a net loss of $100.

Imagine the first guy (the guy distracting you) is the government today offering you a tax credit for doing something that the government approves of today. And then suppose the second guy (wallet snatcher) is government tomorrow financing that tax credit in a way that has a greater burden than the credit that was enacted today.

Even if the government gave the same dollar amount in tax cut today as it took away tomorrow in tax hikes, their costs to society are not the same. If government “gives” society a $100 tax credit today for some arbitrarily determined reason (say hybrid car owners) and then raises marginal tax rates in a way that raises $100 tomorrow (ignoring interest), the tax burden on society has been made larger. The tax burden has not remained the same.

For this reason, whether or not a persistent anti-tax person should support tax credits hinges on what he/she believes government is going to do in response to that tax credit. Will government cut some spending that is not worth much? If so, the tax credit is a net improvement for society. But what if he/she believes government will just raise tax rates to finance that tax credit? Then the tax credit is probably going to make society worse off and actually result in a net tax increase when properly measured.


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