What Are Tax Subsidies and How Do They Work?

Tax subsidies are government incentives delivered through the tax system. They encourage specific activities or behaviors by reducing the tax burden on individuals or businesses. Instead of direct spending, these subsidies represent revenue the government chooses not to collect, functioning as an indirect financial benefit.

What Are Tax Subsidies?

Tax subsidies provide financial advantages to specific activities, entities, or groups, lowering their tax liability. This means the government collects less revenue than it otherwise would, a concept known as “foregone revenue.”

The term “tax expenditures” is often used interchangeably with tax subsidies. These expenditures are considered a counterpart to direct government spending, achieving policy goals by reducing tax collected rather than issuing direct payments. For example, a direct grant might provide $1,000, while a tax subsidy could allow an individual to reduce their tax bill by $1,000. Both offer a financial benefit, but a tax subsidy lets the taxpayer keep more of their own money.

Federal law defines tax expenditures as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” They reduce the tax burden for recipients. Unlike direct spending programs, many tax expenditures are embedded in the tax code and continue unless specifically changed by new legislation.

Mechanisms of Tax Subsidies

Tax subsidies are implemented through various mechanisms within the tax code, each affecting a taxpayer’s liability differently. These provisions reduce the amount a taxpayer owes.

Tax Deductions

Tax deductions reduce a taxpayer’s taxable income, the portion of income subject to taxation. For example, if an individual in the 22% tax bracket qualifies for a $1,000 deduction, their taxable income is reduced by $1,000, resulting in a tax saving of $220 ($1,000 x 0.22).

Tax Credits

Tax credits directly reduce the amount of tax owed, dollar-for-dollar. If a taxpayer owes $1,500 in taxes and qualifies for a $500 tax credit, their tax liability is immediately reduced to $1,000. Tax credits can be either non-refundable or refundable.

A non-refundable tax credit can reduce a taxpayer’s liability to zero, but any excess credit is not refunded. For example, if a taxpayer owes $200 in taxes and has a $500 non-refundable credit, their tax bill becomes $0, but they do not receive the remaining $300. In contrast, a refundable tax credit can reduce the tax owed to zero and, if the credit exceeds the tax liability, the remaining balance is paid out as a refund. The Earned Income Tax Credit (EITC) is a common example of a refundable credit.

Tax Exemptions

Tax exemptions exclude certain types of income, assets, or activities entirely from taxation. For instance, interest income from state and local bonds is often exempt from federal income tax. Additionally, certain qualifying non-profit organizations can receive tax-exempt status from the IRS, meaning they do not pay federal income tax.

Preferential Tax Rates

Preferential tax rates apply a lower tax rate to specific types of income or activities compared to standard ordinary income tax rates. This is commonly seen with long-term capital gains, which are profits from the sale of assets held for more than one year. For most taxpayers, long-term capital gains are taxed at 0%, 15%, or 20%, depending on their overall taxable income. This lower rate incentivizes investment.

Common Applications of Tax Subsidies

Tax subsidies are widely applied across various sectors to encourage specific economic and social behaviors.

Housing

In housing, homeowners can benefit from several tax deductions. The mortgage interest deduction allows taxpayers to deduct interest paid on qualified home loans, generally up to $750,000 of mortgage debt. Property taxes paid on a primary residence can also be deducted, though the deduction for state and local taxes (SALT) is subject to a cap.

Education

Education is another area where tax subsidies are prevalent. The American Opportunity Tax Credit and the Lifetime Learning Credit provide direct reductions in tax liability for qualified education expenses. For example, the American Opportunity Tax Credit can offer up to $2,500 per eligible student, with a portion potentially refundable. Students may also deduct interest paid on qualified student loans, subject to income limitations.

Healthcare

Healthcare costs can be eased through tax provisions like the medical expense deduction, which allows taxpayers to deduct unreimbursed medical expenses exceeding a certain percentage of their adjusted gross income. Tax credits for health insurance premiums are available to help eligible individuals and families afford coverage purchased through the Health Insurance Marketplace. Health Savings Accounts (HSAs) also offer a triple tax advantage: contributions are tax-deductible, earnings grow tax-free, and withdrawals for qualified medical expenses are tax-free.

Environmental Initiatives

To promote environmental initiatives, tax credits are often available for renewable energy investments, such as installing solar panels or making energy-efficient home improvements. These credits directly reduce the amount of tax owed, encouraging homeowners to adopt greener technologies.

Savings and Retirement Planning

Savings and retirement planning are incentivized through tax-advantaged accounts. Contributions to traditional 401(k)s and Individual Retirement Accounts (IRAs) are typically tax-deductible, while earnings grow tax-deferred until retirement. Additionally, long-term capital gains from investments held for over a year receive preferential tax rates.

Charitable Giving

Charitable giving is also supported by tax deductions. Individuals who itemize can generally deduct cash contributions made to qualified charitable organizations, often up to 50% of their adjusted gross income.

Why Governments Use Tax Subsidies

Governments use tax subsidies as a policy instrument to achieve various objectives. These incentives influence economic behavior and outcomes to align with broader societal goals.

Stimulate Economic Activity

Governments use tax subsidies to stimulate economic activity. By offering tax reductions for specific investments or behaviors, they encourage growth in targeted sectors. For instance, tax credits for research and development (R&D) expenses encourage businesses to innovate, leading to new products, technologies, and job creation. Tax advantages for small businesses can also foster entrepreneurship and local economic development.

Promote Social Welfare

Governments also utilize tax subsidies to promote social welfare. For example, tax credits like the Earned Income Tax Credit (EITC) provide financial relief to low and moderate-income families, helping to reduce poverty. Subsidies for homeownership, such as the mortgage interest deduction, aim to make housing more accessible. Tax benefits for education, like tuition credits or student loan interest deductions, seek to increase access to higher education. Encouraging charitable giving through deductions also supports non-profit organizations that deliver social services.

Address Market Failures

Tax subsidies can be used to address market failures. For example, environmental tax credits for renewable energy installations aim to correct the market’s under-provision of clean energy by making it more financially attractive for individuals and businesses to invest in sustainable practices.

Redistribution of Wealth

Tax subsidies can also play a role in wealth redistribution. Refundable tax credits, such as the Earned Income Tax Credit and portions of the Child Tax Credit, provide financial support to lower and middle-income households. These provisions aim to create a more equitable distribution of resources.