Tax Breaks Aren't Subsidies

Tax Breaks Aren't Subsidies

Both the left and the right have been lamenting the fact that "Big Business" has been granted a number of tax exemptions and tax credits. These are often derided as "subsidies," and subsidies, we know, are bad...Why?

Because subsidies are the result of taking from one and giving to another.

As of late, this charge has been made against the AI data centers in Wisconsin. For example, prominent leftists in the Wisconsin Legislature, everyday Republicans and Democrats, and even Wisconsin Treasure, Charlie Berens, have knocked the tax exemptions granted to AI data centers. Often exemptions and credits are put-down when given to business, generally, or when they're given for residential solar or other political pet projects. There's some merit to these complaints, but more on that later.

The state's decision to grant these exemptions and credits is certainly relevant, but not for the reasons that many people think.

Subsidies are Transfer Payments

A subsidy is a transfer payment.

Subsidies always entail forcibly transferring money from one entity to another. Specifically, the state takes money from taxpayers, and gives it to others.

For example, grants are always subsidies. If an employer applies for and receives a grant from the Department of Workforce Development (DWD), the DWD transfers money from its account to the employer's. Since the money is earmarked, the employer spends it to cover the training costs for his employees. But the DWD was only able to give this grant because it first collected the money from taxpayers. The result is that taxpayers under-consume by the size of the tax, and the employer over-consumes workforce training by the size of the grant. Here we have two distortions taking place in the market: the taxpayers have their activity reduced, and the employer has his activity increased beyond what he would have done otherwise.

By extension, this means that all government spending is a subsidy. So public goods like police, fire, Medicare, Social Security, loan guarantees––everything––reduce economic activity in some areas to purposefully increase it in others. This happens no matter what because it is government spending that matters, and not how that spending is financed. So, even deficit spending results in subsidization.

If a deficit is funded with debt, the government's debt "crowds-out" private investment. On the margin, creditors who could earn a 5% return on some private investment choose the "sure thing" offered by government bonds yielding a 4% return. The private-sector loses the investment so that the government program can exist.

If the deficit is instead funded by inflation, then the newly-created money causes an "injection effect" (Cantillon Effect) which progressively weakens the money's purchasing power as it makes its way through the economy, and results in a wealth transfer from those who receive the money later to those who receive it first. The deficit is financed by reducing the power of the Dollar, thus increasing the general price level, and effectively placing a "tax on savings" as Milton Friedman explained.

What Do They Do?

So are tax exemptions and tax credits subsidies? In short, exemptions never are, but credits can be.

Tax Exemptions

Tax exemptions are never subsidies. When something is exempt from tax you consume more of that thing, but you do so with your own money. Removing the tax actually removes the "deadweight loss" that results from taxation by increasing the benefits that emerge from trade. Taxes hamper the market by reducing the volume of trade for a given thing, so removing them restores exchange to the free-market level.

Some people say that exemptions unfairly "subsidize" the consumption or production of one thing over another. But in reality, the tax is discouraging consumption and production of the other.

Imagine you farm corn and wheat in equal proportion, and that both cost the same to produce and earn you the same income. If government places an equal tax on both, your production mix doesn't change. All that changes is your output and your income, which are now lower. If government later decides to eliminate the tax on corn, your production mix will change, and there will be a distortion in the corn and wheat markets. As a result, you will now produce more corn relative to wheat.

It is this effect which is understood by many to be a "subsidy" to the corn industry. Some believe that the lack of a tax on corn causes more corn to be produced. But a thing which does not exist cannot cause an effect. What is actually happening is that the presence of a tax on wheat causes less wheat and more corn to be grown.

This may "promote" or "encourage" corn growing, but not directly. The tax is penalizing wheat growers, and as a result creates a new equilibrium in the corn and wheat markets. Wheat is now more expensive to produce and therefore less profitable; corn is now relatively more profitable, so corn production increases. By farmers increasing their production of corn in pursuit of greater profits, they are actually working to maximize the benefit to consumers by employing resources in a more valuable activity. This is no different from a completely free-market scenario where wheat was naturally more expensive and less profitable than corn. In that world, consumers would positively demand that farmers grow more corn relative to wheat, rather than squander resources in modes of production consumers deem less valuable.

And of course, free market folks would certainly prefer there to be no taxes, or at the very least, equal taxes. But a lot of the time that is not the choice we face. In the case where one good is taxed but not another, the choice is between keeping resources employed where they are regardless of the changing economic conditions, or adapting to those new conditions by changing how resources are utilized to maximize the benefits of trade.

What's worse, some people say "If I'm paying taxes, they need to pay taxes too!"

Who in their right mind would scold a burglar for robbing one house instead of two? Should all homeowners be burgled for equity's sake?

Bottom line: exemptions are not subsidies because there is no forcible transfer of funds from one entity to another.

Tax Credits

Tax credits can be tricky. Sometimes tax credits are subsidies. It depends.

A tax credit works by reducing someone's tax bill. If you owe $10,000 in taxes, but qualify for a $1,000 credit, your tax bill is reduced to $9,000. But what if you qualify for $10,000 in credits? Or more than $10,000?

Consider the individual income tax. If you get enough credits so that your tax bill is $0, that's fine. You're simply keeping what you earned. But if your tax credits are so large that your tax bill is negative, that's a subsidy. This is because you're not just keeping the full amount of your gross income, the state is dipping into someone else's income to cut you a check.

This can become even trickier if we start trying to calculate the value of all the government services someone consumes. When someone receives more from government than they pay in taxes, they become what Murray Rothbard calls a net taker. Frederic Bastiat calls this class of people the plundering class. The opposites of these are net payers and the productive class.

It becomes possible, then, that someone with a positive tax bill is still a net taker while someone with a negative tax bill is not. For example, someone can pay $1,000 in taxes but consume $50,000 of government services. Free housing, medical, education, food stamps, and so on. On the flip side, someone with a negative tax bill could still be a net payer if government services produce negative value––like troopers who over-police by citing drivers for traffic violations they did not commit.

Of course, calculating this sort of thing on an individual basis is practically impossible. As a simple alternative, the best way to determine whether someone is being subsidized is if their tax bill is negative.

When Tax Exemptions & Credits Really Matter

Tax exemptions and credits are probably much more relevant politically than they are economically...assuming the economics of your state are pretty good.

But politically, whether an exemption or credit exists tells you something very important about the mind of a legislator or the fiscal responsibility of a government.

With respect to legislators proposing tax exemptions, this is especially relevant if the exemptions are always granted for business. This is a political mistake and an economic mistake.

Politically, people won't be happy about this. You'll hear all about business needing to pay its "fair share," and exemptions for contentious industries like AI will even ruffle the feathers of folks on the right.

But the economic mistake is much more interesting. Granting businesses exemptions only addresses one side of the economic equation. An economy consists of producers and consumers. Most people are producers, but everyone is a consumer. And it is actually the consumer, not business, who "steers" the economy. As Mises says, the consumer is king...

And just as a practical matter, even if all of business were tax exempt, what would it matter if consumers don't have the means to purchase their products? Sure, business gets to keep every dollar it makes, but if consumers have little to no disposable income (from being over-taxed or having their money inflated into oblivion) then business gets to keep 1 tax-free Dollar rather than $100 post-tax.

Government officials' priorities should consider the burdens of producers and consumers in equal measure, but probably with favor toward consumers since they are the largest economic class. For example, a standard income tax deduction of at least $100,000 would engender an economic boom unlike anything ever seen. But ultimately, when trying to improve the standard of living or grow the economy, they should look toward reducing the total tax burden faced by consumers.

Lastly, tax breaks become politically relevant if they put the government into a fiscally precarious position. If a government is taking on debt or running perpetual deficits, it introduces state-wide vulnerabilities that threaten the economy as a whole. This is an economic concern, but one that has only a political solution. In this regard, if tax breaks would push a government into a deficit, then they must be balanced by reductions in spending.