For years, Congress has preferred to use tax incentives rather than direct spending to encourage investment. Thus, while a home buyer may not care whether she gets a tax credit or a check from HUD, for example, Washington seems to have concluded that the tax subsidy is good while the check from HUD is bad. Never mind that both are, in reality, spending.

This bit of political ledgerdemain has made it increasingly difficult for lawmakers to choose the most efficient way of delivering subsidies. But surprisingly, the current economic mess may be bringing some clarity to this issue. 

While many provisions of the new stimulus act continue the love affair that Congress and President Obama have with tax expenditures, the law also includes a hint that Washington may be rethinking this infatuation. Tax subsidies have little current value for recession-hammered investors who are now losing money and, thus, not paying taxes at all. Perhaps, as a result, at least three provisions of the stimulus act buck the recent trend toward tax expenditures and instead allow businesses and local governments to take their subsidies in the form of grants.

All three allow an election to convert tax benefits into direct grants. One provides cash payments for purchase of property which produces energy from renewable sources. The second lets states substitute direct grants for the low income housing tax credit, which they can then allocate to private developers. The third allows states which issue taxable bonds in place of traditional tax-exempt ones to use cash grants from Washington to cover the higher interest costs.

All three provisions show up in the tax portion of the stimulus act. Does JCT score them as tax cuts? If so, perhaps we can begin to utilize direct grant programs when it is more efficient to do so without being accused of “spending.”

Unlike deductions that provide a greater benefit to those taxed at higher marginal rates, a credit can provide an equal subsidy to all potential investors—as long as they owe enough tax and the credit itself is taxable. And keep in mind that most credits are themselves taxable, often by reducing the cost basis of the subsidized property. So, in these cases all we need to do to provide a benefit that exactly mimics a grant program is to make the “tax credit” refundable as well as taxable. Or more simply do what the stimulus act does and substitute a cash grant

In this regard, one provision of the stimulus act went badly off track. Since the low income housing credit does not require a basis reduction and is accordingly tax-free, the grant states could get to replace the credit would similarly not require a basis reduction. Exempting direct grants from tax is a terrible precedent. 

Of course, the stimulus act may be an aberration and Congress may soon return to its addiction to tax expenditures. Nevertheless, congressional recognition that tax expenditures, even credits, can be ineffective and inefficient is a breath of fresh air. It will be fascinating to see how these new provisions work out.