Just as demand for both alternative energy and low-income housing is growing, is the market drying up for the tax credits that drive much of the investment in both?

Evidence is that the answer is “yes.” The culprits: the crumbling economy, paralyzed bond markets, and the government itself. This may be yet another example of the always-deadly law of unintended consequences.

Here is the problem: With the government largely out of the business of building low-income housing, investment in these units is heavily financed through tax credits. With so many people losing their homes and jobs, the need for such housing is growing. Unfortunately, these credit-driven deals had been financed mostly by large financial institutions—firms that need tax breaks like a starving man needs diet pills. The biggest buyers included Fannie Mae and Freddie Mac (‘nuff said), as well as banks such as Citicorp, which is reporting tens of billions in losses.

Banks with no profits have no use for tax shelters. Worse, thanks to a quiet ruling this fall by the Treasury Dept., healthy banks are now acquiring billions in tax losses of failing competitors, thus eliminating their need for additional credits for years to come.

With demand for these credits dried up, their price has plunged in recent months to as little as 75 cents on the dollar, and many deals are now unworkable.

It is the same for alternative energy, which also relies on credits to compete in the marketplace. One big financier is Wells Fargo, which has bankrolled more than $300 million in solar and wind projects since 2006. But Wells is acquiring billions of dollars in tax losses from Wachovia. Since, by one estimate, Wells purchased enough Wachovia losses to shelter $74 billion in profits, it will be years before it will need additional credits to trim its tax bill.

The demise of the tax credit-driven market may hold a valuable lesson for Barack Obama: Using tax incentives rather than direct spending may have dangerous consequences in a down economy. Many have argued that choosing credits over spending is little more than pandering to Washington’s recent distaste for spending on the poor. But in times of economic stress, there is a big difference between these two forms of subsidy. While spending may help soften the recession’s blow, tax credits lose much of their punch just when they are most needed.

House Ways & Means Committee tax counsel John Buckley told a TPC conference last Friday that the mess has grabbed the attention of his panel. Committee member Lloyd Doggett (D-Tex.) has introduced a bill to bar banks from buying losses from other financial institutions. But that would fix only a small piece of the problem and, besides, that horse may be long out of the barn.

For housing, a better idea may be to eliminate the credits and, instead, expand a program that gives renters cash vouchers. For alternative energy, why not raise taxes on fossil fuels and ditch all technology-specific credits?

Btw, this issue was only one of several fascinating topics that came up at the TPC/Brookings/Tax Analysts tax reform conference last Friday. I’ll be blogging about several others over the next week.