How does the Federal government finace tax credits?

Answer 1

It has been the fiscal policy of the federal government (as far back as I have been doing taxes) that tax law changes have to be zero cost. This means that when they provide a tax credit or tax deduction, the estimated "cost" to the government due to the reduction in tax revenues has to be offset by increases in tax revenues in some other area, either through an increase in taxes or doing away with deductions, so that the net cost of the tax legislation is zero.

Where the taxpayer gets the short end of the stick is typically, tax credits and tax deductions that are enacted by legislation are temporary and will expire within a certain time frame (i.e. the sale tax deduction was set to expire on December 31, 2005). However, many of the tax changes made to "pay" for these tax credits and deductions did not have a similar expiration date and are considered permanent. So when an expired credit or deduction comes up for renewal, tax increases elsewhere needs to be made to pay for this, even though the tax increases that funded the expired credit or deduction is still in place.

A good example of this is the research and development tax credit that corporations can use to claim a tax credit for their R&D expenses. The credit was never made a permanent credit, and Congress kept extending it. However, every time the credit came up for extension, they increased taxes to pay for it.

Answer 2

Generally....it doesn't.

There is no requirement for the Federal Government to have a balanced budget each year so, most offen, tax credits (and other tax cuts) are offset only be additional borrowing. Basically, they are throwing it on a credit card.

However, many states do have to have a balanced budget. Tax Credits given must be offset by tax increases in other parts of the budget or spending cuts.