In my last post, I discussed why tax deductions are inherently unfair in that a deduction of a certain dollar amount is worth more to someone paying a higher marginal tax rate than to someone paying a lower marginal tax rate. In this post, I will discuss tax credits, another mechanism used by the tax code to subsidize certain economic activities and behaviors. Tax credits have several advantages over tax deductions, but are less-widely used.
What is a Tax Credit?
Like a tax deduction, a tax credit subsidizes some economic activity. With a tax deduction, you subtract the amount of the deduction from your income before computing the amount of tax owed. With a tax credit, you compute your income taxes normally (including any deductions), then subtract the credit from the amount of tax you owe.
The IRS lists 19 tax credits available to individuals on their Federal income taxes. Here are some of them:
- Residential Energy Efficient Property credit: A homeowner gets a credit of 30% of the cost of solar electric or solar water heating for their home.
- Earned income tax credit (EITC): This credit is for low-income people who are employed (including self-employed). The amount of the credit varies by number of children and there is an income limit. For example, when married filing jointly and with one child, the adjusted gross income limit (2018) is $46,010 and the tax credit is $3,461. The maximum credit is $6,431 with three or more children.
- Child Tax Credit: This credit is $1,000 per child, phased out at a rate of $50 per thousand dollars over $110,000 in adjusted gross income for married filing jointly. In 2018, this credit doubles and the phaseout begins at $400,000 for married filing jointly.
- Child and Dependent Care tax credit: This credit subsidizes caring for a child or other dependent while working or looking for work. The maximum cost subsidized is $3,000 per year for one child or $6,000 per year for two or more children. The credit varies between 20 and 35 percent of the allowable cost, depending on your adjusted gross income, with the lowest income people getting the largest credit.
- Adoption credit: This credit subsidizes expenses related to adopting a child, up to a maximum credit of $13,570 (in 2017) per adoption, and subject to phaseout beginning at $203,540 of “modified adjusted gross income” (which is different than adjusted gross income!)
- Low-Income Housing tax credit: This tax credit subsidizes investment in housing that is affordable to low-income people. The Federal government provides the tax credits to states, which allocate them to investors in certain types of affordable housing projects. The mechanism is complex, but the Department of Housing and Urban Development claims that the credit “is the most important resource for creating affordable housing in the United States today.”
- Retirement Savings Contributions tax credit: You get a tax credit of up to 50% of the amount you save in IRAs and 401k plans, up to a maximum of $2,000, and subject to phaseout between $38,000 and $63,000 of adjusted gross income.
- American Opportunity tax credit: Provides up to $2,500 tax credit per year for up to four years of postsecondary education per student, subject to an adjusted gross income limit of $180,000 married filing jointly.
Tax Credits are Better Than Tax Deductions
The advantage of the credit over an analogous deduction is that the value of the subsidy is the same regardless of your marginal tax rate and regardless of whether you itemize deductions or not. So, a homeowner with a $300,000 taxable income who spends $40,000 to install a solar electric system gets a $12,000 tax credit, which is worth $12,000, not some amount based on a complicated interaction of income and other deductions or credits. A homeowner with a taxable income of $1,000,000 also gets a tax credit worth $12,000. As explained in a previous post, if the subsidy had instead been provided through a tax deduction, the higher-earning homeowner would have received a larger subsidy than the lower-earning homeowner for the same economic activity.
Refundable and Non-Refundable Tax Credits
What happens if the tax credit exceeds the tax obligation? Some tax credits are refundable tax credits, meaning that if the tax credit is larger than the tax obligation, you get a refund! A good example is the EITC: Many people who are eligible for the credit receive part of it as a refund.
Other credits are non-refundable, meaning that if the tax credit exceeds your tax obligation, you don’t get a refund, limiting the subsidy provided to your tax obligation. In other words, a non-refundable tax credit only reduces the taxes one pays. For example, the dependent care credit is non-refundable.
This is unfortunate because someone earning the Federal minimum wage of $7.25 per hour and working full-time will have no tax obligation after the EITC and, therefore, will get no help from the dependent care tax credit. Non-refundable credits require someone to earn enough to be considered worthy of help, a crazy notion.
The child tax credit is also non-refundable. But, then there is the “additional child tax credit,” introduced in 2009, which effectively substitutes for the non-refundable part of the child tax credit for some people under certain conditions. (I didn’t make this stuff up!)
You can carry forward to the following year the unused portion of some non-refundable tax credits. For example, if your residential energy efficient property credit exceeds your tax obligation, you can carry forward the balance.
Finally, some tax credits are partially refundable. For example, 40% of the American Opportunity tax credit is refundable. And, the 2018 tax law makes the child tax credit refundable up to the lesser of $1,400 or 15% of earned income in excess of $4,500. (The latter means that those earning less than $13,833 get a reduced benefit. Again, I didn’t make this stuff up!)
Are Tax Credits Fair?
Of course, this is a loaded question. The good news is that tax credits, unlike tax deductions, are not inherently regressive. A refundable tax credit, such as the earned income tax credit, helps everyone whose adjusted gross income is below a cutoff.
Indeed, the EITC is considered to reduce poverty significantly, especially among children, and to be, by far, the most progressive tax break in the Federal income tax code. Indeed, the Congressional Budget Office estimated in 2013 that more than half of the benefit of the EITC flows to households in the bottom 20% of household earnings (this is explained in a previous post).
The EITC costs lost tax revenue of about $60 billion per year and some critics have complained that it eliminates the income tax liability of many low-income workers, thus, it is claimed, giving them no “skin in the game” in support of the common good.
Critics also complain about the lost tax revenue. But, this lost revenue pales in comparison to revenue lost from tax breaks given primarily to higher earners, such as the exclusion from taxation of employer-provided health care insurance (about $250 billion per year) and preferential tax rates on capital gains and dividends (about $160 billion per year). It is disingenuous to complain about the revenue lost from tax credits that benefit primarily low-earning people without also discussing the much larger costs of tax preferences that benefit primarily high-earning people.
A fruitful discussion, however, which I plan to have in a future post, is whether we should have any tax-based subsidies. Regardless, we have tax-based subsidies, so let’s continue the discussion of whether they are fair.
Avoiding Regressive Tax Credits
Unlike deductions, tax credits are not necessarily regressive, but they can be regressive. Consider, for example, the residential energy efficient property tax credit. This credit’s purpose is to encourage homeowners to adopt renewable energy technologies, including solar electric, solar hot water, fuel cells, small wind turbines, and geothermal heat pumps. (All of these credits expired at the end of 2016, but the credits for solar electric and solar hot water were extended through 2021.)
While I and many other people believe that encouraging the adoption of renewable energy is good policy (especially given the heavy subsidies provided for fossil fuels), there are important questions about how this is done.
As I described earlier in this post, this tax credit provides the same subsidy to anyone who invests to put solar electric or hot water on their house. That’s good, right? Well, yes, in theory, but in real life to get the credit you must be a homeowner and you must be able to afford the solar energy technologies. So, despite succeeding at its stated purpose of fostering adoption of renewable energy technologies, this flows tax breaks primarily to higher income people. Regardless of the laudable goal of the credit, is that fair? Hard question.
Here’s another way to think about it. If the goal is to foster adoption of renewable energy technologies, why limit that to homeowners? Instead, more broadly foster use of renewable energy to include non-homeowners. Some electric utilities already have programs that allow their customers to purchase electricity generated by renewable technologies. There is a price premium for doing so. If there were more demand for purchasing such electricity, the utilities would use more renewable sources to meet the demand.
So, a renewable energy tax credit could be formulated to include partial reimbursement of the premium you pay to consume electricity generated from renewable sources, or partial reimbursement for investment in renewable energy technology on your house. This would change the tax credit from subsidizing only higher-income homeowners to subsidizing anyone who wants to use renewable energy.
I believe that if we are going to implement subsidies of certain economic activies through tax credits, we should define the subsidies to be as inclusive as possible so that they are not regressive. Certainly, this might increase complexity but it would also be much more fair than the current practice of providing subsidies that primarily benefit higher-income people.
Complex rules govern tax credits and taxpayers must navigate these rules and the accompanying tax forms. The simplest way to file income taxes is on Form 1040-EZ, which is one page. The EITC can be claimed on that form. Other tax credit require using the many-paged Form 1040, along with other forms required for specific tax credits.
Many people eligible for tax credits do not claim them because of the complexity. Jacob Goldin, at Stanford Law School, has studied efforts to increase uptake of the earned income tax credit in light of its complexity. Assisted tax preparation helps, but there are other important factors and techniques that can improve uptake. Goldin also examines the advantages and disadvantages of administering social programs through the tax system.
Formulating Progressive Tax Subsidies
If we, as a society, choose to subsidize certain economic activities through the tax code, it is useful to think about how to formulate those subsidies so that they are progressive, or at least not regressive. Here are a few guidelines:
- Favor tax credits over tax deductions because deductions are always regressive.
- Favor fully-refundable tax credits. Fully-refundable tax credits provide the applicable subsidy to all eligible people, regardless of income.
- Subsidize activities in which people at all income levels can participate. I’ve already discussed this approach above for renewable energy subsidies. Here’s another example: Through deductibility of home mortgage interest and property taxes, the tax code currently subsidizes housing, but only for people who can afford to purchase a house. Instead, we could choose to subsidize housing for everyone, regardless of whether they rent or buy, by providing a refundable tax credit for housing.
- Plan carefully income-based phaseouts of tax credits to avoid disincentives to desirable behaviors. For example, the current EITC phaseout effectively increases the taxpayer’s marginal tax rate in a certain income range, perhaps encouraging the taxpayer to work fewer hours. (The evidence suggests that the EITC actually has little or no such effect.)
Tax credits are inherently a better means than tax deductions for encouraging or subsidizing particular economic activities. One can formulate tax credits to be progressive or to be non-regressive. Using tax credits instead of tax deductions does not eliminate complexity, although the effects of a tax credit are more predictable for a taxpayer because there are fewer interactions with other aspects of the tax system.
My plan is to have another few posts explaining important aspects of how our tax system works, then to begin discussing ideas for what real tax reform might look like. Along the way, I also plan to discuss the pros and cons of providing various subsidies through the tax system.