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October 02, 2005

The Ancient Wisdom of Refundable Tax Credits

By Neil the Ethical Werewolf

One of the coolest things about this blog is its emphasis on making complex policy issues accessible to those who never had a chance to learn Tiger-Style Wonk Fu from the ancient masters. As my duty to Ezra's dojo, I here present a list of three things that one can do to reduce people's taxes -- giving them refundable tax credits, giving them nonrefundable tax credits, and giving them tax deductions. I've listed these from best to worst, in order of how much they do to help the poor. What are they, you ask? And why does anyone need to know about them? Patience, Grasshopper: look below the fold and you shall understand.

Getting a $2000 tax credit means that your tax bill goes down by $2000. If it's a refundable tax credit, it can reduce your tax bill below zero. This means that you pay negative taxes -- the government ends up giving you money! If your tax bill is $500, and you get a $2000 refundable tax credit, the government sends you a check for $1500 and you don't have to pay any taxes. (This $1500 refund will be added to whatever the government refunds you from having withheld too much from your monthly paychecks, so the actual number on the check might look higher than that.) The Earned Income Tax Credit is one example of a refundable credit. It's a great way to stuff the frayed purses of the poor -- while they don't make enough money to have a high tax bill, the government just ends up giving them much-needed money.

Nonrefundable tax credits aren't quite so nifty. The difference between them and refundable tax credits is that they can't drop your tax bill below zero. So if your tax bill is $500 and you get a $2000 nonrefundable tax credit, your tax bill just goes to zero. You don't pay anything, but the government doesn't give you the extra $1500. (They will, of course, refund you whatever they withheld from your paychecks, but it doesn't come with an extra $1500.) This doesn't do an enormous amount lot for poor people, because of the progressivity of income tax rates. Since people in lower tax brackets typically have very low tax bills, nonrefundable tax credits just reduce their taxes a short distance to zero, and don't give them any money. To wealthier taxpayers, however, a nonrefundable tax credit is often just as good as a refundable one. They're paying enough in taxes that there's really no chance of their bills dropping to zero.

Tax deductions do very little to help the poor. If you get a $2000 tax deduction, $2000 of your income goes untaxed. If you're in the 15% tax bracket, like poor people often are, you save $300. Rich people do a lot better with tax deductions. If you're very rich, you might be in the 35% tax bracket, and a $2000 tax deduction saves you $700. Often, Republicans propose that some area of spending -- say, spending on health insurance -- be made tax deductible. This does very little to actually help poor people get health insurance. If you're too poor to afford insurance, a 15% off coupon isn't going to help you. But if you're a very rich person who already has money for insurance, a 35% off coupon will put money in your pocket.

Now you are learned in the ways of tax policy! Perhaps you will want to see the lessons of today in action, as you read of a valiant Democratic Congressman's struggle to expose the uselessness of tax deductions for health insurance.

October 2, 2005 in Taxes | Permalink

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Comments

Neil,

just to make things a little bit more explicit, an example of each:

Refundable tax credit- EITC
Non-refundable tax credit- Lifetime Learning Credit
Tax deduction- Mortgage interest, if you itemize.

In a way it really is in order of returns to wealth ;)

Posted by: TJ | Oct 2, 2005 2:21:59 PM

There's a very, very, large problem with tax credits & deductions: they're almost impossible to unwind. Once a tax credit or deduction is in place, eliminating it looks like you're raising taxes.

The biggest example is the mortgage interest rate deduction. More than social security, this is the third rail of American politics; over $700 billion a year in revenue is lost to the mortgage interest rate deduction. Eliminating it outright would probably be bad policy, but capping it at, say, $500,000 or eliminating it for non-resident homes might be a decent way to mend the deficit.

The smaller problem with credits and deductions is that they're a pain in the ass. The real problem with income taxes in America isn't how much they are, it's how complicated they are. For households with one wage-earner and few deductions it's not so bad, but if you're a small business, if you do lots of charitable giving, if you have a mortgage, if you own stock and have made transactions in the past year, etc .. it gets to be a real nuisance.

Posted by: Nicholas Beaudrot | Oct 2, 2005 3:52:24 PM

Yeah, the mortage interest rate deduction annoys the heck out of me. Was somebody back then saying, "Hey, let's give a tax deduction to everybody except the poor, and set it up so as to encourage suburban sprawl!" While the irrevocability of deductions/credits is a problem when it comes to the mortgage interest deduction, it's an advantage with things like EITC that I want to stick around.

I hope that when Democrats next get control of Congress, they can bundle in some simplification with their tax increases for rich people.

Posted by: Neil the Ethical Werewolf | Oct 2, 2005 4:15:05 PM

Neil, applause for your introduction! However, I think of you more as a young Jedi ...

Posted by: Pepper | Oct 2, 2005 4:59:01 PM

Yeah. The EITC is a good thing. No qualms there. And no one's really going to get rid of it.

It's more the nickel-and-dime deductions and credits: the hybrid car tax credits; the endless rules on what constitutes a "business expense" or a "health care expense", the deductions for educational expenses, etc., that drive me up the wall. Deductions and credits of these sort are a back-door form of social engineering. Economists always say that direct subsidies are almost always a better idea.

Posted by: Nicholas Beaudrot | Oct 2, 2005 5:14:03 PM

Really, Pepper? That makes me feel all exciting and questy and stuff.

Yeah, Nick, I wonder how many of the poor people who we want to take advantage of the educational expense deductions actually think to do it. I might be eligible for them, and I always forget about that stuff.

Posted by: Neil the Ethical Werewolf | Oct 2, 2005 5:48:05 PM

On the mortage deduction: It helps the middle-class and the banks -- it's politically unbeatable.

On the complications of deductions: Income is a very vague concept, so there will always be complicated rules for determining what one's actual income is.

Finally, I'll suggest a "tax reduction" that is even more extreme than the earned-income tax credit: the Alaska Permanent Fund Dividend.

Posted by: Adam | Oct 2, 2005 11:50:43 PM

Harley D at Matt Singer's place had a couple other comments that should be added, so I'm posting them here.

"A couple of points, just for accuracy - we - people who are self-employed or employed - pay two taxes - regular income tax and payroll tax. The payroll tax, once the hidden portion is exposed, bites us all for 14.2%. The earned income credit, perceived by many as “negative income tax”, does nothing more than refund people their payroll tax. So the statement that “This means that you pay negative taxes — the government ends up giving you money!” is not accurate. The other - for low income people, they are entitled to a standard deduction that usually exceeds any deduction they might receive for insurance, etc., so the deduction doesn’t just mean little to them - it means Squat."

Posted by: Neil the Ethical Werewolf | Oct 3, 2005 1:52:51 AM

I have owned a home for 8 years and had the good fortune to refinance at 5%. The downside was that the "tax break" of home ownership became useless. My standard deduction is now greater than my interest + property taxes. The mortgage interest deduction only benefits those who can afford homes over $200,000. So much for spending within my means.

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