The main purpose of taxes is to raise revenue for the government, but the tax law is also guided by other objectives, such as making taxation more equitable or promoting expenditures that benefit the economy. Tax credits provide a specific means of achieving some of these objectives.
Tax credits, unlike deductions, provide a dollar for dollar offset to tax liability. Whereas deductions are used to lower taxable income, tax credits directly lower the tax itself. The main purpose of tax credits is to make the tax code more equitable or to motivate desirable behavior by businesses or individuals.
Example: Some Tax Credits Provide Greater Tax Equity
Tom and Jane have 2 children, but since both parents work outside of the home, they must pay $6,000 annually for childcare. If their combined income is $50,000, then they must pay taxes on the full $50,000, including the money paid for childcare since both of them work outside of the home.
Now consider Mike and Sarah, who also have 2 children, but Sarah stays at home to care for them, providing $6,000 worth of untaxed child-caring services. Mike earns $44,000. Although both couples enjoy the same amount of income and services of $50,000, the working couple has less disposable income because they have to pay tax on the $6,000 that they spend for childcare. So a child care tax credit would make the 2 couple's tax liability more equitable, which would promote more couples to work outside of the home and earn more taxable income.
Tax credits also help poorer single parents or couples to afford childcare. Otherwise, they may be forced to stay at home to watch their children and collect welfare to survive.
Tax credits are also used to promote national economic policy. Some of the most common types of credits include credits to make the United States more energy efficient, such as the residential energy tax credits and alternative vehicle credit, the education tax credits to promote the investment in human capital, the earned income credit to help the poor offset the regressive payroll taxes, and the mortgage interest credit to promote home ownership. Some credits, such as the foreign tax credit, mitigate the effects of double taxation on income.
Businesses also have general tax credits, such as the disabled access credit to promote the modification of buildings to enable easier access for the disabled, and many credits that apply to specific businesses, such as the orphan drug credit to promote the development of drugs that benefit only a few people.
Benefit of Tax Credits Over Tax Deductions
Tax credits differ from tax deductions in that the value of the tax credit is not affected by the taxpayer's marginal tax bracket.
Consider the 3 taxpayers listed in the table below, with the following tax brackets:
- Ava: 35%
- Paul: 15%
- Emma: 10%
Ava and Paul itemize their deductions while Emma claims the standard deduction. They each make a $1,000 expenditure, for which the tax savings of a 20% tax credit, a tax deduction, and an itemized tax deduction are shown for each taxpayer.
|Tax Credit of 20%||$20||$200||$200|
|Itemized Tax Deduction||$350||$150||$0|
As can be seen from the table, tax credits benefit all taxpayers who satisfy the requirement for the credits, while deductions provide a greater benefit for taxpayers in a higher tax bracket. Furthermore, since many of the available deductions for personal expenses must be itemized, taxpayers who claim the standard deduction cannot benefit from itemized deductions. Hence, itemized deductions do not benefit most taxpayers since most of them claim the standard deduction.
So that the wealthy do not benefit, many tax credits for individuals have income limitations, and phaseout rules that reduce the value of the credit at increasing incomes until the credit is eliminated at the upper income limit.
Refundable and Nonrefundable Tax Credits
Tax credits can either be refundable or nonrefundable. Refundable tax credits are wholly available to the taxpayer. Refundable tax credits can not only reduce ordinary income tax liability but also employment tax liability, and if a refundable tax credit is greater than the taxpayer's tax liability, then the difference is refunded to the taxpayer.
Most nonrefundable tax credits, on the other hand, are limited by the taxpayer's ordinary income tax liability; they do not offset payroll tax liability, in most cases. In most cases, the unused portion of nonrefundable tax credits is lost. However, some nonrefundable tax credits do have carryover provisions, like the foreign tax credit, so if the credit is greater than the tax liability for a given year, then the unused portion can be carried forward to reduce tax liability in the future.
The refundable tax credits are the earned income credit, which helps to offset poor people's payroll tax liability, the adoption credit, and taxes withheld on wages. The child tax credit is only partly refundable — it can eliminate the employee's employment (FICA) tax liability, but only half of any self-employment tax. The remaining tax credits are nonrefundable.
Order of Application of Tax Credits
That some credits are refundable or nonrefundable or subject to carryover provisions, the order in which the credits are used to offset tax liability will affect the ultimate tax. However, this order is often stipulated by tax law, and encoded on tax forms, so the taxpayer cannot change the order of their application. The tax credits have to be applied as the tax forms allow.