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. In some cases, tax credits are designed to favor special groups. For instance, the unified tax credit, worth more than $2 million and adjusted annually for inflation, allows the wealthy to pass more than $5 million tax-free to their beneficiaries, usually their children.
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 of $1,000, and an itemized tax deduction are compared for each taxpayer.
|Tax Credit of 20%||$200||$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 the total of refundable tax credits exceeds the taxpayer's tax liability, then the difference is refunded.
Most nonrefundable tax credits, on the other hand, are limited by the taxpayer's ordinary income tax liability, since they are listed in the Tax and Credits section of Form 1040, U.S. Individual Income Tax Return. This section can reduce ordinary income tax liability to zero, but not less than zero. The next section of Form 1040 is the Other Taxes section, which adds additional taxes after the nonrefundable credits are applied, so nonrefundable credits cannot reduce these taxes, including the self-employment tax, the tax penalty for not carrying health insurance, known formally as the individual responsibility payment, household employment taxes, and any additional tax on IRAs, or other qualified retirement plans. 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 future tax liability.
The refundable tax credits are listed in the Payments section of Form 1040, after the Other Taxes section, so they can reduce or eliminate those other taxes, or the taxpayer may even receive a refund, which is why they are called refundable tax credits:
- earned income credit, which helps to offset poor people's payroll tax liability
- the additional child tax credit
- 40% of the American Opportunity credit.
- the net premium tax credit, which offsets the cost of health insurance premiums for low-income taxpayers
Order of Application of Tax Credits
Though credits can be classified as refundable or nonrefundable or subject to carryover provisions, their value in reducing tax or increasing a refund may depend on the order in which they are applied. However, this order is stipulated by tax law, and encoded on tax forms, , as you can see in the above graphic, so the taxpayer cannot change the order of their application. The tax credits have to be applied as the tax forms allow.