Efficiency and Tax Incentives: The Case for Refundable Tax Credits

By Batchelder, Lily L.; Goldberg, Fred T., Jr. et al. | Stanford Law Review, October 2006 | Go to article overview

Efficiency and Tax Incentives: The Case for Refundable Tax Credits


Batchelder, Lily L., Goldberg, Fred T., Jr., Orszag, Peter R., Stanford Law Review


INTRODUCTION
  I. OVERVIEW OF REFUNDABLE TAX CREDITS
     A. Current Refundable Credits
     B. Has Bipartisan Support for Refundable Credits Crested?
 II. THE EFFICIENCY CASE FOR REFUNDABLE TAX CREDITS
     A. Uniform Refundable Credits as the Efficient Default Structure
        for Tax Incentives
        1. Efficient taxation in the presence of externalities
        2. Putting theory into practice
        3. Uniformity and refundable credits
     B. Income Smoothing at the Household Level
     C. Smoothing Macroeconomic Demand
III. POTENTIAL OBJECTIONS
CONCLUSION
APPENDIX A
APPENDIX B

INTRODUCTION

Each year the federal individual income tax code provides over $500 billion worth of incentives intended to encourage socially beneficial activities, such as charitable contributions, homeownership, and education. (1) This is an enormous investment, exceeding our budget for national defense (2) and amounting to about 4% of Gross Domestic Product (GDP). (3) The design of these tax incentives is an immensely important policy matter. Yet despite their efficiency rationale, (4) little attention has been paid to the question of what economic efficiency implies about the form these tax incentives should take.

Currently the vast majority of tax incentives operate through deductions or exclusions, which link the size of the tax preference to a household's marginal tax bracket. Higher-income taxpayers, who are in higher marginal tax brackets, thus receive larger incentives than lower-income taxpayers. This Article argues that providing a larger incentive to higher-income households is economically inefficient unless policymakers have specific knowledge that such households are more responsive to the incentive or that their engaging in the behavior generates larger social benefits. Absent such empirical evidence, all households should face the same set of incentives.

This Article therefore proposes a dramatic change in how the government should provide tax incentives for socially valued activities: the default for all such tax incentives should be a uniform refundable tax credit. Unlike other forms of tax incentives, a uniform refundable credit is not related to a household's marginal tax rate and provides cash payments to qualifying households even if they owe no income tax. Such credits would thus provide a much more even and widespread motivation for socially valued behavior than the current set of tax incentives. Moreover, they could further enhance economic efficiency by smoothing household income shocks and macroeconomic fluctuations. While transforming deduction-like incentives into uniform refundable credits would represent a substantial tax reform, it could be done on a revenue-neutral basis.

Refundable credits are not a new concept in the tax code. Prior to 1975, all individual tax incentives were structured as deductions or exclusions or, occasionally, as non-refundable tax credits. Today refundable credits are more widespread, accounting for about 18% of the roughly $500 billion in tax incentives. (5) Nevertheless, increasingly there has been heated debate about whether refundable tax credits are an appropriate part of our tax system. Some policymakers believe that the purpose of the income tax is to raise revenue and that all Americans should pay at least some income tax as a duty of citizenship. (6) They argue that "[i]f it's a refundable credit, it has no business in the tax system" (7) and that refundable tax credits are "turn[ing] our income tax code into a welfare system." (8) Others contend that the income tax should seek to reduce disparities of income, wealth, and opportunity and that refundable tax credits are a fundamental element of any fair tax system. These divergent perspectives are illustrated in last fall's report by the President's Advisory Panel on Federal Tax Reform (9) and the extensive debate that has occurred regarding the priority given to refundability of the child tax credit. …

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