Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
The Case for Tax Credits
Brian H. Jenn*
*Associate Attorney, Skadden, Arps, Slate, Meagher, and Flom LLP.
Despite perennial calls from politicians, policy analysts, and populists for a major individual income tax overhaul that would cleanse the tax system by eliminating its eclectic collection of tax incentives and preferences, the ideal of tax base purity has yet to be realized and seems unlikely to find its way to fruition in the foreseeable future. Middle-class Americans appear too fond of their tax preferences for expenses such as home mortgage interest, health insurance, and charitable contributions to let go, as evidenced by the reluctance of savvy politicians to put forward a serious reform package that eliminates those tax benefits. For the 2007 fiscal year, the largest 25 tax expenditures reported in the President’s Budget were expected to have a total value of over $750 billion in terms of foregone revenue. By comparison, the entire amount of revenue raised by the federal individual income tax during the same period was only $1.096 trillion, meaning that total revenue would be over 70% higher without these tax preferences if current tax rates were unchanged.
Given that this most prominent feature of the federal tax landscape is apparently here to stay in one form or another, the pertinent policy question becomes whether there is a better way to implement tax preferences and incentives currently provided through deductions, exemptions, and exclusions. One proposal that has been advanced and implemented with increasing regularity in recent years—and that received prominent notice with the reforms proposed in 2005 by the President’s Advisory Panel on Tax Reform—is the conversion of existing deductions and exclusions into partial tax credits (that is, credits for some fraction of eligible expenditures).
Converting a deduction into a credit is fairly straightforward in light of the basic equivalence between credits and deductions. For a taxpayer in the 15% tax bracket with positive tax liability, the replacement of a deduction for a particular expenditure with a 15% tax credit for the same expenditure should be a matter of indifference because it leaves the taxpayer’s tax bill unchanged. On the other hand, where the taxpayer’s marginal tax rate exceeds the credit rate, the conversion of a deduction into a credit results in a higher final tax bill. Where the taxpayer’s marginal tax rate is below 15%, the credit is more attractive than the deduction. Nevertheless, it is the basic equivalence between credits and deductions where the credit rate and taxpayer’s marginal tax rate are the same that, as a matter of tax mechanics, makes possible proposals to transform deductions into credits.
An awareness of the equivalence of deductions and credits under certain conditions is evident in the tax policy literature at least as early as the middle of last century, but the credit alternative did not gain serious currency until more recent decades. Although the foreign tax credit has existed from 1919, it was not until 1948 that Professor William Vickery, motivated by equity concerns, suggested replacing an existing deduction with a tax credit. Vickery did not extend his proposal beyond the charitable deduction, however, and it was not until the early 1970s that serious discussion of these alternatives appeared in the literature. Even then, Stanley Surrey gave only brief notice to the relative advantages of credits over deductions in his seminal 1973 book on tax expenditures, Pathways to Tax Reform, instead focusing his analysis on the shortcomings of tax expenditures understood as deductions and exclusions.
In the mid-1970s, Congress began to create a constellation of credits available to individual taxpayers. Most of these credits have been of relatively minor magnitudes, however, compared to the largest tax expenditures. In an early example of a credit substituted for a deduction, Congress in 1976 implemented a child care credit in place of a pre-existing deduction, citing equity considerations as a reason for the change. In 1984, the concept of replacing deductions with credits earned a significant endorsement from Senator Bill Bradley and Representative Dick Gephardt, who proposed a tax reform package that would have allowed all itemized deductions—including the home mortgage interest deduction, the deductions for state and local income and real property taxes, and the charitable contribution deduction—to be taken only against the 14% bottom bracket. This proposed mechanism is the mathematical equivalent of converting all itemized deductions (excluding the standard deduction) into 14% tax credits.
Since the late 20th century, credits have proliferated where deductions might previously have been used, including tax credits for adoption expenses, education expenses, fuel cells, and alternative motor fuel vehicles. Despite this proliferation of mostly minor credits, however, the tax expenditure budget continues to be dominated by deductions and exclusions. Of the top 25 tax expenditures ranked by foregone revenue for fiscal year 2007, only two tax expenditures—the child tax credit and the earned income tax credit (EITC)—were credits. Notably, those two tax preferences are not even intuitively susceptible of implementation as deductions or exclusions because a primary characteristic of both the child credit and the EITC is “refundability,” a design feature that allows taxpayers to receive the benefit of a credit even where the value of the credit exceeds pre-credit tax liability. The largest items, including preferences for health insurance, mortgage interest, retirement savings, and state and local taxes, are all deductions and exclusions.
In the face of the continuing sideline status of tax credits as an option for implementing tax incentives, the President’s Advisory Panel on Federal Tax Reform recently generated discussion by offering a limited endorsement of the strategy of converting some major existing deductions into partial credits. Notably, the Panel did not adopt an across-the-board strategy of converting deductions to credits but, instead, appears to have individually considered the most appropriate form for a variety of existing deductions. Citing primarily equity considerations, the Panel recommended the replacement of the home mortgage interest deduction with a Home Credit equal to 15% of mortgage interest paid. In justifying this choice, the Panel noted simplification of benefits from eliminating the need to itemize to obtain the mortgage interest deduction. The Panel’s primary motivation for its choice of a credit, however, was the fairness gains from a credit that would allow both itemizers and non-itemizers to share in the tax benefits connected with home ownership (and to do so at the same rate) and that would allow total benefits to be easily capped. For charitable giving, on the other hand, the Panel specifically recommended that the tax incentive take the form of a deduction “to provide incremental incentives to higher-income donors, an important source of charitable deductions.” The Panel also recommended preserving (but capping) the exclusion for health insurance premiums but—after acknowledging that under the current system most of the tax benefits from the exclusion flow to high-bracket individuals—failed to explain why the exclusion was preferable to a credit.
With the notable exception of the 1984 Bradley-Gephardt tax reform plan, most proposals for reforming tax expenditures have mirrored the approach of the Tax Panel, focusing on one tax incentive at a time in considering the relative advantages of a credit over a deduction mechanism. Tax credits have been favored in particular contexts for the perception that they eliminate what Stanley Surrey identified as the inequitable “upside-down subsidy” effect whereby the pattern of benefits generated by a deduction skews to taxpayers in the highest brackets. Credits have also been touted for eliminating the deduction’s preference for itemizers over non-itemizers and because credits have certain efficiency properties that deductions and exclusions lack. In some particular cases, a deduction remains the only viable option: In the design of retirement savings incentives, for example, an exclusion or deduction is necessary if the goal is to postpone tax until funds are used for consumption, as would be the case in a consumption tax. Still, the question of whether there is a general case for the use of tax credits rather than deductions, or even whether there is even a systematic approach for choosing between credits and deductions in a particular context, has remained largely unaddressed.
This Article attempts to fill the gap in the academic and policy literature by systematically examining the general case for implementing tax expenditures as credits rather than deductions and by proposing a framework for choosing between credits and deductions. Professor Lily Batchelder, together with Fred Goldberg and Peter Orszag, recently made a case for making tax credits refundable but left largely unaddressed the prior question of when tax incentives should be implemented as credits. Nonetheless, the two questions are closely related, and some of the analysis of Batchelder and her colleagues will find useful application in this Article. In the foregoing, the more abstract question of whether a deduction (as opposed to a credit) is required for the sake of accurate income measurement will be set aside. Because the major tax expenditures appear primarily to be incentives to engage in certain behavior, they will be evaluated on that basis.Part II examines the tax equity issues associated with deductions and credits, including the upside-down subsidy issue, with reference to the traditional tax policy concepts of horizontal and vertical equity. Part III explores the efficiency implications of the choice between implementing tax incentives in the form of credits as compared to deductions or exclusions, employing a number of different concepts of efficiency. Part IV evaluates the generality of the case for credits instead of deductions, analyzing how far the credit model can be extended and presenting a set of considerations for policymakers faced with this design choice. Part V applies these considerations to evaluate the design of some of the largest tax expenditures currently in the federal budget. Part VI provides concluding remarks.