I was poking around on the Internet the other day, reading about movie financing. It occurred to me that “tax incentive” is one of the oiliest terms in public policy, and that “refundable” is one of those words that you really want to keep an ear out for. A “refundable tax credit” is really just a gov’t handout.
“Tax Incentive” is a broad term that covers at least three classes of programs:
- Tax Deductions
- Tax Credits
- Refundable Tax Credits
The three programs are quite different.
Tax deductions are the least sneaky of tax incentives; they allow the taxpayer to reduce the amount of his taxable income. In some sense, the very definition of taxable income (as distinct from total income) implies the existence of tax deductions. For instance, if a business is taxed on its profits, then it must deduct its expenses from its revenues to compute its taxable income.
Tax deductions are widespread: Individuals may take standard deductions on their income tax, or subtract state tax paid from their federally taxable income, or (if homeowners) deduct mortgage interest. Businesses can deduct the depreciation of certain assets. Tax deductions are also pretty well understood.
(Refundable) Tax Credits
Tax credits are similar to tax deductions, but instead of being applied to taxable income, they are applied to tax liability directly. Consequently, a tax credit is much more valuable than a tax deduction of an equal amount.
Normal tax credits are non-refundable; if they reduce a taxpayer’s liability below zero, then he pays nothing, but he doesn’t receive a refund for the negative balance. Refundable tax credits do away with this restriction: Negative tax liabilities arising from refundable tax credits are refunded to the taxpayer.
Let’s say that ConHugeCo conducts all its business in SimpleState. ConHugeCo, absent any incentives, reports $1000 in taxable income. SimpleState has a single 15% corporate tax rate. Therefore, in the base case, ConHugeCo would face a tax bill of $150.
If SimpleState offered a $300 tax deduction for businesses in this example, then ConHugeCo would report $700 in taxable income, and pay $105 in taxes.
If SimpleState instead offered a $300 tax credit for businesses in this example, then ConHugeCo would report $1000 in taxable income, face a negative $150 tax liability, and therefore pay nothing in taxes.
If SimpleState instead offered a $300 refundable tax credit for businesses in this example, then ConHugeCo would report $1000 in taxable income, face a negative $150 tax liability, and therefore receive a check for $150. If ConHugeCo reported $0 in taxable income (they had a bad year) they would then receive a check for $300.
The difference between deductions, credits, and refundable credits is significant.
I yield to no one in my enthusiasm for limited gov’t and low taxes, but the refundable tax credit is an idea into which all sorts of mischief can be stuffed. These programs can be a way for politicians to funnel money to favored constituencies through the tax authority, via the simple expedient of instructing the tax man to write checks instead of collecting them. I’m not at all sure that this is a helpful public policy innovation.