When a politician promises a tax cut, most people would be inclined to think that taxpayers would simply get to keep more of what they’ve earned. But, this isn’t always the case. In some cases, filers will get a little extra back above and beyond their income tax liability. This occurs because of what are known as “refundable credits.”
As our Who Pays Income Taxes page shows, a small share of income earners bear a disproportionate share of the income tax burden. Correspondingly, over one-third of filers have no net income tax liability. This figure is due in part to the health of the economy and the unemployment rate, but is also reflective of the increase in the Tax Code of preferences, including the expanded use of refundable credits. These credits don’t just reduce a filer’s income tax liability, but also result in spending through the Tax Code.
Refundable credits can be claimed by eligible filers whether or not they owe any income taxes. The first refundable credit, the Earned Income Tax Credit (EITC), was established as a temporary program in 1975 to offset Social Security payroll taxes. The EITC was made permanent in 1978, and in 1999 a new Child Tax Credit was added and yet another addition in 2003 with the creation of a new refundable Health Coverage Tax Credit.
The number and cost of these credits jumped after the 2008 economic crisis. President Obama boasted that the American Recovery and Reinvestment Act (the so-called “stimulus” bill passed early in his administration) included the “biggest middle-class tax cut in history,” but much of these tax breaks took the form of refundable credits. While several of the refundable credits established in the “stimulus” bill have since expired, a new health care premium credit was established through the Affordable Care Act that cost $27 billion in FY 2015 and $39 billion in 2016. Proposals to increase refundable credits were featured prominently during the 2016 campaign by both Democratic and Republican candidates as a way to enact “middle class tax cuts,” or to assist households with child care expenses.
Since most people have some interaction with the IRS, the process of receiving a refundable credit is simpler than applying for related welfare programs or assistance grants. Refundable credits, tied to earnings have also been shown to reduce the disincentive to work that is a common adverse side effect of welfare programs. These credits can also be designed like the Child Tax Credit to provide immediate and temporary assistance to those who need it.
On the negative side, the outlay costs of these credits have grown significantly. In 1996, the lone enacted refundable credit cost $19 billion. The FY 2016 budget estimated outlays of $127 billion for nine different credits (see table below).
|Refundable Tax Credit (Outlays in Millions)||FY 2015||FY 2016 Estimated|
|Earned Income Tax Credit||$60,084||$61,381|
|Child Tax Credit||$20,592||$21,627|
|Health Coverage Tax Credit||$0||$6|
|Small Business Health Insurance Tax Credit||$38||$59|
|Alternative Minimum Tax Credit||$7||$5|
|Payment Where Certain Tax Credits Exceed Liability for Corporate Tax||$152||$198|
|American Opportunity Tax Credit||$4,153||$4,398|
|Refundable Premium Tax Credit||$27,213||$39,285|
Scope is not the only issue with refundable credits. They can be duplicative of spending under welfare programs, increase tax code complexity and compliance costs for filers, and result in a high rate of improper payments. The IRS estimated that 23.8 percent ($15.6 billion) of payments under the EITC in 2015 were issued improperly. The American Opportunity Tax Credit (for certain education expenses) had a 30 percent improper payment rate in 2015.
While refundable credits are popular as a way to provide temporary and direct relief (and, in some cases to disguise spending increases as “tax cuts”), there are significant concerns that policymakers will need to address either as they reform the Tax Code, or as they follow through on proposals to expand or create refundable credits, such as the proposal for child care. Reforms could theoretically also be tied in with spending reform. If the government can more effectively provide direct assistance via the Tax Code to verifiably eligible individuals, lawmakers should consider consolidating the dozens of welfare programs in the budget to help alleviate the burden on all taxpayers.