Members of Congress are on a two-week recess before returning to consider a possible “phase 4” package to boost the economy and help individuals and businesses suffering from the economic effects of the most significant pandemic in the last century.
Policymakers may be tempted to reach into the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code to find a solution to these issues by changing credits. While tax changes to preserve firm liquidity, protect vulnerable individuals, and improve growth is appropriate, policymakers should be wary of the complications that arise when modifying credits and deductions on a temporary basis in the next round of legislation.
Instead, lawmakers should choose other mechanisms to assist taxpayers rather than temporarily reformulating tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. eligibility for individuals. Especially in the midst of a pandemic, altering the tax code by changing who qualifies for complicated credits is not the best route to accomplish short-term policy solutions.
Credits and Their Drawbacks
The tax code is often an inefficient instrument for achieving a policy goal. Yet, policymakers repeatedly return to it as a mechanism to subsidize preferred activity, penalize disfavored activity, and accomplish political goals. For example, consider the family and work-related tax credits in the current code.
The Earned Income Tax Credit (EITC)—created in the late 1970s—is designed to reduce tax liability dollar-for-dollar for taxpayers with children under certain income limits. The credit, in effect, blunts the impact of marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s on earned income for lower-income filers and subsidizes families with more eligible dependents. In some cases, the credit results in negative tax liability (i.e., a refund) for those who do not have enough earned income to owe any income taxes, mostly families in the bottom quintile.
The EITC shares a similar tax effect with the Child Tax Credit (especially the refundable portion of the CTC, known as the Additional Child Tax Credit) and the Child and Dependent Care Tax Credit (CDCTC).
What is the relevance of these policies for the current debate? Within the context of phase 4, policymakers are considering marginal changes to the EITC, such as expanding the credit’s eligibility and generosity on a temporary basis. Others have proposed a credit to subsidize vacation and travel. These changes are arguably aimed at helping vulnerable individuals and increasing economic activity.
While all these credits intend to accomplish similar results, the fact that there are three separate tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans. s that provide benefits for filers with dependents means there is overlap, distorted incentives, and a high compliance burden on those who are least likely to have the resources to deal with it. These problems exist even in the absence of the personal exemption removed by the Tax Cuts and Jobs Act (TCJA) in favor of a higher standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and more generous CTC.
Consider a Treasury report in April which found that one in four payments under the EITC for Fiscal Year 2019 were improper. This is not the first-time federal oversight revealed gross misallocation of public funds. EITC error rates have been a chronic issue throughout the last two decades. One school of thought would suggest that lawmakers clarify and consolidate the various dependent-related credits into a single and simple policy available to all families. Indeed, this plan was proposed 15 years ago as part of President George W. Bush’s Panel on Federal Tax Reform report.
Instead, lawmakers have chosen to use the legislative vehicle of coronavirus relief and economic stabilization to create more credits, add additional layers of complexity (albeit with the aim of increased generosity), and include pet social policy projects through the tax code. Doing so increases complexity and confusion throughout the code and only adds to the volumes of pages which make up our mangled tax system.
Vice President Mike Pence once quipped that the tax code is “three times longer than the Bible and there are no good stories.” While that is a bit simplistic, it is not far off. The purpose of the tax code is to raise revenue for government to finance public services which cannot be accomplished as efficiently by private enterprise. It should not be the backdoor method of arriving at an end policy goal which could be accomplished more efficiently and equitably.
Policymakers often use the code because it is an existing policy infrastructure to accomplish a policy objective rather than creating a dedicated government program, bureaucracy, or simply legislating a pure income redistribution (i.e., Social Security). No doubt, phase 4 may include changes to credits, deductions, taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. , rebates, and filing deadlines for businesses and individuals.
If the next round of legislation is like the HEROES Act released by congressional Democrats in June, these tax changes will be temporary (e.g., for the 2020 tax year) and highly-targeted to lower-income individuals. Those individuals will still need to surmount compliance burdens to get the benefits.
As policymakers consider returning to the tax code as a tool to revive a struggling economy with high unemployment and an unpredictable virus, they should remember to avoid—as I’ve written before (here, here, and here)— temporary changes that can be distortive in the short term and inefficient in the long term.
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