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Think Twice on Tax Credits (Even Popular Ones)

1 min readBy: Brian Phillips

Today, the Chairman and Ranking Member of the Senate Finance Committee have made an impassioned plea for Congress to renew the research and development 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. . While this credit is very popular, as Chairman Grassley pointed out, we do question the wisdom of using the government’s source of revenue to pick winners and losers. The primary problem is that 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. credits erode the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . As the tax base shrinks, lawmakers will attempt to make up the lost revenue by increasing tax rates–leading to higher rates for everyone. Some Democratic leaders, poised to take over Congress next year, have already begun to suggest that raising tax rates will be necessary to pay for “middle-class tax cuts.” But Tax Foundation studies have shown that tax rates are already twice as high as they otherwise would be if the tax base were not worn down with tax credits:

The current system requires six tax rates ranging from 10 percent to 35 percent to raise the $912 billion in federal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. revenue expected in 2005. That amounts to an average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. of 19.5 percent. If all personal income were taxed instead, the same revenue could be raised with rates ranging from just 4 percent to 17 percent. That would amount to an average tax rate of just 9 percent—less than half the current effective rate.

Chairman Grassley is right: tax credits are popular. But sound tax policy requires rising above politically popular measures and instead allocating the public treasure wisely. There is no reason to support measures that provide short-term gain but ultimately damage the economy in the long term.