Weighing the Value of Tax Credits During an Economic Crisis

Policymakers are nearing a deal on a third round of legislation to address the economic and public health crisis caused by the outbreak of COVID-19, and some have already outlined ideas for a fourth proposal.

One idea under consideration is adjusting existing 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, such as the Child 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. (CTC) or Earned Income Tax Credit (EITC), to provide financial relief during the crisis. An advantage of this approach is that it may be easier to administer existing programs than new spending programs. However, credits are also prone to administrative complexity and logistical difficulties, which may blunt their effectiveness.

Options such as rebates or direct payments are better suited to provide quick financial relief to businesses and families. The central message to policymakers is straightforward: Don’t get wrapped up trying to tinker with credits. Instead, give individuals more liquidity and let them make decisions about which purchases to make and expenses to pay.

Understanding Tax Credits

Tax credits reduce a taxpayer’s final tax liability dollar-for-dollar. Tax credits differ from deductions and exemptions, which reduce 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. , rather than the taxpayer’s tax liability directly.

Tax credits can be divided into two types: refundable and nonrefundable. A refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit (EITC). allows a taxpayer to receive a refund if the credit they are owed is greater than their tax liability. A nonrefundable credit allows a taxpayer to only receive a reduction in their tax liability until it reaches zero.

Suppose a taxpayer, Chris, who has one dependent, comes to the end of the filing process and owes the IRS $1,300 (his tax liability). A tax credit would reduce this amount owed by the amount of the credit eligible to the taxpayer. In this case, Chris would want to claim the Child Tax Credit, which is valued at a maximum of $2,000 per child ($1,400 of which is refundable). If he took no other credits and met the income thresholds, Chris would receive a $100 refund (see table 1).

Table 1. Example of a Refundable Tax Credit in Action

Refundable Credit (Example A)
Chris’ Tax Liability = $1,300
Apply the Child Tax Credit ($2,000 total; $1,400 refundable)
$1,300-$1,400 = -$100
Chris’ Refund = $100
Source: Author’s calculations

As the public health situation continues to evolve, tax economists and the White House have suggested using tax credits, such as the EITC, to provide financial support to households struggling to make ends meet.

For example, Elaine Maag, a tax policy scholar at the Tax Policy Center, recently argued that “during a recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. , policymakers should focus on enacting policies that can boost the economy and provide income security to people who are vulnerable. Because the EITC delivers targeted tax relief to low- and moderate-income workers, it would do both.”

Advantages and Disadvantages of Using Tax Credits as a Fiscal Policy Support

Many tax credits, such as the CTC and EITC, are designed to target tax relief to specific populations, such as low-income taxpayers with dependents. Increasing the CTC and EITC’s maximum value, number of payments, and refundability ratio would provide financial relief for these targeted taxpayers. Providing relief this way is preferable to unfunded mandates for businesses or state and local governments.

However, tying financial relief to filing a tax return presents challenges, and is perhaps more difficult due to the recently granted delays of tax payment and filing requirements during the crisis. For example, one challenge unique to this crisis would be for the taxpayers to submit returns and the IRS to receive and remit benefits all while people are following social distancing, shelter-in-place, and quarantines.

As a way around the filing and timing challenges, some have proposed allowing advance payments for EITC benefits or dividing the annual EITC refund into quarterly installments for eligible taxpayers. This may reduce some administrative difficulty; however, if eligibility is expanded to include additional taxpayers, there may be other administrative difficulties associated with that.

Proposing a Better Method of Providing Tax Relief

While increasing or accelerating credit payments for the EITC and CTC would likely increase relief for families with dependents, it would still require filers to determine eligibility and file a return, keeping in mind deadlines have been delayed until July 15. As many Americans face layoffs and prepare for business closures and quarantines, short-term liquidity is paramount.

One option would be to disburse a flat amount of money to all Americans through a rebate credit that accounts for filing status, income, and number of dependents. This would provide financial flexibility until those filers can submit their tax forms and await a return. Lawmakers are currently debating a proposal that aligns closely with this option as part of their third legislative response; further relief efforts could focus on expanding or repeating this type of rebate.

In terms of timing, a rebate credit would likely be much quicker and effective to provide needed liquidity for taxpayers than modifying the CTC or EITC for this tax year. In the present situation, direct forms of relief (e.g., direct payments) would be a better option for policymakers than expanding credits such as the EITC and CTC on a temporary basis.

Conclusion

Changes to existing credits is currently being considered as one way to provide relief to taxpayers trying to make ends meet during an economic downturn. However, providing a temporary financial payment to families through a rebate or direct payment would be more effective and efficient than tinkering with eligibility and refundability within the current credit structures of the EITC and CTC. Consumers need flexibility and liquidity now more than ever. By providing direct payments in the short term, policymakers can help the economy transition through shockwaves of the crisis and onto more stable footing.

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