December 28, 2006

New Congress Should Call Truce on Tax Credits

(The following commentary appeared in the Winter 2007 issue of Tax Watch.)

After watching Republicans’ humiliation over “earmarked” pork-barrel projects like the “Bridge to Nowhere,” the new Democratic majority has promised to cut earmarks and make the practice more transparent. But while they’re fixing the spending process, they’d do well to call a truce on tax credits aimed at achieving social, political, or economic goals through the tax code as well.

Special tax breaks may not have the sexy appeal of “Fleecing of America,” but they are a major factor contributing to the Byzantine complexity of the tax code. Moreover, they steer private resources in the direction that politicians favor, rather than the marketplace. And by carving up the tax base, they force up tax rates on the rest of us, and serve as a roadblock to fundamental tax reform.

The outgoing Republican majority enacted many sound tax provisions since taking control of Congress in 1995, such as reduced capital gains, dividend, and personal income tax rates. But they also enacted some very poor tax measures.

One of these-the Child Tax Credit-was the centerpiece of the 1994 “Contract with America.” Enacted with the best of intentions, the tax credit has knocked millions of taxpayers off the tax rolls and deepened the divide between Americans with “skin in the game” and those without. Today, there are more than 43 million households that file a tax return but have no tax liability after they have taken advantage of all of the credits and deductions available to them. That’s a 50 percent increase in the number of “nonpayers” since 2000. And many of these households also receive generous cash benefits back through provisions such as the Earned Income Tax Credit.

Because of growing tax credits, the IRS has become an important component of the modern “welfare state,” distributing nearly $50 billion in credits per year.

Republicans have also tried to solve other problems with tax credits. For example, the Energy Policy Act of 2005 authorized $1.65 billion in tax credits for “clean” coal projects. The IRS and Department of Energy recently announced $1 billion in tax credits to just nine companies. A total of 49 companies applied for the credits, but the Department of Energy–rather than the marketplace–determined that just nine winners had the right technology to qualify.

In January, the new Democratic majority will take over with their own laundry list of ways they’d like to use the tax code to achieve various goals, including tax breaks for college tuition, bio-fuels, broadband service, and small business health insurance.

Each of these will certainly be popular with voters and, no doubt, will be well-intended. However, because so many Americans today pay zero federal income taxes, it is unlikely that many of those who are targeted will be able to take advantage of the new credits, unless they’re made refundable. And if they are, millions more will be taken off the federal tax rolls, potentially expanding the number of nonpayers to half of the U.S. population. And that simply cannot be good for democracy.

Scott Hodge is the president of the Tax Foundation.