CBO: Three Things you Probably Didn't Know About Refundable Tax Credits

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Rejoice! Tax season is upon us! We’re sure you’re looking forward to breaking out those calculators and crunching some hard numbers (Lord knows we are).

Seriously though, as tax season quickly approaches, we got to thinking: Just what is the story behind refundable tax credits (because that's the sort of thing we think about)?

It just so happens that the Congressional Budget Office has released a comprehensive review of the “evolution and federal costs of refundable tax credits, their effects on the economy and the tax system, the administrative challenges in providing subsidies, and the transparency of such credits in the federal budget.”

But before we go any further, you’re probably wondering about that “federal costs of refundable tax credits” part.

Let’s dig into this.

“Refundable tax credits differ from other preferences [that lower or eliminate the amount of taxes owed] in a significant way: Whereas other preferences reduce the amount of taxes owed to the government, refundable credits can result in net payments from the government,” Janet Holtzblatt of CBO’s Tax Analysis Division and Grant Driessen, formerly of CBO, explain.

“Specifically, if the amount of a refundable tax credit exceeds a filer’s tax liability before that credit is applied, the government pays the excess to that person or business,” they add.

So, yes, in certain cases, the feds actually pay out more than they take in.

“In the federal budget, the portion of refundable credits that reduces the amount of taxes owed is counted as a reduction in revenues, and the portion that exceeds people’s tax liabilities is treated as an outlay; the total federal cost is the sum of those two components,” Holtzblatt and Driessen add.

Noting that the first refundable credit appeared in 1975 (the earned income tax credit [EITC]), the CBO report goes on to illustrate the exponential rise in the cost and number of these specific credits.

Let’s take a look at CBO's report on the evolution and cost of refundable tax credits:

1. Total Cost of Refundable Credits: 1975-2010

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“The number of credits peaked at 11 in 2010 before dropping to 6 in 2013,” the report explains. “Their total costs reached a high of $238 billion in 2008.”

“In 2013, the costs will drop to $149 billion,” the report adds, “mostly for the EITC and the child tax credit. By 2018, three more credits will have expired, and the child tax credit and the EITC will have been scaled back.”

The report also claims that the cutback in refundable credits will be offset by new “health-related subsides” brought in via the tax system.

“Starting in 2014, a new refundable tax credit will be available to some people for the purchase of health insurance through newly created exchanges. The cost of that credit will be about $110 billion by 2021,” the report notes, “bringing the total cost of refundable tax credits in that year to $213 billion -- roughly the same as the costs in 2009 and 2010, even though the number of refundable tax credits will have fallen by more than half between 2010 and 2021.”

2. Recent Refundable Tax Credits Aren't Directly Tied to People's Earnings

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Refundable tax credits nowadays are more focused on subsidizing the cost of health insurance and higher education than they are on earnings.

“Not only have the number and costs of refundable tax credits grown over the years, but the nature of those credits has evolved. Eligibility for the first refundable tax credit -- the EITC -- was based primarily on the recipient’s earnings, adjusted gross income, and the number of children in his or her home,” the CBO report claims.

“However, many of the newer refundable tax credits are not limited to people with earnings but are instead used to compensate people for expenditures on items such as health insurance and higher education,” the report adds.

3. The Long-Term Effect of Refundable Credits on the Economy & Tax System

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Because credits have a tendency to favor certain goods and services, resource allocation can be heavily biased.

“Credits that decline in value as income rises prompt some people to work fewer hours,” the report notes. “However, credits that increase as earnings rise, such as the EITC at certain income levels, provide an incentive for some people to work more. The EITC also draws people into the labor force by increasing their after-tax income. On balance, the latter effect appears to dominate.”

It continues:

In addition, the growth of refundable tax credits has contributed to a decline in average tax rates among households in the bottom 40 percent of the income distribution. That decline is most notable for individual income tax rates, which between 2007 and 2009 became increasingly negative for low-income households (that is, on average, those households received money back from the federal government instead of owing income taxes). Most of those households, however, pay federal payroll taxes.

Refundable tax credits also affect the administration of taxes. By adding more complicated rules, more tax forms, and more computations, the credits increase the costs incurred by taxpayers in complying with the tax code and by the government in administering those laws.

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The report goes on to suggest that the goal of issuing refundable tax credits (i.e. "providing income support for low-income households, expanding health insurance coverage, or increasing college enrollment") might be better achieved through government spending programs such as Supplemental Nutrition Assistance Program (food stamps), the Temporary Assistance for Needy Families program, Medicaid, etc.

Hold on! Hold on! The CBO clarifies its position.

As a cost-cutting measure, the report explains that any decision to replace refundable tax credits with government spending programs would hinge largely on "administrative considerations" (i.e. "the effectiveness in reaching the target population, timeliness, and the ability to ensure compliance with rules"). Basically, a well-run and well-thought-out government program might serve low-income households better than a needlessly complicated and ever-expanding tax system.

And that seems like a fairly reasonable suggestion. It's either that or reform the tax code (ha-ha).

Question is, are there enough people in our nation's capital capable of putting together the type of cost-efficient program the CBO suggests?

Click here to read the full CBO report.

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