The Power of Credits

Tax credits are a powerful tool in the fiscal policy arsenal that governments use to incentivize behavior, support individuals and families, reduce poverty, and stimulate economic activity. Unlike tax deductions, which reduce your taxable income, tax credits provide a dollar-for-dollar reduction of tax owed or an increase in a tax refund.

This direct financial impact gives them considerable power in influencing taxpayer behavior and providing relief.

There are two main credits, refundable and non-refundable, with different implications for taxpayers. Refundable Tax Credits: Refundable tax credits can reduce your tax liability below zero. If a refundable tax credit amount is greater than what you owe in taxes, the difference will be refunded. In other words, you can still benefit from a refundable credit even if you do not owe any tax. A typical example of a refundable tax credit is the Earned Income Tax Credit (EITC).

Non-Refundable Tax Credits

Non-refundable tax credits only reduce your tax liability to zero but not below it. If you have a non-refundable tax credit that exceeds your tax liability, you will not get the excess amount as a refund; instead, the surplus credit ceases to benefit you. An example of a non-refundable tax credit is the Mortgage Interest Tax Credit.

The distinction between refundable and non-refundable credits is essential for budgeting and planning purposes. Refundable credits can result in money coming back to you, potentially increasing your tax refund, while non-refundable credits solely reduce the amount of tax you pay up to the amount you owe.

Here are some ways in which tax credits show their power

1. Supporting Families and Individuals

Credits like the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC) are crafted to assist low- and moderate-income families. The EITC is known for its effectiveness in lifting people out of poverty and supplementing the wages of low-income workers. Child Tax Credit is another credit that rewards and encourages families to have children. It offers financial assistance to families aimed at reducing the burden of the costs associated with raising children. In some countries, CTC seeks to increase the county’s population.

For the tax year 2023, the child tax credit would be up to $2,000 per qualifying child under the age of 17 at the end of the tax year. This includes a maximum refundable portion, the Additional Child Tax Credit (ACTC), up to $1,600 if the taxpayer does not owe taxes. If you qualify for CTC, there are other tax credits for families worth looking into, such as Child and Dependent Care Credits, Adoption Credit and Adoption Assistance Programs, Education Credits, or Credits for Other Dependents.

2. Promoting Social Objectives

Certain tax credits are designed to encourage behaviors that align with social goals, such as higher education (e.g., the American Opportunity Tax Credit), home purchases (e.g., past Homebuyer’s Tax Credits), and energy efficiency improvements.

For example, the Residential Energy Efficient Property Credit is a tax credit available to homeowners in the United States who install energy-efficient improvements to their homes, including solar energy systems, small wind turbines, geothermal heat pumps, and fuel cells. For example, if you purchased and installed a Tesla Solar Roof or Tesla solar panels on your property, you might be eligible for this credit.

3. Spurring Economic Development

Tax credits stimulate economic growth by attracting investments in specific areas. For example, the New Markets Tax Credit (NMTC) targets investment in economically distressed communities to foster business growth and job creation.

The NMTC provides a tax incentive for investors to make qualified equity investments in designated Community Development Entities (CDEs). The CDEs then use the capital to invest in low-income communities, supporting various development projects, such as affordable housing, commercial real estate, and community facilities.

4. Encouraging Research and Development

The R&D tax credit incentivizes companies to invest in innovation by providing a tax credit relative to the extent of their spending on research and development, fostering technological advancement and potentially boosting competitiveness.

5. Comforting During Times of Crisis

In response to economic downturns or disasters, governments may offer targeted tax credits to deliver prompt relief to affected individuals or businesses, such as the recovery rebates provided under the CARES Act in the U.S.

6. Increasing Purchasing Power

By reducing tax liability, tax credits effectively boost the purchasing power of consumers, which can drive demand in the economy and potentially lead to higher economic growth.

7. Directing Business Behavior

With tax credits for certain activities or industries (e.g., renewable energy), governments can steer businesses toward more desirable practices, such as environmental sustainability or specific hiring practices.

For example, the Work Opportunity Tax Credit (WOTC) is available to businesses for hiring individuals from certain target groups who face significant employment barriers. These groups include veterans, Temporary Assistance for Needy Families (TANF) recipients, designated community residents living in Empowerment Zones, ex-felons, and individuals who have been unemployed for an extended period.

8. Complexity and Compliance

While tax credits can be powerful, they also add complexity to the tax code. Proper implementation requires taxpayers to understand eligibility criteria and for the government to enforce compliance, which can sometimes prove challenging. Individuals and businesses must adhere to the regulations and procedures set by the IRS to claim these credits successfully.

Because tax credits can be complex and the rules can change frequently, individuals and businesses should consult a tax professional familiar with the latest tax laws and credits. They can help ensure that individuals and businesses take full advantage of available credits while complying with tax regulations.

The examples provided are simplified illustrations, and the actual process would involve detailed compliance with the tax law. Note that the amount of credit and whether you qualify may change, as tax laws are subject to frequent updates. Always refer to the latest information provided by the IRS or consult with a tax professional.

Overall, tax credits are a powerful mechanism for achieving economic and social policy objectives, as well as helping individuals and businesses reduce their taxes, due to their direct impact on taxpayers’ financial obligations and their flexibility in design and implementation.