The voices of Tax Policy Center's researchers and staff
Among the ruins of the American Health Care Act, there remains an important debate over tax credits versus tax deductions. This turns out to be as much a matter of tax theology as tax policy, but it has important implications as Congress and President Trump try to resurrect their health financing initiative and move on to a major tax bill.
The health plan principally written by House Speaker Paul Ryan (R-WI) would have helped subsidize the cost of health insurance with refundable, advanceable tax credits. These credits differed somewhat from the Affordable Care Act credits—for example, they would have been based primarily on age rather than income—but they relied on basically the same mechanism. Because they were refundable, very-low-income insurance buyers, even those who pay no income tax, would have qualifyied for the credits.
But credits, especially refundable credits, are anathema to many conservatives. To them, a new health credit is a federal entitlement program and thus unacceptable. They are not opposed to subsidizing the cost of health insurance or direct medical care through the tax code. But they say it should only be done through deductions or exclusions from taxable income, not refundable credits. This is how Rep Jim Jordan, a member of the Freedom Caucus put it to CNN on March 6: "If it's an advanced, refundable tax credit so you're giving a credit to people who don't have a liability, that's just a subsidy."
To understand what this is all about, let’s start with a quick taxonomy.
Deductions v. Credits
Deductions reduce your taxable income. Thus, they are more valuable to someone in a high tax bracket than to a person who pays a low tax rate. For example, a $10,000 deduction reduces taxes by $1,500 for someone in the 15 percent bracket, but by $3,500 for a person in the 35 percent bracket. An exclusion from income, for, say, a contribution to a Health Savings Account or an IRA, works the same way.
Tax credits are different. They directly reduce your tax liability instead of your taxable income. Thus, a $2,000 credit is worth the same to the person in the 15 percent bracket as to someone in the 35 percent bracket. If a credit is refundable, filers get it regardless of their tax liability. Someone who pays no income tax at all would still receive the same $2,000. Three major credits already on the books are fully or partially refundable: the Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit.
New Spending Or A Tax Cut?
That leads to the first bit of theological disputation. By the conventions of budget scoring, deductions are treated as lost revenue to the Treasury (or, in common language: tax cuts). But the refundable portion of a tax credit is counted as spending. And, of course, among many lawmakers tax cuts are good while additional spending is bad.
But in the real world, both subsidies are delivered through the tax code. And in fiscal terms, a dollar of foregone tax revenue is no different from a dollar of extra spending. If your concern is deficits and debt, you should be indifferent to these two forms of subsidy.
But there is one big difference: the distribution of benefits. Deductions tend to be worth more to high-income taxpayers. Credits are more likely to benefit low- and moderate-income households. And low-income households with no federal income tax liability can only benefit from the refundable portion of credits.
Friedman and Reagan
That brings us back to the core argument: that a refundable credit is an entitlement (thus bad) while a deduction is a tax cut (thus good). But the American godfather of refundable credits was conservative icon Milton Friedman, who adopted the idea of a negative income tax from the UK in the 1940s. Friedman’s model eventually jumped the partisan divide and became a key economic plank for 1972 Democratic presidential candidate George McGovern. Though McGovern was crushed in that race, the idea became law a few years later during the administration of President Ford. A decade later, President Reagan presided over a major expansion of the EITC, a key element of the 1986 Tax Reform Act.
Refundable credits are an idea with impeccable conservative credentials. Yet, they trouble many of today’s Republican lawmakers, seemingly because they provide a cash benefit to those without federal income tax liability. In their world, it is acceptable to give a $20,000 tax deduction (worth more than $8,000 in tax savings) to someone making $15 million but not give a $2,000 refundable credit to someone making $15,000.
This controversy is not going away. It will return should Republicans find a way to resurrect their health plan. And it will surely raise its head in any debate over tax reform, when those refundable credits may once again become a hot topic for debate among Republican policymakers.
Posts and Comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
(AP Photo/Steven Senne)