Efficiency and tax incentives: the case for refundable tax credits.

• Author: Batchelder, Lily L.

INTRODUCTION I. OVERVIEW OF REFUNDABLE TAX CREDITS A. Current Refundable Credits B. Has Bipartisan Support for Refundable Credits Crested? II. THE EFFICIENCY CASE FOR REFUNDABLE TAX CREDITS A. Uniform Refundable Credits as the Efficient Default Structure for Tax Incentives 1. Efficient taxation in the presence of externalities 2. Putting theory into practice 3. Uniformity and refundable credits B. Income Smoothing at the Household Level C. Smoothing Macroeconomic Demand III. POTENTIAL OBJECTIONS CONCLUSION APPENDIX A APPENDIX B INTRODUCTION

Each year the federal individual income tax code provides over $500 billion worth of incentives intended to encourage socially beneficial activities, such as charitable contributions, homeownership, and education. (1) This is an enormous investment, exceeding our budget for national defense (2) and amounting to about 4% of Gross Domestic Product (GDP). (3) The design of these tax incentives is an immensely important policy matter. Yet despite their efficiency rationale, (4) little attention has been paid to the question of what economic efficiency implies about the form these tax incentives should take.

Currently the vast majority of tax incentives operate through deductions or exclusions, which link the size of the tax preference to a household's marginal tax bracket. Higher-income taxpayers, who are in higher marginal tax brackets, thus receive larger incentives than lower-income taxpayers. This Article argues that providing a larger incentive to higher-income households is economically inefficient unless policymakers have specific knowledge that such households are more responsive to the incentive or that their engaging in the behavior generates larger social benefits. Absent such empirical evidence, all households should face the same set of incentives.

This Article therefore proposes a dramatic change in how the government should provide tax incentives for socially valued activities: the default for all such tax incentives should be a uniform refundable tax credit. Unlike other forms of tax incentives, a uniform refundable credit is not related to a household's marginal tax rate and provides cash payments to qualifying households even if they owe no income tax. Such credits would thus provide a much more even and widespread motivation for socially valued behavior than the current set of tax incentives. Moreover, they could further enhance economic efficiency by smoothing household income shocks and macroeconomic fluctuations. While transforming deduction-like incentives into uniform refundable credits would represent a substantial tax reform, it could be done on a revenue-neutral basis.

Refundable credits are not a new concept in the tax code. Prior to 1975, all individual tax incentives were structured as deductions or exclusions or, occasionally, as non-refundable tax credits. Today refundable credits are more widespread, accounting for about 18% of the roughly $500 billion in tax incentives. (5) Nevertheless, increasingly there has been heated debate about whether refundable tax credits are an appropriate part of our tax system. Some policymakers believe that the purpose of the income tax is to raise revenue and that all Americans should pay at least some income tax as a duty of citizenship. (6) They argue that "[i]f it's a refundable credit, it has no business in the tax system" (7) and that refundable tax credits are "turn[ing] our income tax code into a welfare system." (8) Others contend that the income tax should seek to reduce disparities of income, wealth, and opportunity and that refundable tax credits are a fundamental element of any fair tax system. These divergent perspectives are illustrated in last fall's report by the President's Advisory Panel on Federal Tax Reform (9) and the extensive debate that has occurred regarding the priority given to refundability of the child tax credit. (10)

This Article is motivated by our concern about the focus of this debate. We believe that by focusing too exclusively on enforcement issues and the progressivity of the tax code--issues subject to deep partisan divides--the debate has moved policymakers away from common ground and obscured other sound rationales for refundability. To be sure, distributional concerns and the comparative advantages of the tax versus transfer systems are critical issues to be considered with respect to any current or proposed tax benefit. But for tax incentives justified on efficiency grounds, efficiency concerns should be a first-order consideration. Accordingly, this Article seeks to move beyond the stalemate that the debate has generated by examining refundable credits from an efficiency perspective instead. (11)

The question this Article addresses is how to efficiently structure a tax incentive intended to encourage behavior generating positive externalities, assuming some type of tax incentive has been deemed appropriate and distributional objectives are set aside. (12) By contrast, previous literature generally has failed to disaggregate equity and administrative arguments for different forms of tax incentives from efficiency concerns. For instance, both the comprehensive tax base literature and the tax expenditure literature argue that tax incentives should be repealed because they inefficiently narrow the tax base and needlessly complicate the tax system. (13) As a result, they have paid relatively little attention to the issue of efficient tax incentive design. (14) Other work has acknowledged the possibility that tax incentives can be desirable but has only considered the merits of specific tax incentives on efficiency grounds or, alternatively, has focused exclusively on equity concerns. (15) We depart from this prior scholarship by acknowledging that tax incentives can enhance efficiency, considering what efficiency implies about their ideal design, and concluding that uniform refundable credits are the most efficient default form.

We reach this conclusion first by explaining why uniform refundable credits represent the most efficient type of tax incentive absent evidence of differences in externalities and elasticities by income class. Under the most reasonable set of default assumptions, (16) a tax incentive provision correcting for positive externalities should apply uniformly across the income distribution and different lifetime earnings patterns. Refundable credits are the only straightforward way to achieve such uniform application. (17) Thus, by default, they are the best way to minimize the distortions that necessarily result from our inability to perfectly correct for the externalities involved. Indeed, they are the most efficient default even if no externalities or negative externalities are present.

Non-uniform incentives certainly may be justified if the weight of available evidence suggests that the externalities generated by the activity or responsiveness to the subsidy vary systematically by income class. Moreover, these differences between various income groups surely exist in reality. Nevertheless, when--as is frequently the case--the evidence on these issues is nonexistent or directionally inconclusive, uniform refundable credits minimize the expected deadweight loss remaining as a result of errors in the incentive's structure. (18) The burden of proof should therefore be on those who prefer some other form of tax incentive to demonstrate that deviations from a uniform refundable credit are warranted by empirical evidence.

Indeed, even when such empirical evidence exists, the optimal subsidy is almost certainly still some type of refundable credit. It is extremely unlikely that externalities and elasticities change in an abrupt and discontinuous fashion exactly at the point of zero income tax liability or the marginal tax rate thresholds. Yet such discontinuities are inherent in the application of all basic forms for tax incentives other than refundable credits.

Uniform refundable credits likely hold significant potential to enhance economic efficiency in practice on these grounds. Under current law, more than 35% of tax units during any given year have no income tax liability, and these tax units are home to almost half of all American children. (19) Deductions, exclusions, and non-refundable credits are typically worthless to them. By contrast, refundable tax credits are the only simple type of income tax incentive that can reach these families and their children directly.

The potential benefits of uniform refundable credits are further magnified by a second feature: their ability to help smooth income at a household level. We explain how converting existing tax incentives into uniform refundable credits on a revenue-neutral basis would heighten household income smoothing in two ways. First, it would eliminate tax penalties that other types of tax incentives impose on households experiencing income fluctuations. Second, it would target such relief on relatively low-income years. In addition, new refundable credits could also heighten household income smoothing if they increased the progressivity of the tax system overall. (20) Such income smoothing can enhance efficiency by reducing adjustment costs associated with economic instability and offsetting failures in insurance markets, and it is likely to be particularly valuable for the low-income households that only refundable credits can reach. (21)

The final element of the efficiency case for refundable credits follows from their potential to help smooth household income: Refundable credits can help stabilize macroeconomic demand in the face of economy-wide shocks, which is also considered efficiency enhancing independent of distributional concerns. (22) Relative to other forms for tax incentives, they can do so in two ways. First, they reduce tax burdens during recessionary periods as more households fall into the income range where refundability is relevant. (23) Second, they provide...