Why Tax Credits Should Never Be Income-Tested

Anderson: Tax credits are highly progressive by nature and income-testing them is plainly overkill

(Martin Barraud/Getty Images)
(Martin Barraud/Getty Images)

“An Alternative to Obamacare,” released by the Hudson Institute, proposes simple, refundable, non-income-based tax credits. Some have criticized this approach as not demonstrating sufficient progressivity. But such claims reveal a lack of understanding about the workings of tax credits. Tax credits are highly progressive by their very nature, and income-testing them is plainly overkill.

The following tables clearly demonstrate this. Unlike Obamacare’s direct outlays to insurance companies, genuine tax credits go directly to individuals or families. “An Alternative to Obamacare,” which I authored, proposes tax credits of $1,200 for those under the age of 35, $2,100 for those between 35 and 50, and $3,000 for those 50 and over; plus $900 per child.

Here is the percentage tax break that a 40-year-old single person would get under such a system of tax credits (with tallies reflecting the 2016 tax year for those who claim the standard deduction—those who itemize or claim special deductions could get an even larger tax break):

So, someone making $27,000 would get a 100% tax cut, someone making $53,000 would get a 33% tax cut, and someone making $110,000 would get a 10% tax cut. That’s not progressive enough?

Here’s the percentage tax break that a 40-year-old married couple with two children would get under such tax credits:

The fact that a system of such substantial tax credits would save more than $1.1 trillion in federal spending over a decade versus Obamacare, based on nonpartisan scoring, is a testament to just how colossally expensive and fiscally profligate Obamacare really is.

Given their inherent progressivity, tax credits should never be income-tested. As I write in “An Alternative to Obamacare,”

“Not income-testing the tax credits is much simpler, reduces the role of the I.R.S. (which would otherwise have to check incomes to establish eligibility), avoids creating a disincentive to work, and lets every individual or family quickly calculate what they’d be getting. In direct contrast, Obamacare’s income-based subsidies are byzantine, empower the I.R.S., discourage work, and make it nearly impossible for individuals or families to calculate what, if anything, they (or, more exactly, their insurance company) will be getting. (Not income-testing the tax credits also avoids marriage penalties, whereas Obamacare’s income-based subsidies routinely penalize marriage.)

“Moreover, the tax credits proposed herein will usually take the form of a tax cut. But when they don’t—because their recipients don’t pay as much money in income taxes as they will get through the tax credits—they will count as spending. Most of that spending—more than two-thirds, in fact—will be paid for by the top ten percent of income-earners. Not making the tax credit available to people at that income level would therefore be like having ten people order dinner together in a restaurant, having one of them agree to pick up two-thirds of the tab, and then telling that person that he or she can’t have any of the food.”

Finally, tax credits’ natural progressivity means that preventing wealthier Americans from claiming them could actually cost the Treasury money. Say that Bill Gates had a $50,000 health insurance policy through his employer, which would give him about a $20,000 income tax break—as that $50,000 wouldn’t count as taxable income, and his marginal tax rate would be about 40%. If he instead wanted to buy health insurance on his own and claim the $3,000 tax credit—in lieu of his $20,000 tax break for having employer-based insurance—that would benefit the Treasury by some $17,000. So everyday Americans should hope Gates would claim the tax credit, rather than keeping his current deduction.