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Credits Against Tax

30 July, 2015 - 16:23

The Code provides that certain expenditures count as credits against the taxpayer’s tax liability. Some of these credits promote a more efficient or productive economy, i.e., the credit for dependent care services necessary for gainful employment (§ 21) and the Hope and Lifetime Learning Credits for some educational expenses (§ 25A). They are subject to income phasedowns (§ 21) or phaseouts (§ 25A). This implies that taxpayers with higher incomes do not need strong incentives or do not need incentives at all in order to incur such expenses. These credits are not refundable, meaning that they can reduce taxpayer’s tax liability to $0, but no more.

Section 24 provides a “child tax credit” of $1000 for each qualifying child of the taxpayer who is 16 or younger and a resident or citizen of the United States. The credit is subject to a phaseout as taxpayer’s income increases. A portion of this credit is refundable through tax year 2017.

The earned income credit (§ 32) is available to lower-income taxpayers who work. The tax credit first increases with earned income and then phases out completely. The idea here is to encourage lower-income taxpayers to work and to earn more. This credit is refundable, meaning that taxpayer is entitled to a refund if the credit is for more than taxpayer’s tax liability. Section 36B provides a refundable credit to low income taxpayers who purchase health insurance.

Note about Tax Credits

We should note that Congress can use credits to target tax benefits to certain taxpayers. Congress can target tax benefits by phasing out or phasing down entitlement to them as taxpayer’s adjusted gross income increases. Congress can also target greater benefits to those in certain tax brackets, even if a tax credit is not subject to a phasedown or phaseout. We earlier noted the “upside down” effect of progressive tax rates on deductions. Higher income taxpayers benefit more from a deduction than lower income taxpayers. A credit can reverse this. The amount of a tax credit can be dependent on the amount that taxpayer spends on a certain item, e.g., 20%. That percentage will provide a greater benefit to those taxpayers whose marginal tax bracket is lower than 20% than a deduction would. The converse is true for those taxpayers whose marginal tax bracket is above 20%; those whose tax brackets are more than 20% would have benefit more from a deduction.

Consider this example: Taxpayer has $100,000 of taxable income on which s/he pays $20,000 of income tax. Congress wishes to “reward” Taxpayer for having spent the last $1000 that Taxpayer earned on a particular item. The net after-tax cost to the Taxpayer for having spent the money in this way would be the following for taxpayers in each of the current tax brackets with either a deduction or a credit.

Taxpayer’s Tax Bracket

Net Cost of Benefit with a Deduction

Net Cost of Benefit with a 20% Tax Credit























You can see from the table that taxpayers in the 10% and 15% brackets should prefer a credit. Taxpayers in the brackets above 20% should prefer a deduction or exclusion. By setting the credit amount between the marginal tax rates, Congress can favor those taxpayers whose tax brackets are lower than the credit amount, and disfavor those taxpayers whose tax brackets are higher than the credit amount.

Do you think that Congress should make more use of tax credits? Less use? Why?

Limitations on Deductions: Floors, Phaseouts, and Phaseouts

Section 67 limits so-called “miscellaneous deductions” to the amount by which they exceed 2% of taxpayer’s AGI. In addition, Congress recently reinstated a phasedown of high income taxpayers’ itemized deductions 1 and a phaseout of high income taxpayers’ deduction for personal exemptions. Section 68 reduces the itemized deductions of taxpayers whose AGI is above a threshold amount by 3% of the excess, but no more than 80% of taxpayer’s itemized deductions. The threshold amount is $300,000 for a joint return or surviving spouse, ½ that amount for a married individual filing separately, $275,000 for a head of household, and $250,000 for all others. § 68(b))(1). These amounts are subject to adjustments for inflation after 2013. § 68(b)(2). Section 151(d)(3) phases down a taxpayer’s deduction for personal exemptions by a certain percentage, that percentage increasing in 2% increments for every $2500 by which taxpayer’s AGI exceeds the threshold of § 68, but no more than 100% of taxpayer’s deductions for personal exemptions.