Tax Credits

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Tax Credits

A tax credit is an amount that reduces payable taxes during a specific time period. Tax credits occur because a particular expense is tax deductible or because of a public policy that provides a credit up to a fixed amount. In order to calculate a tax credit, we use the following equation: Tax Credit = (Tax deductible expense) * (Tax rate).

In some countries interest expenses, depreciation, labor costs, and raw materials costs are tax deductible from a company’s taxable profits. Hence equivalent tax credits are estimated based on these expenses. Tax credits have a meaning only when a company (or an individual person) has enough profits to be taxed. Specifically in Australia, Canada, the United Kingdom, and the United States, a tax credit is considered a disbursement (payment) toward taxes owed by a company or individual. There is a similar item in the French tax system, though under another name.

A tax credit differs from a tax deduction, tax allowance, or tax relief because the latter three reduce taxable income, whereas the tax credit decreases tax liability unit for unit—in other words, it reduces the tax itself. Tax credits can be divided into two categories. The first consists of refundable (or non-wastable) tax credits, which can decrease owed taxes below zero and which thus lead to a net payment to the taxpayer, greater than their payments into the tax system. Hence they function like a moderate form of negative income tax. Examples of this type of tax credit in the U.S. tax system are the Earned Income Tax Credit and the Child Tax Credit. In the United Kingdom tax system examples include the Working Tax Credit and the Child Tax Credit. The second category consists of nonrefundable (or wastable) tax credits, which cannot reduce owed taxes below zero and thus do not allow the taxpayer to get a refund in excess of his or her payments into the tax system. Examples of this type of tax credit in the U.S. system include two educational tax credits, the Hope Tax Credit and the Lifetime Learning Tax Credit. Examples in the United Kingdom tax system include the former Children’s Tax Credit and the Declared Gifts Tax Credit, given to registered charities under the Giftaid scheme.

TAX CREDITS IN THE UNITED STATES

Principal tax credits in the U.S. tax system include the Child Tax Credit, the Federal Tax Credit for Energy Efficiency, the Earned Income Tax Credit, and the Low Income Housing Tax Credit. The Child Tax Credit (CTC) is based on the number of children in a family. In 2005 an individual could claim $1,000 of CTC per child. According to Internal Revenue Service (IRS) regulations, a child must be claimed as a dependent. To be eligible to be declared as a dependent, a child must have a Social Security number, be related to the taxpayer, be less than seventeen years old, and be a citizen or resident of the United States. The CTC is not available to wealthy people or to those who do not pay any taxes. For a couple (filing a joint return) the maximum adjusted gross income (i.e., combined income) is $110,000. For a single parent it is $75,000, and for a married couple filing separately it is $55,000 each. Finally, it should be noted that if a couple or single parent gets the CTC, this does not prohibit them from getting any other tax credit they qualify for.

The Earned Income Tax Credit (EITC) is a refundable tax credit that decreases or eliminates the taxes paid by low-income people. In some respects it can be considered a wage subsidy for low-income workers. The EITC was established in 1975 and expanded in 1986, 1990, 1993, and 2001. In 2006 this tax credit was one of the major antipoverty tools the U.S. government had and was widely supported.

The EITC has a three-stage structure: the phase-in stage, in which the tax credit increases as earnings increase; the plateau stage, in which the maximum range has been reached and the amount of credit is not affected by an increase in earnings; and the phase-out stage, in which the tax credit decreases as earnings increase. For instance, in 2006 the EITC for a four-member family was equal to 40 percent of the first $10,750 earned, the maximum credit was $4,400, the EITC decreased as earnings passed $15,000, and it became zero when earnings went beyond $35,000.

In 2004 the EITC cost the federal government approximately $36 billion. According to the General Accounting Office and the IRS, 15 to 20 percent of Americans who qualify for the EITC do not claim it. For this reason several nonprofit organizations, with the help of the government, have initiated special programs all over the United States to make the EITC known to taxpayers and to help taxpayers claim it. In addition to the federal EITC, eleven states and some other areas offer local EITC.

Overall the EITC has increased the percentage of people who join the labor force. There is some evidence that this rise in worker supply has caused a decrease in wages (on a per hour basis) for those that qualify for this particular tax credit.

The Federal Tax Credit for Energy Efficiency, which was established by the Energy Policy Act of 2005, applies to people and companies in four categories:

Consumers who make home improvements to save energy, such as insulation, window replacement, or the instillation of heating or cooling systems; or who buy energy-efficient cars, such as hybrid gasoline-electric, diesel, battery-electric, alternative fuel, and fuel cell vehicles, or who install solar water heating, photovoltaic, fuel cell, and microturbine systems.
Homebuilders who, in order to construct energy-efficient homes, pay for building-envelope improvements and energy-efficient heating and cooling systems.
Appliance manufacturers who manufacture energy-efficient washing machines, dishwashers, and refrigerators. This in turn can lead to a price reduction for these types of appliances.
Owners or designers of commercial buildings in which lighting, heating, and cooling systems meet efficiency standards. Credits in this category go up to $1.80 per square foot.

Another category of tax credit is the Low Income Housing Tax Credit (LIHTC), which was established by the Tax Reform Act of 1986 (TRA86). This tax credit aims to give low-income Americans incentives to own a house rather than rent. TRA86 offered incentives to investors to buy homes by changing the treatment of imputed rent, local property taxes, and mortgage interest payments. These changes, however, negatively affected low-income people, who usually lived in rented homes. Hence the LIHTC was established along with the TRA86 to mitigate these negative consequences. The LIHTC directly subsidizes the development costs of low-income residential units, excluding land acquisition costs. Tax credits are claimed as an annuity for a period of ten years (the credit period) and not as a lump sum as with other tax credits. Since 2002, 40 to 50 percent of new construction of family residences has been developed under the LIHTC program at a cost to the federal government of approximately $3 billion per year.

TAX CREDITS IN CANADA

In the Canadian tax system, one important tax credit is the Canada Child Tax Benefit (CCTB). The CCTB is a monthly tax-free payment available to qualifying Canadian families made in order to help defray some of the costs of raising children. The CCTB can incorporate the National Child Benefit and the Child Disability Benefit. The former is a monthly payment to low-income families with children. The latter is a monthly payment to families with children that have severe and prolonged mental or physical disabilities.

Another tax credit that has existed since 1980 is the Scientific Research and Experimental Development Tax Incentive Program (SR&ED or SRED). This tax credit applies to businesses in Canada and is intended to support and encourage applied research and experimental development leading to new or improved goods and services. The program costs the Canadian government approximately $1.8 billion per year. The Ministry of Finance is responsible for legislation of the SR&ED tax credit, and the Canada Revenue Agency is responsible for its administration.

Even if SR&ED expenses have already been deducted from revenue, businesses may qualify for Investment Tax Credit (ITC) if those expenses are associated with experimental development, applied research, basic research, or research support work. Relevant expenditures include wages, materials, equipment overhead, and SR&ED contracts arising from the aforementioned activities. The amount of the ITC depends on how much of a business’s SR&ED expenses were incurred in Canada and on the business’s legal status. Furthermore each region in Canada has the right to provide provincial or territorial tax credits to qualifying businesses that pursue SR&ED activities in those regions.

TAX CREDITS IN THE UNITED KINGDOM

In the United Kingdom tax system significant tax credits include the Working Tax Credit and the Child Tax Credit. To qualify for these credits, a person must be older than sixteen and live in the United Kingdom—either as a British citizen or as a European Economic Area citizen working in the country—or receive a United Kingdom state pension while living abroad. The Child Tax Credit (CTC) is given to people who are responsible for at least one child or qualifying young person. It is paid directly to the person who is responsible for child care. A single parent can claim individually, but a couple must make a joint claim. The Working Tax Credit (WTC) is given to people who are employed or self-employed (either alone or in a partnership) if they meet the following criteria:

they usually work sixteen or more hours per week;
they are paid for that work;
they expect to work for at least four weeks;
they are older than sixteen and responsible for at least one child, or are sixteen years old and disabled, or are above twenty-five and work at least thirty hours per week on average.

If both people in a couple are working sixteen hours or more per week, only one can receive the WTC. There is, however, also a child care component of the WTC, which is always paid to the person responsible for raising a child, in addition to CTC payments. Before 2003, when the WTC and the CTC were established, the Working Families Tax Credit, created in 1999, combined the functions of the WTC and CTC. Before that, from 1986 to 1999, United Kingdom taxpayers received the Family Credit.

The amount of tax credits received depends on annual income. For instance, a family with income below £58,000 can claim the CTC in addition to child benefits. If a child or children are disabled, higher rates are paid. If the income is below £50,000, the CTC is £545 per year for the family (£1,090 if there is a baby under twelve months old). For low-income families, there is an additional £1,765 per child per year. The CTC can be claimed even by families that are rich. Both the WTC and the CTC are made up of components (elements) according to individual cases that form the basic amount of tax credit receivable. For instance, the basic element is £1,665 for the year 2006–2007, then other elements follow, such as the couple and lone parent element £1,640, the thirty hour element £680, the disabled worker element £2,225, and so on. For the CTC, the family element is £545, and then follow the family element, baby addition £545, the child element £1,765, the disabled child element £2,350, and so forth that are applied according to individual cases. Both these tax credits are paid based on the gross household income earned during the previous tax year.

WTC and CTC tax credits were not well administered when they were first established, and many cases of overpayment were observed. Nevertheless, tax credits are considered an important means of encouraging low-income employees, as they help avoid the disincentive to work that occurs when wages amount to little more than unemployment benefits.

SEE ALSO Earned Income Tax Credit; Research and Development; Taxes

BIBLIOGRAPHY

Canada Revenue Agency. Child and Family Benefits. http://www.cra-arc.gc.ca/benefits/menu-e.html.

Canada Revenue Agency. SR&ED Program: About Our Program. http://www.cra-arc.gc.ca/taxcredit/sred/aboutus-e.html.

Congressional Budget Office, U.S. Congress. 2007. Letter to Charles E. Grassley, Chairman of the U.S. Senate’s Committee on Finance. http://www.cbo.gov/ftpdocs/77xx/doc7721/01-09-MinimumWageEITC.pdf.

Congressional Research Service Reports. The Earned Income Tax Credit (EITC): Percentage of Total Tax Returns and Credit Amount by State.http://www.digital.library.unt.edu/govdocs/crs/data/2005/meta-crs-7962.tkl.

Department of the Treasury, Internal Revenue Service. Earned Income Credit (EIC). http://www.irs.gov/pub/irs-pdf/p596.pdf.

Energy Star. Federal Tax Credits for Energy Efficiency. http://www.energystar.gov/index.cfm?c=products.pr_tax_ credits.

Government of Canada. 2005. Taxation Info-Guide. http://www.cbsc.org/servlet/ContentServer?cid=1089652659 441&pagename=CBSC_FE%2Fdisplay&lang=en&c= GuideInfoGuide.

Government of Newfoundland and Labrador, Canada. Scientific Research and Experimental Development Tax Credit.http://www.fin.gov.nl.ca/fin/scientific.html.

Greenstein, Robert, and Isaac Shapiro. 1998. New Research Findings on the Effects of the Earned Income Tax Credit. Center on Budget and Policy Priorities Report. http://www.cbpp.org/311eitc.htm.

HM Revenue and Customs. Rates and Allowances: Tax Credits/Child Benefit. http://www.hmrc.gov.uk/rates/taxcredits.htm.

HM Revenue and Customs. What Are Tax Credits? http://www.taxcredits.inlandrevenue.gov.uk/qualify/WhatAreTaxCredits.aspx.

HM Treasury. 2005. 2005 Pre-Budget Report. http://www.hm-treasury.gov.uk/pre_budget_report/prebud_pbr05/press_notices/prebud_pbr05_press02.cfm.

Motley Fool. The Child Tax Credit. http://www.fool.com/personal-finance/taxes/2003/02/21/the-child-tax-credit.aspx.

Katerina Lyroudi

International Encyclopedia of the Social Sciences