Why All Tax Credits Should Be Refundable

Critics of George W. Bush's proposal to expand the number of Americans with health insurance correctly identify its weak link: a reliance on tax deductions. According to the Kaiser Family Foundation, 43 percent of the 46 million uninsured have no income tax liability. As a result, the White House predicts its proposal will reduce the uninsured by only 7-10 percent.

Hopefully, the critical weakness of the White House health care incentive will open the door to a wider debate about the shortcomings of tax deductions (and credits) overall.

The cost of tax breaks, or as economists now more accurately describe them, "tax expenditures," is $500 billion to $800 billion a year, roughly 5 percent of the gross domestic product. The vast majority of these tax breaks are inherently unfair. A $1,000 tax deduction might be worth $400 to a wealthy household, $200 to a middle-income household, and not a penny to a poor family. Indeed, 37 percent of all households, home to almost half of all children, have no tax liability.

Why do we skew tax breaks to favor richer people and more profitable businesses? No evidence suggests that they have a higher propensity to engage in socially beneficial behavior. Just ask any waitress or waiter to tell you who tips them better, the wealthy or the working class.

There is a way to avoid incentive inequity. Make the tax incentives refundable tax credits. This is how the earned income tax credit (EITC) works. The government will send you a check even if you pay no taxes. As a result, the EITC is now the largest and arguably by far the most effective anti-poverty initiative.

More typical is our housing tax incentives. For all but the very rich, houses represent the single largest source of lifetime financial savings. The lack of housing, and the resulting lack of savings, is particularly high among blacks and Hispanics. In 2005, government provided $150 billion to homeowners in tax subsidies, but the way the subsidies were structured did little to improve the situation.

Why not replace the housing tax deductions with a level refundable tax credit? It could be revenue neutral by using the current Treasury loss for housing deductions as the cap. Economists Richard Green and Kerry Vandell have examined such a system and predicted it could increase overall home ownership by 3-5 percentage points, and even more impressive, increase home ownership by up to 8 percentage points among the lowest income households.

Economists at Brookings and MIT have proposed that we replace the current tax incentives for contributions to retirement plans with a 30 percent government matching contribution. Under this scenario, worker contributions to 401k accounts would no longer be excluded from taxable income. Contributions to IRAs would no longer be tax deductible. Employer contributions to the plan would be taxable, just the way current wages are.

To the federal treasury, the change would be revenue neutral. To the recipient, the tax policy would be a great deal fairer.

As currently designed, tax breaks are not only inequitable. They are inefficient. This is particularly striking with federal renewable energy incentives.

Owners of wind turbines currently qualify for a federal tax credit per kwh generated. But farmers and other rural residents very rarely earn sufficient taxable income to take advantage of this incentive. As a result, to enable "locally owned" wind turbines, which produce the same amount of wind energy while generating a far higher amount of local and regional economic activity, a cumbersome corporate structure is created. The locals become partners with Wall Street or corporate investment firms that take the tax incentives and provide the financing.

If the federal government converted the incentive into a refundable tax credit, the cost to the Treasury would be the same. But 100 percent of the incentive would reach the local owners and the rural development impact would be far greater.