Sunday, February 25, 2007

Tax credits

While deductions and exemptions reduce your income, credits directly reduce your tax itself. As such credits are better, their effect doesn't depend on the marginal rate. Formally, the effect of credits can be reflected in a new tax equation.

* C, a vector of Credits
* T1, the tax equation defined before

The most important credit is the earned income tax credit (EITC). The EITC is a very special tax credit, it is refundable, in other words if you end up with a negative tax, the government will effectively send you back some money. Note that this is different from a refund, the EITC is only valid for low income taxpayers and correspond to a work incentive, in a certain range of income, the government chips in some extra money towards your disposable income. The EITC is one of the largest aid programs, as mentioned in "Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply"
In fact, the EITC is the largest cash transfer program for lower-income families at the federal level. An unusual feature of the credit is its explicit goal to use the tax system to encourage and support those who choose to work.

The next figure is extracted from the same document (based on values provided in table 13-14, Green Book, 2004, Joint Committee on Taxation, Ways and Means Committee) and shows the evolution of the EITC. To put things in perspective, the total amount of individual tax liability is about 800 billions in 2003.

As alluded, the EITC increases with an increase in income, mathematically this means negative marginal rates, i.e. your tax decreases (in this case becomes more negative) as your income increases. The exact rates are variable and depend on the phaseout characteristics of the EITC, this will be discussed in the more general article on phaseout effects.


Anonymous said...

As a mathematician and a tax scholar I want to say that your work is among the worst things I have ever seen in my life.

Mathematicians should simplify with elegant explanations of how things work. You have taken simple concepts and made them needlessly complex.

I wouldn't be concerned if obfuscators such as yourself weren't responsible for so much of the confusion in the world.

Anonymous said...

Needlessly complex? Pah! Economics journals are full of this sort of thing. Granted nobody has ever accused economists of making things simple.

I think the credit equation merits differentiating between refundable and nonrefundable credits. The equation appears to refer to refundable credits since tax is reduced by the sum of the credits. If the credits were nonrefundable it would only reduce tax to zero.

Orval said...

Indeed the difference between refundable and non refundable credits is important for correctness. To be honest, I'm more interested in the right side of the curve (phaseouts) than the left side. I know the EITC is refundable, I'll need to check other credits.