Saturday, January 30, 2010

Are Tax Credits Really Tax Cuts?

Americans have a much greater aversion towards taxes than the citizens in most European countries. Yet its politicians are as eager as European politicians to use government created economic incentives and other forms of government coercion to manipulate people's life.

How have American politicians solved this dilemma?

In some cases they use regulation as a substitute for taxes. One good example is the government imposed so-called fuel efficiency standards for cars. Except for the aspect that it won't involve any formal monetary transactions, this has a similar effect as a gasoline tax. Because raising gasoline taxes are considered political suicide, Obama and others who want people to use less gasoline won't dare raise gas taxes. Instead they use regulation which impose similar costs for auto makers and drivers as a gas tax, but isn't perceived as a tax.

Another way to resolve this dilemma is to call taxes something other than taxes. The best example of this is the "cap and trade" scheme which Obama and most Democrats have been eager to implement, but which looks politically dead now after "Climategate", the failure of the Copenhagen summit and the victory of "cap and trade" opponent Scott Brown in Massachusetts. "Cap and trade" doesn't sound like a tax, and many of its supporters even call the scheme a "market based solution", yet the fact is that it is a tax. Even if the emission rights are given away rather than auctioned out, it would still be a tax, only combined with subsidies for the companies who are given the rights.

A third way is in a way even more disingenuous than the two aforementioned: the use of so-called tax credits. In this case, not only can the politicians claim that they aren't raising taxes, they can even say that they are cutting taxes. One example of this was in Obama's "State of the Union"-address, where he said:

"We cut taxes for first-time homebuyers. We cut taxes for parents trying to care for their children. We cut taxes for 8 million Americans paying for college."

However, in none of those cases did the tax cut involve reduction of some tax on home purchases, child care or college education. Instead it came in the form of tax credits that told people that they must behave in a certain way in order to keep their money. And that is not a genuine tax cut. As Ilana Mercer puts it in her latest column, commenting on the above Obama quote:

"You lie!: Obama has not cut taxes; he has cut welfare checks for workers, many of whom receive more in reimbursements from the government than they pay in taxes. Moreover – and with a flick of his forked tongue – the president simply redefined the meaning of a tax cut. A tax cut is a reduction in tax rates. It means letting a poor sod (or serf) keep more of his rightful earnings.

Obama's "tax credits" are not tax cuts. Ask Wikipedia, the left-leaning online encyclopedia, according to which tax credits are "subsidies disguised as tax cuts. In other words, they are spending in the form of direct transfers from the treasury to individuals, except that they are administered by the tax authorities rather than the agencies usually responsible for welfare."

A better definition of tax credits is social tinkering or engineering, as they target certain politically desirable constituents to the detriment of others. "Taxpayers can receive a raft of tax credits if they engage in various government-specified activities," confirms Peter Ferrara, director of entitlement and budget policy for the Institute for Policy Innovation."

The problem here is first of all that many of these tax credits are refundable, meaning that some can get them even though they're not paying taxes. A second and perhaps even more serious problem is that they for all practical purposes work as transfer payments or government consumption expenditures.

In Sweden and most other European countries, child care and college education are paid partially or fully by the government. People who use these services generally don't feel that they're getting a hand out however, because these subsidies are financed by taxes that they or their parents are paying. They are in other words simply keeping money that they have earned and otherwise would have gone to others. This is exactly like the tax credits that Obama brags about. While the formal arrangements differ somewhat, in terms of both the distributive effect and the effect on incentives, tax credits are essentially the same as subsidized services received by tax payers. Both have the characteristic of enabling people to keep money that they've earned and both have the characteristic of inducing some people to do things they wouldn't have done in the absence of taxation.

Some libertarian supporters of tax credits, such as Murray Rothbard, claims that people skeptical about tax credits assume that all income really belongs to the government. But that is not true as the problematic aspect is not that government finances are weakened (direct spending do that too), but that government manipulates behavior by telling them that they must buy certain services or perform certain activities or the government will not let them keep that income.

Rothbard's counter-argument to the fact that tax credits distort behavior, that in the absence of tax credits more money will go to the government, is in fact just a version of his previous argument, and fails for the same reason. Except for when tax credits are reduced as a fiscal austerity measure (and this applies equally to other fiscal austerity measures such as spending cuts or marginal tax rate increases), all revenues will through transfer payments, government services or marginal rate tax cuts ultimately go back to households. So the issue isn't whether or not households or government will be financial net receivers, the issue is whether or not government decides how money will be spent. If marginal tax rates are reduced, then government will decide less, but if the government increases spending on or issues tax credits for certain forms of behavior then government will increase its influenc