Definition
A tax credit is a tax incentive which allows certain taxpayers to subtract the amount of the credit they have accrued from the total they owe the state. It may also be a credit granted in recognition of taxes already paid or, as in the United Kingdom, a form of state support.
Tax Credit
What is a ‘Tax Credit’
A tax credit is an amount of money a taxpayer is able to subtract from taxes owed to the government. The value of a tax credit depends on the nature of the credit, and certain types of tax credits are granted to individuals or businesses in specific locations, classifications or industries. Unlike deductions and exemptions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed.
Explaining ‘Tax Credit’
Governments may grant a tax credit to promote a specific behavior, such as replacing older appliances with more efficient ones, or to help disadvantaged taxpayers by reducing the total cost of housing.
Nonrefundable Tax Credits
Nonrefundable tax credits are items directly deducted from the tax liability until the tax liability equals $0. Any excess nonrefundable tax credit is not utilized, as any amount that would potentially reduce the tax liability further is not paid out. Nonrefundable tax credits negatively impact low-income taxpayers, as they are often unable to utilize the entire amount of the credit. Nonrefundable tax credits are valid in the year of reporting only, expire after the return is filed, and may not be carried over to future years. As of 2016, specific examples of nonrefundable tax credits include benefits for adoption, raising children, earning foreign income, and paying mortgage interest.
Refundable Tax Credits
Refundable tax credits are the most beneficial credit, as they are entirely refundable. This indicates that, regardless of a taxpayer’s income or tax liability, he is entitled to the entire amount of the credit. This is true even if the refundable tax credit reduces the tax liability below $0, indicating the taxpayer is due a refund. As of 2016, the most common refundable tax credit is the Earned Income Tax Credit (EITC). Other refundable tax credits are available for education, health care coverage and for raising children.
Partially Refundable Tax Credits
Some tax credits are partially refundable, which can both decrease taxable income and lower tax liability. As of 2016, an example of a partially refundable tax credit is the American Opportunity Tax Credit. If a taxpayer reduces his tax liability to $0 before using the entire portion of the $2,500 tax deduction, 40% of remaining eligible credit may be taken as a refundable credit.
Further Reading
- Tax reforms to influence corporate financial policy: the case of the Italian business tax reform of 1997-98 – ideas.repec.org [PDF]
- The welfare economics of a biofuel tax credit and the interaction effects with price contingent farm subsidies – academic.oup.com [PDF]
- The production tax credit for wind turbine powerplants is an ineffective incentive – www.sciencedirect.com [PDF]
- Foreign tax credit limitations and capital structure decisions – www.jstor.org [PDF]
- The impact of family income on child achievement: Evidence from the earned income tax credit – www.aeaweb.org [PDF]
- A cross‐national comparison of R&D expenditure decisions: tax incentives and financial constraints – onlinelibrary.wiley.com [PDF]
- Earned income tax credit policies: Impact and optimality: The Adam Smith Lecture, 2005 – www.sciencedirect.com [PDF]
- The dividend tax credit and Canadian ownership objectives – www.jstor.org [PDF]
- The low income housing tax credit and racial segregation – www.tandfonline.com [PDF]
- What can we learn about the low-income housing tax credit program by looking at the tenants? – www.tandfonline.com [PDF]
