Tuesday, August 16, 2011

Are Tax Credits Subsidies?

Recently, Ron Paul published an article titled “How Should Government Treat Energy Producers?”

In discussing the tax code he makes the following claim (emphasis mine), "with tax credits and deductions, industries, business, and individuals simply get to keep more of the money they have earned." He uses this to justify his support for tax credits and that, “Removing tax credits is nothing more than a tax increase.” It should be noted that is the same position Murray Rothbard held in his essay “The Case Against the Flat Tax”.

I emphasized “they have earned” above because that is the crucial question. If a credit or deduction allows an individual (to use the terms “industries” and “business” is redundant as they are in fact made up of individuals) to retain his own income then this is indeed a good thing (from a libertarian point of view). It takes the form of Sam steals from Paul to give back to Paul. If, however, the credit or deduction is the income of someone else then this is a subsidy and a distribution of wealth that takes the form Sam steals from Paul to give to Peter.

Let us first to a definition of a tax credit via Robert Wenzel at economicpolicyjournal.com,

            Here is the definition of a tax credit from Merriam-Webster's Dictionary of Law:

            Function: noun
            : an amount that may be subtracted from the sum of tax otherwise due and that is distinguished from a deduction applied to gross income in the calculation of taxable income


We actually find two definitions in one. A deduction is applied to reduce your taxable income. This adjusted gross income is then used to calculate how much tax you owe. A deduction allows you to retain more of your income and libertarians should fully support them.

But what do we learn of the tax credit? All that is shown is that it is “an amount that may be subtracted from the sum of tax otherwise due.” It does not help answer the question of whether it is Sam robbing Paul to give back to Paul or if it is Sam robbing Paul to give to Peter.

When you pay taxes you are paying into an account at a tax bank. Your debits, or liabilities, are determined by adjusting your income by subtracting deductions and allowances. This is your total liability.

Throughout the year you or your employer must deposit money into this account to meet the total liability. This credit (or asset) side of the account is where tax credits are applied. At the end of the year your liability is subtracted from your asset side to determine your refund.

It is true that the tax credit allows you to retain more of your income but only because the tax credit was deposited into your account. This tax credit deposit can only be funded by either; A) income tax you have already paid, B) income tax somebody else paid, or C) inflation.

Case A would be an example of returning property to the original victim. But the reality of this case is highly unlikely for two reasons. First, if the money is coming from taxes you have already paid then why not make the credit a deduction? Second, you can receive a refund from tax credit even if you paid no income tax.

I believe to ask the first question is to answer it. Deductions are a genuine tool for reducing the tax burden whereas credits are used as redistribution that masquerade as tax reductions. It's actually a clever trick because now the principled libertarians (even Rothbard!) are supporting a State redistribution scheme while pseudo-libertarians (the Kochs) are against them.

Consider this thought experiment. If deductions were maximized to include any action (spending, saving, investment) then the State would have zero income tax revenue. On the other hand if credits were maximized the State would need to fund these through higher taxes on other people (case B) or inflation (case C).

With all due respect the positions of Ron Paul and Murray Rothbard are wrong. I have shown that tax credits, in absence of the unlikely Case A, are an example of Sam exploiting Paul to give to Peter. Therefore the proper libertarian position (aside from eliminating the income tax altogether) is to call for all credits to be converted to deductions. This would ensure that individuals are allowed to keep more of their money. Indeed if every action (spending, saving, investment) was deductible for all individuals the income tax would be eliminated.

No comments: