Debate over refundability of tax credits

Yet in a polite but pointed exchange with the No. 2 House Republican, Eric Cantor of Virginia, Mr. Obama took note of the parties’ fundamental differences on tax policy toward low-wage workers, and insisted that his view would prevail.

At issue is Mr. Obama’s proposal that his tax breaks for low- and middle-income workers, including his centerpiece “Making Work Pay” tax credit, be refundable — that is, that the benefits also go to workers who earn too little to pay income taxes but who pay Social Security and Medicare taxes. Republicans generally oppose giving such refunds to people who pay no income taxes.

From today's New York Times in Obama Presses for Quick Jolt to the Economy

My comments:

There are two reasons that many anaysts advocate that tax cuts to stimulate the economy take the form of refundable tax credits:

1) Vertical equity/redistribution/fairness concerns--to direct some of the tax cuts towards the lowest income taxpayers, who would otherwise get no benefit from non-refundable credits.

2) Greater fiscal stimulus "bang for the buck"--lower income taxpayers are more likely to spend their credits and stimulate the economy. (In economic terms, the MPC or "marginal propensity to consume" is higher for low income taxpayers. Higher income taxpayers are more likely to save rather than to consume out of additional income, compared to low income taxpayers.)

The main argument against refundability of tax credits is that not everyone shares the view that redistribution is a proper goal of the tax system, or at least not everyone agrees that the country should move in the direction of more redistribution. Reasonable people can differ on the "right" amount of income redistribution.

You may recall the "Joe the Plumber"/"share the wealth" controversy in last fall's campaign. Some make the case that income tax cuts should only go to those who pay income taxes, and not to the lowest income people who pay no income taxes*. However, even Senator McCain called for refundable tax credits to help all Americans to buy health insurance. In fact, Republican President Nixon launched the refundable Earned Income Tax Credit.

In fact, no major political leader seriously proposes to dismantle the current refundable credits--the question is whether additional fiscal stimulus tax cuts should take the form of refundable credits or not.

[*Footnote: And it should be noted that even though the lowest income Americans do not pay income taxes, they do pay many other kinds of taxes: Social Security and Medicare taxes (payroll taxes, which we can see in box 4 and box 6 of their W-2s for wage-earners, or on Schedule SE for the self-employed), federal and state excise taxes (included in the price of gasoline, alcohol, tobacco, airline tickets, etc.), and state and local general sales taxes. A recent CBO study estimated that Americans in the bottom 20% of the income distribution pay about 4% of their income in all federal taxes combined, and they likely pay an even higher percentage of their income in state and local taxes, since those tend to be more regressive than the federal tax system.

Moreover, economic incidence analysis shows us that people may bear the burden of many taxes indirectly, even if they don't write the actual checks to the government to pay the taxes. A renter, for example, does not pay property tax to the local government, but his landlord does pay the tax. Empirical estimates of the relative elasticity of supply and demand can help predict how much of that property tax will ultimately be passed on to the tenant in the form of higher rent.]