Credits and cuts
As talk of the latest budget proposal from President Obama is filtering down to the public at large, I have been asked the question of what is the difference between a tax cut and a tax credit. I believe that based on the questions I have been asked that this is a bigger question many people have, but for the appearance of looking smart people will not ask. So I will throw my hat into the ring on this issue.
Basically a tax or any type of cut is what it sounds like. It is a reduction in whatever it is applied to. In the case of taxes is it the reductrion in the amopunt of tax paid by the public. This policy is an immediate affect that applies directly to all those that qualify for it.
Thus a tax cut of say 10% for all income brackets would be an increase in paychecks to workers, a reduction in costs to employers, and (debatably) a decrease in revenues to the IRS and Government. Now I said debatably because the theory, which has worked in the past, is that the extra income then becomes available for various purchases, each of which has seperate taxes that can be collected. In addition, if enough money is available some will use that to create new businesses and innovations which in turn create more jobs and thus add to the total number of people paying taxes – thus increasing revenues to the IRS and Government.
Cuts, tax cuts in this example, are an immedate action that has a long-term result.
A tax credit is almost the opposite effect. A tax credit, say for making a home more “green” as has been offered by President Obama, is for a fixed amount. Thus it does not vary based on the income of the individual using it. If, as in this example, the tax credit is for $12,000 it will not vary if the income of the user is $250,000 or $15,000.
Further, a credit requires that the individual does something to activate the credit. In the above it would be buying items for a home that makes it more energy efficient. Thus a person could spend $24,000 to make a home “green”, but the credit would make that $12,000. So the initial outlay of cash is 100%, with a credit for the money used to be applied to taxes at a future date. Very much similar to a rebate, except that at no point does the individual actually receive any cash in hand.
Thus the tax credit is a long-term device with a long-term effect. If you have no money to buy something (say windows) to make a home more “green” then the credit sits unused. The effect is limited to the individual with the means for the original purchase. The theory behind this is that those that do have the funds will spend more money based on the credit, which will then stimuluate the economy as more goods are sold and need to be made. The Government makes more money as items are purchased and people employed. This theory is less proven.
Tax credits are a means of stimulating the growth in sales of a specific item and/or sector. Another example was the $4500 credit for the Cash for Clunkers program. But this highlights other problems with tax credits. First a person had to qualify for the credit/program. That exempts a wide portion of the public. Next a person had to have enough funds available to purchase a new car, which exempts a greater portion of the population – though the discount to price did make it a larger group than normal.
Another problem is that this is the Govrnment gambling on specific industries, buying patterns, and businesses. The effect is also limited to the time in which the credit is available. While Cash for Clunkers dramatically increased car sales for a month, the next several months resulted in greater than average drops in sales rates – since those that would have bought a new car in that timeframe had already done so.
Another problem is the unintended consequences. During and after the Cash for Clunkers many car mechanixcs, body shops and other associated industries lost money. This is because people that might have needed or used their services opted instead to purchase the new car.
Thus the result is that there is a brief (the time period for the credit) spike in sales and revenues based on the credit, followed by an equally sharp and extended drop. The credit does not create new buyers as it requires an accress to funds that limits the pool of potential individuals that can access it. It does not create greater revenues for the Goverrnment as the increase is offset by the decrease. But it can potentially create a greater loss long-term as other factors (like less need of mechanics or body shops cause lay-offs and increase unemployment at least on the short-term) are negatively affected by the artificial change in patterns.
So why do politicians like tax credits as opposed to tax cuts? Because of politics. A spike in business looks good and gets lots of press coverage. An increase in unemployment or slower sales after the fact is less reported and can be attributed to any number of other factors, absolving the politician of any guilt.
Also a tax credit sounds better. It requires less thought and appears more concrete. If a person is offered $12,000 as a credit or 10% cut in taxes, many will pick the credit. Because they can immediately quantify $12,000. Of course 10% may be better on a dollar basis if the math is done. The tax cut might also be better because it creates a pool of money that can be used for anything, as opposed to the limited focus of the credit. But most do not consider the math or opportunity in the face of an absolute number that does not vary from person to person. Thus even if they can’t qualify for the credit, the politician can sound like they offered a great sum to the individual.
This is a simplistic example of credits and cuts. There are any number of examples that an economist might be able to show on how at a speciific time, under specific conditions something counter to what I have explained has happened. But as a general rule I believe this to be true.
I hope this helps.
