Millions of Americans will file income tax returns over the next several months, and the term “refund” is often misunderstood.
Federal, state, and local governments employ a wide range of levies to raise revenue. They come in the form of sales taxes, property taxes, payroll taxes, excise taxes, surcharges on businesses that get passed to consumers, and income taxes, among others. Assuming the best in politicians’ motives and the need to boost government coffers, each type of tax can easily be justified. Sales taxes discourage profligate consumption, property taxes fund education, “sin taxes” discourage vices that have adverse social and health consequences, etc.
While most taxes are applied uniformly – any two Milwaukee residents would pay the same sales tax for identical television sets and the same excise tax on a pack of cigarettes – income taxes greatly diverge from this notion.
Most income taxes are applied using a progressive scale. Someone making $20,000 a year may experience a federal marginal tax rate of 15%, whereas the rates for $50,000 and $200,000 of income are 25% and 33%, respectively. Much of the current political discourse revolves around different conceptions of “fairness,” with lawmakers balancing marginal utility with the distortion of incentives and resulting economic inefficiencies.
In recent years, however, progressivity has taken on new meaning with some people incurring zero or even negative income tax liability. Traditionally, individuals and families sought to maximize tax deductions to help reduce the amount of income subject to taxation. Recently, tax credits have become more prevalent, where taxes themselves (not just income subject to taxes) get reduced directly.
As a simple example, let’s say someone makes $5,000 and has a 10% federal income tax rate. Here is how a $500 deduction vs. a $500 credit would impact him or her:
Deduction
Taxes = (Income - Deduction) * Tax Rate
Taxes = ($5,000 - $500) * 10%
Taxes = $4,500 * 10%
Taxes = $450
$450 is 9% of Income
Credit
Taxes = (Income * Tax Rate) - Credit
Taxes = ($5,000 * 10%) - $500
Taxes = $500 - $500
Taxes = $0
$0 is 0% of Income
As you can see, credits affect income tax liability more than deductions affect it.
This brings us to the notion of refundable vs. non-refundable tax credits. Non-refundable credits cannot reduce overall tax liability to less than $0, whereas refundable credits can. Using the above example, let’s look at how a $1,000 tax credit would affect the taxpayer:
Non-Refundable Tax Credit
Taxes = (Income * Tax Rate) - Eligible Credit
Taxes = ($5,000 * 10%) - Eligible Credit
Taxes = $500 - Eligible Credit
Eligible Credit à Tax liability cannot be negative
Eligible Credit = $500
Taxes = $0
Refundable Tax Credit
Taxes = (Income * Tax Rate) - Entire Credit
Taxes = ($5,000 * 10%) - $1,000
Taxes = $500 - $1,000
Taxes = –$500
In the latter example, the refundable tax credit not only nullifies any tax liability, but the government will actually make a transfer payment to this individual. Keep in mind, of course, that the government is a behemoth middleman taking money from someone else and distributing it to this person. In effect, this example is nothing more than glorified welfare, where Washington uses the tax code to engage in direct wealth redistribution. Therefore, transferring money to someone who contributes $0 in income taxes and calling it an “income tax credit” or “income tax refund” is a complete and purposeful misnomer.
A tax refund is simply the money that was over-withheld from your paychecks that the government has been able to borrow at a 0% interest rate. In contrast, the assertion that someone who pays no income taxes and receives additional payments from taxpayers has received a “tax refund” is a logical fallacy. Try going to a store and demanding a refund for something you didn’t pay for in the first place.
Keep these terms in mind when filing your own tax return, and hopefully this post cleared up any misconceptions.
This was really helpful and insightful! Thanks for making something as complicated as taxes accessible to everyone.
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