Tax credits: social policy in bad disguise

Most analyses of the Clinton administration's new budget focus on reforming Social Security and cutting taxes, but have largely overlooked a disturbing new trend in tax policy - the increased use of credits.

This year, the administration has proposed credits for inner-city investment, home health- care, families with children less than a year old, environmental programs, and a host of additional items. Following on the heels of expanded earned-income credits in 1993 and new child and education credits in 1997, these proposals will create numerous problems and will plague tax policy for years to come.

The rise in the use of credits is probably best seen as the outcome of an ill-fated political compromise. Republicans like credits because they look like tax cuts. Democrats like them because they advance social policies without raising government spending. Both sides are getting a bad deal.

Unfortunately for Republicans, targeted tax credits do not make government smaller. It's true that a spending program raises official government outlays, whereas a credit does not. This occurs because the budget records the expenses associated with a credit as a reduction in tax revenues, rather than as outlays. But this does not mean that government has claimed less of the private sector's resources when using a credit, because, in either case, the program has to be financed.

For example, if the government enacted and raised revenues to finance a $1-billion-spending program, the budget would record an added $1 billion in spending and $1 billion in revenues. In contrast, if a $1-billion tax-credit program were enacted and financed, official program outlays and revenues would both be zero. In either case, though, the government would have to raise $1 billion in tax revenues to provide the spending or the credit.

Unfortunately for Democrats, credits are a poor way to administer social policy. Unless the credits are refundable - that is, unless they actually give people cash back instead of just reducing tax liabilities - they will not help low-income households.

New nonrefundable credits would be useless to families of four that earn less than $28,000, because they already pay no federal income taxes. In fact, about a third of the nation's children live in families with incomes too low to receive any benefit from the child credit enacted in 1997. To the extent that they are intended to benefit children, credits are a particularly inappropriate policy tool. Kids do not file tax returns, so the credit has to go to the parents, with the hope that parents spend the added resources on their children.

In contrast, programs that have benefited children most provide services directly to the kids - including public education, Head Start, and Medicaid.

Unfortunately for all of us, credits create a series of additional problems. Each individual credit makes tax policy more complex. In addition, tax subsidies tend to breed demand for more subsidies. For example, the tax credit for college education, created in 1997, quickly generated demands for a credit for high school or elementary educational expenses. These new demands further add to the costs of understanding and complying with the tax system.

Defenders note that it might actually cost less to enact credits rather than spending programs, because 120 million people already file tax forms and because spending programs often require whole new bureaucracies. But, by embedding targeted subsidies in the tax code rather than in spending programs, the increased use of credits will make it more difficult to bring about broad-based tax reform. The more people who gain from special treatment in the current system, the more difficult it will be politically to clean house and install a simpler, loophole-free, low-rate tax system.

A final problem is that many of the credits have been poorly-targeted and ineffective. The majority of funds paid under the new college credit, for example, are likely to go to families who would have sent their kids to college anyway.

The increasing use of credits is therefore both deceptive and dangerous.

A better approach would be to decide on the goals of public policy and find a straightforward and open way to pay for them. The old-fashioned method of running subsidies as spending programs, rather than complicating the tax code at every turn, would be a place to start. That would allow taxpayers and politicians to understand the costs and benefits of policy choices more clearly.

*William G. Gale, who was a staff member of President Bush's council of economic advisers, is a senior fellow at The Brookings Institution in Washington.