Before I go on my complete rant, it may be helpful to understand what a refundable tax credit is. Let's take a stepping stone approach. First, there is an income tax. This causes you, the taxpayer, to owe to the government an amount of money based on your income. Whether you like it or not, the 16th Amendment to the US Constitution permits such an income tax to be imposed and attempts to prove that the 16th Amendment was never ratified have been shot down by the US Supreme Court.
Our Tax Code ("The Internal Revenue Code of 1986, as Amended," if you care, which you probably don't) provides that there are items that get taxed (such as wages) and other items that produce offsets to that tax or credits. One such well-known credit is the deduction for contributions to a bona fide charity. That seems reasonable to me. Such charitable contributions to a BONA FIDE charity are in the public interest and giving an individual or corporation a credit of some number of cents on the dollar seems reasonable.
Now, suppose your tax liability before considering the credits is, say, $1,000. And, suppose that you paid no installments (through payroll or otherwise) on your taxes during the year. Further, suppose that your nonrefundable (normal) credits add up to $500, leaving you, tentatively, with a tax bill of $500. Finally, suppose that you qualify for 3 refundable tax credits in the amounts of $750, $1,000, and $2,500. Then, your tax bill is 0, right?
Wrong, not only do you not have to pay any tax, you get a tax refund despite the fact that you have paid nothing into the system. That's right, you paid nothing in, but you get $3,750 back. IMHO, that is not fair to all the good people who have paid into the system.
In recent years, these refundable tax credits have become really popular. You see, they have the potential to get a politician votes from two constituencies at once -- the people who get the credits and the industry being favored by the credit.
If this doesn't make sense, let's consider an example. Suppose I am running for Congress from the lovely 5th Congressional District of California (for those among you who haven't memorized California's Congressional districting map, this is essentially Napa and Sonoma counties). Further suppose that I introduce legislation for a refundable tax credit on the purchase of Napa or Sonoma produced wine. Wine drinkers will be thrilled with me. But, even more so, since wine drinkers will essentially be paying less for their product, so to will the wine producers love me.
Let's look at some of the refundable tax credits which actually have become part of the Tax Code in recent years.
First-Time Homebuyers Credit
In all fairness, this wasn't so much a credit as an interest-free loan from the government to you. If you were a first-time homebuyer in 2008 or 2009, you were entitled to a refundable tax credit for that year of 10% of the purchase price of that home, but not to exceed $7,500. But, starting in 2010, you were required to repay that 'loan' to the government in equal installments over 15 years. Of course, if adding that $500 into your tax liability left you still with no liability, you owed nothing.
Making Work Pay Credit
This was a 2009 and 2010 reduction in your tax bill of up to $400 if you were single, or married filing separately and up to $800 if you were married filing jointly. It was put in place by the 2009 stimulus bill. I didn't find it to be very stimulating. It phased out for people that the government decided didn't need it as their incomes were high enough already.
American Opportunity Tax Credit
This one is for qualified education expenses for years 2009 through 2012. If your income was less than $80,000 for individuals or $160,000 for couples, you can get a refundable tax credit of 100 percent of the first $2,000 of tuition, fees, and course materials paid during the taxable year and 25% of the next $2,000.
Health Care Premium Tax Credit
This was brought to you by the Patient Protection and Affordable Care Act, or Health Care Reform, if you prefer. I'd love to explain it for you in a nutshell, but the IRS proposed regulations on the topic are 20 pages of 3-column gibberish long. let's just be glad that we have until tax season during 2015 to figure it all out.
Adoption Tax Credit
This one was part of the Health Care and Education Reconciliation Act of 2010, also known as Public Law 111-152. Under this law, adopting parent(s) can claim a credit of up to $13,170. For parents who go through traditional adoption procedures, that amount cannot come close to covering the cost of the adoption or the costs that they will incur. On the other hand, there have been well-documented stories of parents adopting children to get these credits for little if any cost. Like many other provisions, I like the intent, but not necessarily the execution.
Additional Child Tax Credit
This is one that I have never understood. Essentially, families with three or more children and who have low enough earned income are entitled to a refundable tax credit for each child in excess of two. You don't get it either?
Perhaps you are one of the people who thinks that these refiundable tax credits are a good idea. If so, then consider this in the National Taxpayer Advocate's Annual Address to Congress:
While refundable credits provide valuable benefits to the target populations, they can be tempting targets for fraud because taxpayers eligible for them may claim refunds that exceed the amount of taxes they have paid. In 2011, the IRS’s Electronic Fraud Detection System (EFDS) flagged 1,054,704 returns on suspicion of fraud, an increase of 72 percent over 2010. Meanwhile, the IRS’s centralized Identity Protection Specialized Unit (IPSU) received more than 226,000 identity theft-related cases, an increase of 20 percent over 2010.That's a lot of potential fraud. I think it's time to consider whether there is a better way than these refundable tax credits.