Friday, April 28, 2006
Recent policy discussions have revealed increasingly heated debate about whether refundable tax credits are an appropriate part of the tax system. This article seeks to reframe this debate by setting aside distributional and administrative objectives and focusing instead on a relatively overlooked issue: the efficient form for tax incentives. Based on theoretical analysis and original empirical findings, it concludes that the arguments put forward by refundable credit opponents generally are unpersuasive on their own terms or fail to counter efficiency-based justifications for refundable credits. In particular, we argue that refundable credits are by default the most efficient way to structure tax incentives designed to encourage behavior generating positive externalities, absent clear evidence that the desired behavior or externalities vary by income class. The efficiency benefits of refundable credits are further magnified by their tendency to smooth household income and macroeconomic demand. In light of these findings, we conclude that serious consideration should be given to restructuring existing tax incentives, and designing new ones, as refundable tax credits.