Capitol Gains: What makes a good tax credit?
Note: Capitol Gains is a regular feature on fiscal happenings in the Colorado legislature.
By Ali Mickelson
Historically, when revenue is increasing, lawmakers have been eager to increase spending of tax dollars through the tax code in the form of tax credits, exemptions and deductions. The 2015 General Assembly has been no exception.
With 12 new tax credits introduced in the first month alone, lawmakers appear to be taking a page out of the Colorado revenue-reduction history books and charging ahead with unprecedented tax credit vigor. Lawmakers from both parties have introduced such proposals.
As always, this prompts us at the Colorado Fiscal Institute to brush off our Tax Principles. CFI evaluates all tax credits using a set of principles that the nonpartisan National Conference of State Legislatures has developed to describe a tax system that provides enough resources and does so equitably. These principles include efficiency, effectiveness, equity and evaluation. We don’t suggest that all tax credits are bad. We simply want to make sure that we spend our limited state tax dollars in the most productive and sustainable ways possible.
CFI’s principles for evaluating tax credits, deductions and exemptions:
- Is the tax expenditure effective? When evaluating a new tax credit, deduction or exemption, CFI considers whether it has been proven to meet a targeted goal. CFI also considers the return on investment from the tax expenditure when compared to the benefit and cost of investing in other state priorities.
Example of an effective tax expenditure: The Earned Income Tax Credit (EITC) is an example of an effective tax expenditure. The EITC was created to reward work and help move families out of poverty. Since its enactment, it has become the No. 1 most effective anti-poverty tool, lifting more families out of poverty than any other program, and it has been proven to increase the amount of work, income, educational and health benefits of its recipients and their children. It is an incredibly effective tax credit.
Example of an ineffective tax expenditure: An example of an ineffective tax expenditure is a temporary sales tax exemption, or “holiday,” for school supplies. Research shows that tax holidays are ineffective because retailers often increase their prices during the holiday or don’t offer discounts they otherwise would have, and local spending isn’t stimulated because consumers merely shift normal purchasing patterns to a different time of year. Furthermore, many consumers don’t benefit from tax holidays because they don’t have the flexibility to shop during one particular timeframe during the year.
- Is the tax expenditure economically efficient? CFI evaluates all tax expenditures from an economic standpoint. A good tax expenditure will produce the intended outcome without significant additional cost or disruption to public spending or the economy. CFI also considers the behavior the tax expenditure is intended to incentivize and if this behavior would occur anyway. Tax expenditures are often used to incentivize certain behaviors but should never be given to reward behavior that would have happened anyway.
Example of an efficient tax expenditure: An example of an efficient tax expenditure is the federal tax credit for electric vehicles. The federal government has established that the purchase of electric cars should be incentivized because of long-term environmental benefits. Research by the Congressional Budget Office shows that the tax credit is frequently the deciding factor for purchasing an electric vehicle. Therefore, because of the credit, people are buying electric vehicles, and the credit is incentivizing the intended behavior.
Example of an inefficient tax expenditure: The state “Vendor Fee” is an example of an inefficient tax expenditure. This program allows vendors to keep a portion, or “fee,” of the sales tax they collect from customers — even though businesses are already required by law to collect sales tax.This is an inefficient use of taxpayer dollars.
- Is the tax expenditure equitable? Equity in evaluating tax expenditures focuses on who benefits from the favored tax treatment proposed by the credit, deduction or exemption. All tax expenditures create winners and losers in the tax system, and CFI evaluates the impact of the expenditure in two ways. First, we consider horizontal equity, which occurs when similarly situated taxpayers are treated in a similar manner. Second, CFI assesses vertical equity, or who pays taxes in light of who currently shoulders the largest tax responsibility. CFI evaluates the equitable distribution of the tax benefit based on ability to pay and other principles of equity.
Example of an equitable tax expenditure: The sales tax exemption on food for home consumption is an example of an equitable tax expenditure because it benefits low- and middle-income families who pay more of their income in taxes than higher income families. Since low- and middle-income families spend a greater portion of their income on groceries than wealthier families, the exemption offsets some of the regressivity that is built into the tax system and creates more equity.
Example of an inequitable tax expenditure: The state income tax credit for the Business Personal Property Tax is an example of an inequitable tax credit because businesses in low-millage jurisdictions receive a smaller state tax credit than those in high-millage districts, even if the businesses are all the same size.
- Will the tax expenditure be regularly reviewed and evaluated? Tax expenditures, just like any general fund appropriation, need regular review to evaluate whether they are working and to let taxpayers know how their money is being used. In order to determine if a tax expenditure is achieving its targeted goal and is the best use of taxpayer dollars, they must be reviewed and evaluated regularly based on a clear set of objectives. CFI always considers the measures of transparency and accountability that are included in any new tax expenditure or economic incentive.
- Will the tax expenditure lift up the middle class? The middle class in Colorado is still struggling to recover from the recent recession. Tax expenditures can impact this recovery by either supporting targeted middle-class growth, or by shifting support to other priorities. CFI considers whether a credit supports middle-class families and an economy that works for everyone.
We encourage lawmakers to consider these principles when developing new tax policies. Not all tax credits are created equal, and we count on the General Assembly to make sure that they spend our limited resources in the best, most impactful ways possible. This includes spending through the tax code.
