Tax Cut Semantics

When is a tax cut not a tax cut? Barack Obama claims that his economic proposals include tax cuts for 95% of Americans. But to do so would require redefining what it means to cut someone’s taxes. To understand what I mean, it’s necessary to illustrate the differences between tax deductions, nonrefundable tax credits, and refundable tax credits.

The basic concept behind income taxation is pretty simple. You take your income and subtract out deductions to come up with adjusted gross income (AGI). Then you multiply AGI by a percentage to figure how much tax you have to pay. The US tax is progressive. That is, the more money you make, the bigger the percentage you hand over to the Federal government.

Tax deductions are things like paying home mortgage interest, or saving for retirement by putting money into an IRA. You deduct the money you put into those things from your income. So if you are in a 15% tax bracket, for every dollar you put toward your IRA, your taxes are reduced by fifteen cents.

Your deductions can only drop your income down to zero. You can’t have negative income and get any kind of rebate from the IRS.

Then there are the tax credits, nonrefundable and refundable. After calculating how much tax you owe, based on your adjusted income, tax credits reduce the final sum of taxes paid. For every dollar of tax credit, your taxes are reduced by a dollar. For nonrefundable credits, you can reduce your tax liability down to zero, but then the game stops. With nonrefundable credits, you can’t have a negative liability and get any kind of a rebate from the IRS.

This brings us to refundable tax credits. With this type of tax credit, after your tax liability is reduced to zero, any credit left over is yours to keep. Which means the government sends you a check.

Tax deductions, nonrefundable tax credits, and refundable tax credits: guess which type the Barack Obama plan calls for when he says he’ll cut taxes for 95% of Americans? Now here’s the thing about this tax “cut.” After deductions from income, and existing tax credits, about 40% of American households don’t pay any income tax. But under the Obama plan, they would be getting money from the government.

So, getting back to our original question, when is a tax cut not a tax cut? When it’s welfare.