Whether tax benefits should be provided as a deduction from the base or a tax credit to reduce the tax owed, has been an issue for decades. This question received renewed attention in 2005 with the issuance of the final report from the President's Advisory Panel on Federal Tax Reform. One of the panel's proposals was to replace the home mortgage interest deduction with a credit equal to 15% of interest paid on acquisition debt (no home equity debt) with a limit tied to the region's median home price. The Panel noted that this change would enable all homeowners to claim a benefit for their mortgage interest (even if they do not itemize deductions) and would cause the benefits of this preference to be more equitably spread among differing income groups. You can find the background and description of this proposal in the Panel's final report at pages 70 - 75.
The Joint Committee on Taxation's annual tax expenditure report shows how some tax preferences are claimed among different income groups.
What is the most equitable treatment for tax preferences - deduction or credit? Should the credit be refundable (taxpayer receives the credit even if it exceeds tax owed)? Does this make sense for the home mortgage interest deduction only? What about other deductions?
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First of all, we need to understand the difference between a credit and a deduction. A credit is a dollar for dollar reduction of tax liability while a deduction is a reduction of taxable income before tax liability. For example, individual A and individual B has the same $10,000 of mortgage interest. A is in the 25% tax bracket while B is in 35% bracket. If the law allows a 15% credit for mortgage interest, A and B can reduce their tax liability by $1,500. If A and B are taking a deduction for the mortgage interest, A can reduce his tax liability by $2,500 while B can reduce his tax liability by $3,500. Therefore, a tax deduction is of greater benefit to taxpayers in higher tax bracket than those in lower bracket.
It was estimated that the tax expenditure resulting from mortgage interest deduction in 2007 was $73.7 billion [http://www.jct.gov/s-3-07.pdf]. In essence, the government is subsidizing taxpayers’ mortgage interest expenses. It would not be fair when the government is subsidizing only 15% of A’s mortgage interest deduction but 35% of B’s. Therefore, a credit for home mortgage interest would make the system more equitable than a deduction because everybody enjoys the same benefit of a credit for every dollar spent. The proposal for a tax credit instead of a deduction came up again as one of the many budget options proposed by the Congressional Budget Office that aim at reducing the nation’s budget deficit [http://www.cbo.gov/ftpdocs/102xx/doc10294/08-06-BudgetOptions.pdf].
Second, the credit should be refundable because it is resulting from the mortgage interest expense that was incurred. Given it is a government’s subsidy, everyone who is entitled to should get a benefit of it. Therefore, it would be unfair if a credit is disallowed because it exceeds the tax owed (which may be due to other factors such as income threshold, tax bracket etc.). Third, other items such as real estate tax, state/local income tax or sales tax, or charitable contribution can be taken as a credit in the same way as mortgage interest. Credit is easier to understand and much simpler compared to itemized deduction and its associated phase-out provisions. With a credit, a taxpayer can always know the true cost and/or tax benefit of an expense before incurring because the tax rate is known upfront. With a deduction, a taxpayer won’t know it until his total income is calculated after many steps and a marginal tax rate is determined.
Both deductions and credits are “tax expenditures,” (also called “tax preferences”) which are a form of government spending. Although “tax expenditures” cost the government a lot of money and make tax laws more complex, they are often justified on the ground that they encourage taxpayers to engage in certain valued activities. Thus, taxpayers, who engage in those activities, can enjoy the benefits of government spending.
However, tax benefits are not shared evenly among all taxpayers if they are provided in the form of tax deductions. The deduction, by nature, provides a better tax benefit for high income taxpayers due to their higher tax bracket. That is, it generally benefits high-income taxpayers more than low-income taxpayers. Moreover, itemized deduction is allowed to just 35% of individuals who itemize, and itemizers tend to have higher incomes than non-itemizers. [http://govinfo.library.unt.edu/taxreformpanel/final-report/TaxPanel_1_11-1.pdf].
Current provisions for home mortgage interest deduction, for example, are only available to taxpayers who itemize deductions. The final report from the President's Advisory Panel on Federal Tax Reform shows that the deduction provides disproportionate benefits among taxpayers; per the report, “over 70 percent of tax filers did not receive any benefit from the home mortgage interest deduction in 2002.” Moreover, “more than 55 percent of the estimated tax expenditure for home mortgage interest deductions went to the 12 percent of taxpayers who had cash income of $100,000 or more in 2004.”
[http://govinfo.library.unt.edu/taxreformpanel/final-report/TaxPanel_5-7.pdf].
In contrast, a credit is more equitable than a deduction because a tax credit benefits all taxpayers equally by providing a dollar for dollar decrease in tax liability. For example, a credit of $100 is worth $100 to all taxpayers whether they have income of $100,000 or $1,000. A refundable credit is even more equitable than a nonrefundable credit. If a credit is refundable, taxpayers -whose credit amount exceeds their tax liabilities- can still enjoy the same tax benefits as other taxpayers. Other items, currently allowed as a deduction, can be replaced with a credit to make the tax system more equitable. For example, a charitable contribution deduction can be replaced with a credit; although, the percentage limits should be continued and addressed in a credit through the credit percentage rate. Also, various taxes that are allowed as itemized deductions, such as state/local taxes, can also be replaced with a credit.
Since a tax credit (a direct dollar-for-dollar adjustment against a tax liability) could be taken by all taxpayers - regardless of whether they take standard or itemized deductions - it provides more fair tax treatment comparing to a tax deduction (an expense of a taxpayer, the cost of which lowers the taxpayer's adjusted gross income to arrive at taxable income). However, tax credit could only be able to reduce a tax liability to zero, unless the credit is refundable (such as The Earned Income Tax Credit). Also, replacing a tax deduction by a tax credit for home mortgage interest only may create more questions of “what about other deductions?” Such as the medical expenses and donations.
Therefore I think unless there is a short-term need of encouraging or influencing taxpayers’ decisions, instead of replacing a deduction by a credit (such as the sales tax deduction for the car purchase on/before December 31. 2009), it is better to replace a deduction by as above-the-line deduction. As above-the-line deductions are not subject to income-sensitive phase-outs or limitations.
Because a tax credit lower taxpayer's bill dollar for dollar is preferable to a deduction which just take money off from the taxable income and the value depends on each taxpayer's bracket. For example; if the tax bracket is 25% a $3,000 deduction will lower taxpayer's bill by $750, but in the case of a 10% bracket, the tax bill will be lower only with $300. A credit on the other hand will lower the tax liability by the full amount no matter the bracket the taxpayer is. It is a direct proportion between the bracket the taxpayer is and the amount of the deduction he will have . A taxpayer with a more expensive property will receive a bigger deduction in this case . However, the equity and fairness, one of the 10 principle of good tax policy which requires that similarly situated taxpayers are taxed similarly is ignored. A taxpayer with a greater ability to pay , with a higher income, who can afford a bigger and more expensive house will have a higher deduction.I consider that a credit is a better choice , because credit will reduce the tax liability.
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