A refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words,a refundable tax creditcreates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit (EITC).
How Does It Work?
An individual who qualifies for a refundable tax credit will receive a payment from the government in excess of the taxes they would otherwise owe. Instead of paying taxes, they are eligible to be net recipients.
For instance, let’s say an individual has a tax bill of $100, but is eligible for a refundable tax credit of $150. Instead of paying $100 in tax, the worker’s tax bill is reduced to negative $50, meaning they will receive $50 from the government. This is essentially a negative income tax.
What Are Some Examples?
In U.S. federal policy, the two main refundable tax credits are the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC). The EITC is targeted at low-income workers. The majority of those benefits accrue to people with an adjusted gross income (AGI) under $30,000, and about a third of benefits accrue to people with an AGI under $15,000.
The ACTC is a portion of the Child Tax Credit which is refundable. The maximum ACTC for 2024 is $1,700.
Reasons for Having These Credits
Refundable tax credits like the EITC and the ACTC create negative income taxes. This means that some earners get refunded by the tax system because of their family status, level of income, or some combination of both.
For those in favor of a progressive tax system, negative rates at the bottom of the income distribution help to ensure progressivity. Additionally, negative income taxes can help to offset the role that payroll taxes play in the tax burden of lower-income individuals.
Policymakers also may favor these credits to create incentives for work, including shifts from unemployment to employment which may coincide with loss of unemployment benefits. A negative income tax can increase the return to working beyond an individual’s wages. However, credits like the EITC are designed not only to incentivize work but, because the credit is limited by income, can also increase marginal tax rates as the benefits are reduced when individuals earn more.
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