The term tax credit
describes two different concepts:
- The first is a recognition of partial payment already made towards taxes due.
- The second is a state benefit paid to employees through the tax system, which has the effect of increasing (rather than reducing) net income.
Tax credits in recognition of tax already deducted
Within the Australian
, United Kingdom
, and United States tax
systems, a tax credit
is a recognition of partial payment already made towards taxes due
. A similar concept exists (Avoir fiscal
) in the French tax system
. This situation arises, for example, when standard rate tax has been deducted at source ("withholding tax
"), but the tax-payer is subject to further taxation at a higher rate. It also applies in dividend imputation
In some countries (e.g. the United Kingdom), "tax credit" refers to tax treated as deducted at source, which has not actually been deducted or paid.
Tax credits as a form of state benefit
Tax credits may be characterized as either refundable
, or equivalently non-wastable
. Refundable or non-wastable tax credits can reduce the tax owed
below zero, and result in a net payment to the taxpayer beyond their own payments into the tax system, appearing to be a moderate form of negative income tax
. Examples of refundable tax credits include the earned income tax credit
and the additional child tax credit
in the U.S., and working tax credits
or child tax credits
in the UK.
A non-refundable or wastable tax credit cannot reduce the tax owed below zero, and hence cannot cause a taxpayer to receive a refund in excess of their payments into the tax system. Some examples of non-refundable tax credits are the Hope and Lifetime Learning educational tax credits in the U.S. or the former children's tax credit in the UK. Another example would be declared gifts made to registered charities in the UK under the current Giftaid scheme, which attract tax relief (claimed by the charity) at the standard rate but which cannot reduce the donor's liability beyond the amount of tax actually paid by them in a given year. All tax credits in Ireland are non-refundable.
Tax credits and minimum wage
Tax credits are like a means tested benefit paid direct to employees to encourage them into work. In the United Kingdom, ‘child tax credit
’ and ‘working tax credit
’ are paid directly into the claimant's bank account post office account or by GIRO. A minimum level of child tax credits
is paid to all individuals or couples with children. The amount paid is increased if either parent works for at least 16 hours a week. Working tax credit
is paid to single low earners without children who are aged over 25 or over and are working over 30 hours per week and also to couples without children, at least one of whom is over 25, provided they are working for 30 hours a week combined and at least one of them is working for 16 hours a week. They are means-tested and the rules for calculating both child tax credit and working tax credit are very complex.
Some argue that tax credits contribute to the poverty traps as they are tapered as earnings rise. That means the disincentive to work when expected wages are little more than unemployment benefits, and the difficulty for workers to break above a net earning margin faced with not just income tax, but national insurance, VAT, student loan repayments and other cumulative tax burdens, and loss of other benefits such as housing and council tax benefits, free school meals, and free prescriptions.
This indirect wage regulation forms an important part of income for low earners and their families. It reduces the stigma of collecting benefits for workers. Some commentators have suggested that raising the personal allowance could achieve a similar effect for single workers with reduced administrative burden for both employers and HMRC.
Tax credits and tax deductions
A tax credit is generally more valuable than a tax deduction
or tax allowance
of the same magnitude because a tax credit reduces tax directly, while a deduction or allowance only reduces taxable income and so the reduction in tax is only a fraction (the marginal tax rate) of the deduction or allowance.
Corporate tax payers may lower the total amount of tax they owe to the federal government, via programs such as the New Markets Tax Credit Program.