- Posted by:
- Category: Tax Law
As my colleague Elaine Maag noted the other day, Democrats are squabbling again (or is it still) over how to structure the Child Tax Credit. Some want to be sure that very low-income households get the full credit. Others want to reduce or even eliminate benefits for higher-income households.
Many solutions to the high-income problem are either off the table for political reasons or, as Elaine noted, create a mess of unintended consequences. So here is another idea: Make the credit taxable.
Currently, the full credit is available to parents making as much as $400,000. Elaine suggested a simple way to offset that: Raise the top individual income tax rate. But Democrats ditched that idea after Senator Kyrsten Sinema (D-AZ) said she won’t vote for any version of President Biden’s Build Back Better (BBB) plan that includes rate increases.
If Congress makes the credit taxable, it still would be tax-free for households whose income is below the standard deduction ($25,100 for couples filing jointly in 2022). But the after-tax value of the credit would gradually decline as income rises for all other parents.
Making the CTC taxable would be unusual. The government would be giving money with one hand and taking it back with the other.
But it would not be unheard of. After all, this already happens with Social Security benefits where joint filers with incomes of at least $32,000 and single filers making $24,000 or more have to pay individual income tax on part of their Social Security benefits.
Payments to Alaska residents from the state’s Permanent Fund Dividend program are subject to federal income tax. In New York, the Tax Court ruled in 2015 that the refundable portion of New York state business tax credits should be treated as taxable income, according to an article in the Journal of Accountancy.
Similarly, some versions of a universal basic income make those payments taxable. My colleague Len Burman has proposed a universal earned income tax credit that also would be taxable.
Until now, Congress has tried to target the credit by phasing it out at some income level—starting at $150,000 for the now-expired provisions in the American Rescue Plan and $400,000 for the version included in 2017 Tax Cuts and Jobs Act (TCJA).
But, as Elaine pointed out, phase-outs are clumsy and especially problematic at lower income levels. Ending the credits creates multiple problems: It results in high marginal tax rates through the phase-out range. It is hard for tax filers to understand. And it makes the CTC feel like a welfare program, which could make it more politically unstable than it already is.
Taxing child credits is not ideal. It would set a precedent for refundable tax credits that could trouble many advocates for government assistance programs. At the same time, it would result in a tax cut for very high-income households with children.
Congress could address that problem by combining the tax with a high-income phase-out. In other words, the taxable credit could phase out between, say $200,000 and $300,000 (or wherever Congress chooses). But parents with higher incomes would be ineligible for any credit. Or, to protect some middle-income parents, benefits only above some amount would be taxed. That would be similar to the way Social Security works today, though it could be made less complex. Of course, any of these adjustments would make the program more complicated, partially defeating one of the advantages of a taxable credit.
Lawmakers also might want to distinguish credits as income for tax purposes from income used to determine eligibility for other government assistance such as Medicaid.
Still, a taxable credit might cost less and be easier to administer than the tax-free version with multiple phase-outs, which is what most congressional Democrats are aiming for. It might satisfy Sinema since it isn’t a tax rate increase. It might be acceptable to Sen. Joe Manchin (D-WV) who objects to giving benefits to higher-income families though it wouldn’t address his other demand: for a work requirement.
There are other ways to pay for an expanded CTC without raising tax rates. Congress could, for example, eliminate tax preferences that largely benefit high-income households. Sen. Mitt Romney (R-UT) would partially fund his Family Security Act, a replacement for the CTC, by eliminating the state and local tax (SALT) deduction. But scaling back popular preferences isn’t in the political cards either.
Given the limited options Democrats have as they struggle to pass Build Back Better in any form, they might want to think more creatively about how to restore the more generous CTC that expired last month while better targeting the support to those who most need it. And taxing benefits is one way to do that.