Tax Incentives

Corporate Tax Incentives

Especially since 1960, the United States has relied on tax policy to direct private investment toward social objectives. The use of business tax incentives—that is, the adoption of particular features of the tax code as instruments of public policy rather than merely as revenue-raising devices—goes back at least to 1954, with the introduction of accelerated depreciation. Business tax incentives have been justified above all as a stimulus to capital formation. Even when the rationale is job creation, it is job creation via capital investment. Incentives have been provided for areas as [Page 2058]diverse as the continued use and rehabilitation of older structures in an effort to arrest urban decay, research and development costs to encourage innovation, and employment subsidies to increase employment among the poor.

Tax subsidies often favor larger firms within an industry and can alter industry structure. Even if the price of products is not affected, the larger firms receive an advantage by having more earnings after taxes and consequently more resources for investment and greater growth potential. On the other hand, if these larger firms do pass the full tax savings on to consumers, they may be able to lower product prices below the average costs for smaller firms facing higher effective tax rates, potentially driving some of the small companies out of business and increasing industry concentration.

Individual Income Tax Incentives

A number of tax incentives are available to individuals. These can be in the form of deductions from taxable income, gifts, or savings accounts that can grow either tax-free or tax-deferred. Some examples are given below:

• Deductions: Expenditures for home ownership, excess medical expenses, state and local income taxes, property taxes, and gifts to charity can be used to reduce taxes.
• Gift and estate taxes: Under current law, individuals are permitted to make gifts of $12,000 per recipient, per year, free from any gift or estate taxes. This allowance permits a substantial sum to be transferred to heirs free of tax. While yearly amounts may be small, consistent use of this annual exemption can lead to the tax-free transfer of large amounts of wealth.
• Education savings: The Coverdell education savings account (ESA) and Internal Revenue Code Section 529 savings plans are structured so that after-tax dollars grow tax-free. Earnings are never taxed if withdrawals are used for qualified education expenses.
• Retirement savings: Individual retirement accounts (IRAs), 401(k) plans, and 403(b) accounts all offer incentives to save for the future. Closely related are employee stock purchase plans (ESPPs), which are employer-sponsored programs that permit employees to save by purchasing company stock, while contributions to them and accumulations within them are subject to favorable tax treatment.
• Health savings accounts: Several options are available for saving for future qualified medical and retiree health expenses on a tax-favored basis.

Tax Credits

A tax credit is an amount subtracted from the gross tax to determine the net tax due. Credits, then, are similar to prepayments of the tax and are not a part of the computation of taxable income, the tax base. Therefore, tax credits are more beneficial to taxpayers than tax deductions. There are three general groups of tax credits. First, there are credits related to business operations and investments. These consist of credits for expenditures such as for historic rehabilitation, research and development costs, hiring individuals from targeted groups, environmental remediation costs, development of renewable resources, and low-income housing developments. Second, there are credits allowed to individuals only because of some special need, such as the child care credit or the credit for the elderly and people with disabilities, or for purchasing certain targeted products, such as electric and clean fuel vehicles. The third group consists of credits related to prepayments and includes credits such as those allowed for income taxes paid to foreign countries and offhighway use of fuels. The availability of such tax credits provides behavioral incentives for taxpayers above and beyond other tax incentives specifically written into the tax code as deductions against income.

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