Why trying to solve problems using tax credits is illogical.
I sometimes hear people suggest solving problems using tax credits. For example, I have heard people suggest using tax credits to encourage people who live in areas that are prone to flooding or forest fires to move. The problem is that this will never work.
What are tax credits
A tax credit is a dollar-for-dollar reduction of the income tax you owe. Unlike deductions and exemptions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed.
For example, the federal government offers a tax credit for the cost of purchasing solar panels for your home.
There are two types of tax credits.
Nonrefundable tax credits can reduce your total tax bill to zero, but the government will not pay you if your tax credits exceed your tax liability. Most tax credits are nonrefundable.
Refundable tax credits can reduce your total tax bill to below zero, meaning that the government will pay you if your tax credits exceed your tax liability.
For more information see the following.
- TurboTax Tips: What Are Tax Credits?
- Investopedia: What Is a Tax Credit?
- What Are Refundable Tax Credits?
Why tax credits do not work.
Tax credits only benifit those who already have money in hand to spend.
Consider the following hypothetical scenario. You hear about a government program to encourage people to move out of an area that is prone to forest fires through tax credits. You find to your amazement that the tax credits are refundable tax credits, which is very unlikely since most tax credits are nonrefundable. You then search for and purchase a new house. Then at the end of the year you file your tax return and the governement sends you a huge check.
Why were you able to do this? Because you are one of the few people who have enough money in their bank account that buying a new propert was an option.
If you are living paycheck to paycheck, you will never be able to make use of any government program that is based on tax credits. If 100% of each and every paycheck is spent on keeping you housed, clothed, and fed you simply cannot afford to buy an new house. Your only choice is to stay in the house you already have and hope it will not be burned down by the next forest fire. It is simple logic.
This hypothetical scenario ignores another problem. Tax credits never actually pay the full cost of the change they are trying to encourage. They only pay you back a portion of the cost. In the hypothetical tax credits to encourage you to move scenario, you would be lucky to get 10% of the cost of moving. You would never get 100% of the cost.