Introduction Tax credits, at both the federal and state levels, directly offset an individual or business’ tax bill for the year. Tax credits are often part of a package deal when it comes to policymaking: tax deductions, tax incentives, and tax “breaks” are all closely associated with tax credits. It is often counterintuitive to think that lowering the tax bur-den of a business or individual through tax credits is a bad thing; however, as research shows, tax credits (or, on a larger scale, tax incentives), violate the principles of sound tax policy. Instead, policymakers should aim for 1

tax policy that is equitable, simple, and stable. This is beneficial for both taxpayers and government.

This Guide briefly discusses tax policy and provides Al-abama policymakers with a framework for making tax policy decisions that ensure fair and stable tax revenue for the state, as well as a minimal impact on families and businesses.

What Guides Good Tax Policy? From the time of economist and philosopher Adam Smith’s pioneering work in 1776 on what constitutes a good tax system, several principles of tax policy have be-come generally agreed upon in both research and in practice. 2

Stability Stability means taxpayers should already have a reason-able idea of what their tax burdens will be for the com-ing years, and the government has a reasonable estimate of incoming tax revenue. Making numerous changes to the tax code undermines the taxpayer’s ability to under-stand (and comply with) his tax bill, as well as the gov-ernment’s ability to predict future tax revenue levels.

Simplicity Simplicity is an important consideration of good tax pol-icy. Taxpayers must be able to comply with the tax code without facing overly complex and onerous rules. As the tax code grows, so does its complexity. Individuals and businesses spend more time and income on complying, as does the government. A complex tax code means the state spends more on tax administration and compliance. “Frequent changes to the tax laws,” which also violate the

Alabama Policy Institute         |        2213 Morris Avenue, Birmingham, Alabama 35203        |        205.870.9900        |         www.alabamapolicy.org

ISSUE SNAPSHOT ★Tax credits, at both the federal and state levels,

directly offset an individual or business’ tax bill for the year.

★As research shows, tax credits (or, on a larger scale, tax incentives), violate the principles of sound tax policy.

★ Instead, policymakers should aim for tax policy that is equitable, simple, and stable. This is benefi-cial for both taxpayers and government.

RECOMMENDATIONS • To eliminate tax credits without further harming

individuals and businesses’ bottom lines, state and local tax rates should be lowered and applied to a broader taxpayer base.

• Alabama policymakers should consider simplify-ing the tax code and providing an attractive tax regime for all businesses looking to locate here.

• If tax incentives must be offered, which they cur-rently are, Alabama must establish reporting re-quirements. This increases transparency in the tax code.

Tax Credits in Alabama

stability principle, keep the government from “effective fiscal planning” as well. 3

Transparency A staple of a limited and open government is trans-parency in policymaking. Along with transparency in the process of creating and passing new tax law, transparency in the tax code means straightforward language that al-lows taxpayers to effectively understand what the changes mean for them. Since taxes are sometimes justi-fied by attempting to sway consumer choices (such as taxes on alcohol or cigarettes), it is also crucial that the government assess whether the tax is achieving its goal. 4

Equity Equity in tax policy, sometimes also called neutrality, means that similar tax burdens apply to individuals or businesses in similar circumstances. While equity could be considered important because it promotes fairness in taxation, it is also important for sustaining low tax rates across the board and not interfering with an individual or business’s decision making. This is because “the pur-pose of taxes is to raise needed revenue,” so providing selective tax breaks means foregone tax revenue must come from somewhere else. Hefty tax breaks interfere 5

with the economy by influencing business decisions. By maintaining lower tax rates that apply to a broad base, tax revenue grows when the economy does, and tax bur-dens are equitable.

The Problem with Credits As the use of tax credits grew throughout the 1990s, the research on their usefulness in boosting the economy also grew, with disappointing outcomes. In 1999, The 6

Brookings Institution wrote that, “Republicans like cred-its because they look like tax cuts. Democrats like them because they advance social policies without raising gov-ernment spending. Both sides are getting a bad deal.” 7

Analyzing tax credits through the lens of established tax policy principles, it becomes clear that credits violate all of them. First, tax credits erode simplicity by increasing the number of rules to comply with; additionally, sim-

plicity and stability are undermined when tax credits are temporary, which they sometimes are. Transparency is perhaps the most egregiously violated principle, since Alabama is one of the few states with no reporting re-quirements for tax incentive schemes offered. Finally, 8

the equity principle is violated. Tax credits do not apply to all businesses looking to bring jobs and growth to Al-abama, and are usually targeted at major businesses, which leaves small shops without the same benefits. 9

Tax credits technically lower the tax burdens of some, but credits do not necessarily decrease government size or spending. Government spending must be financed somehow; providing tax credits for certain businesses means tax revenue must come out of some other part of the private sector. Reductions in taxation are rarely, if 10

ever, accompanied by reductions in government spend-ing.

Taxes and the Economy If Alabama policymakers want to grow the economy and attract business to the state, “the evidence shows that states with the best tax systems will be the most compet-itive at attracting new businesses and most effective at generating economic and employment growth.” The 11

Tax Foundation ranks Alabama’s business tax climate 35th out of 50 states for 2018. As the report explains, it 12

is tempting to offer tax incentives—like credits—as a way to attract economic activity; however, “the truth is that if a state needs to offer such packages, it is most likely covering for an undesirable business tax climate.” 13

This theory fits with research showing that tax incentives offered in Alabama have failed to boost economic growth and entrepreneurial activity in meaningful ways. 14

The following is a list of credits for businesses currently offered under the Code of Alabama 1975, via the Al-abama Department of Revenue: 1516

2

Conclusion The keys to good tax policy lie in having a tax system that is simple, applies equitably to similar entities, and is transparent. To eliminate tax credits without further harming individuals and businesses’ bottom lines, state and local tax rates should be lowered and applied to a broader taxpayer base. Alabama policymakers should consider simplifying the tax code and providing an at-tractive tax regime for all businesses looking to locate here. If tax incentives must be offered, which they cur-rently are, Alabama must establish reporting require-ments. This increases transparency in the tax code.

CREDIT TYPE

Income Tax Capital Credit Business

Income Tax Enterprise Zone Credit Business

Income Tax Education Credit Business

Coal Credit Business

Full Employment Act of 2011 Credit Business

Alabama Small Business and Agribusiness Jobs Act Credit

Business

Heroes for Hire Tax Credit Act of 2012 Employer Credit

Business

Heroes for Hire Tax Credit Act of 2012 Business Start-Up Expense Credit

Business

Qualified Irrigation System/Reservoir System Tax Credit

Business

Alabama Accountability Credit Business and Individual

Dual Enrollment Credit Business

Rehabilitation, Preservation, and Development of Historic Structures Credit

Business

Investment Credit Business

Port Credit Business

Growing Alabama Credit Business and Individual

Apprenticeship Tax Credit Business

3

Brunori, David. “Principles of Tax Policy and Targeted Tax Incentives.” State and Local Government Review, 29(1). 1997; Ross, Justin M. “A Primer on State and Local Tax Policy: 1Trade-Offs Among Tax Instruments.” Mercatus Research, Mercatus Center at George Mason University. 2014. Smith, Adam. The Wealth of Nations. Book V, Chapter 2.; Tax Foundation. “Principles of Sound Tax Policy.” Brunori (1997). Ross (2014).2

Brunori, 1997. Pp. 53.3

Brunori, 1997. Pp. 53.4 Tax Foundation. “Principles of Sound Tax Policy.”5

Gale, William G. “Tax Credits: Social Policy in Bad Disguise.” Brookings Institution. 1999. Lynch, Robert G. “Rethinking Growth Strategies: How State and Local Taxes and 6Services Affect Economic Development.” Economic Policy Institute. 2004; “Principles of a High-Quality State Revenue System.” National Conference of State Legislatures. 1992. For more on federal tax credits introduced and/or expanded during the 1990s, see: http://www.taxpolicycenter.org/laws-proposals/major-enacted-tax-legislation-1990-1999. Specifically, the Taxpayer Relief Act of 1997; the Tax Extension Act of 1991; and Omnibus Budget Reconciliation Act of 1990. Gale (1999). 7

Dove and Smith, page 51.8 Tax credits in Alabama, such as the Full Employment Act of 2011 credit and the Alabama Small Business and Agribusiness Jobs Act Credit, offer credits to businesses employing 9fewer than 50 or 75 employees, respectively. However, this does not change that tax credits violate the principles of sound tax policy discussed, or that large businesses are disproportionately sought after by the state.

Ibid.10 2018 State Business Tax Climate Index. Tax Foundation. Pp. 9. 11

Ibid, p. 3.12

Ibid, p. 10.13 Crowley, George. “Tax Incentives, Job Creation, and the Unseen: Is Alabama Giving Away the Store to Attract New Industry?” Dove, John A. and Daniel J. Smith. “Alabama at 14the Crossroads: An Economic Guide to a Fiscally Sustainable Future.” Mercatus Center at George Mason University. P. 56.

This list does not include Alabama’s constitutional income tax limits, federal tax deductions from state income tax, or income tax net operating loss carryforwards. It is strictly 15tax incentives offered by Alabama to businesses. “Income Tax Incentives.” Alabama Department of Revenue. 16

4