The Child Tax Credit Ambiguity in the GOP Tax Plans That Will Make or Break Tax Reform for 6 Million Parents

Parents haven't been the main focus of either the House and the Senate tax plans thus far. The bulk of the benefit in both plans has consistently come from business tax relief, even as they have evolved to stay within fiscal constraints. By contrast, while both plans expand the child tax credit, they have fallen short of ideas from both parties to direct more tax relief to parents, such as the Bennet-Brown and Rubio-Lee plans. The House bill even initially repealed the adoption tax credit, before restoring it later.

Both plans will help many parents early on before individual tax relief expires and the slower chained CPI inflation adjustment has time to bite. Exactly how many however hinges on a key ambiguity around the Child Tax Credit that arises from the way they expand the child tax credit. Six million primarily working- and middle-class parents could get either a tax hike or a tax cut from the Senate bill in 2018 depending on how this expansion is interpreted. Millions more will see larger refunds or smaller tax bills.

To be clear, this ambiguity isn't relevant in the later years in the Senate bill, since that plan reverses virtually all of its individual tax changes after 2025, and the number of parents who are worse off rises substantially.

To be equally clear, JCT seems to already interpret the House and Senate bills in the more generous way. But given the lack of clarity in the legislative language, this is not necessarily conclusive for how the final tax plan, should it become law, gets interpreted by the IRS or others later. More clarity in the final bill is needed.

The Additional Child Tax Credit Under Current Law

The ambiguity arises from the Additional Child Tax Credit (ACTC). Under current law, the regular Child Tax Credit is $1,000 per qualified child, but it's also nonrefundable. This means it can only offset any federal tax you owe. If you owe no tax, the regular CTC itself cannot give you any more benefit.

Enter the ACTC, which takes the regular CTC and makes some of it refundable for certain families. Sometimes this is called the "refundable portion" of the CTC. To simplify it: if you have any "unused" portion of the regular CTC -- meaning you can't claim the full $1,000 per child regular CTC benefit because your federal tax liability falls to $0 first --  then that unused portion spills over into the ACTC and gets refunded back to you, even if you don't have any federal tax liability.

There are several restrictions on this however; for example, the ACTC benefit is capped at 15% of your earnings, and your first $3,000 of earning don't count for this calculation. Other restrictions apply as well. In practice then the total benefit of the CTC plus the ACTC may be lower than $1,000 per child for some families.

Despite these limitations -- and again, simplifying here -- it might be helpful to our discussion of the House and Senate plans in a moment to think of the CTC/ACTC in tandem as essentially being a single (potentially) refundable credit of up to $1,000 per child under current law. As I mentioned before, this isn't strictly true in all cases, but it illustrates the key take-away that any dollar used under the regular CTC to reduce federal tax liability reduces the potential amount of the ACTC 1-for-1. Because of this, the two pieces are in alignment with one another.

Illustration of the House and the Senate Plans

The House and Senate bills however bring the two out of alignment.

The Senate bill raises the regular CTC to $2,000 per child while the House bill raises it to $1,600. Both bills meanwhile only raise the ACTC to $1,100 (though they do allow the ACTC to gradually grow over time with inflation until it converges with the regular CTC, a process that is likely to take well beyond 10 years).

Interestingly -- and counterintuitively -- even though both the CTC and ACTC have been expanded under both plans, it's still possible under some interpretations that a family could end up with less benefit. I'll use an illustrative example to show how.

Take a single mom whom I'll name Janet with 9 year old twins in 2018, earning $36,000 in wages and filing as Head of Household (I crafted this example specifically to avoid some of the complexities of the ACTC mentioned above that aren't relevant to my core point).

Under current law, which is the first column in the table above, Janet takes her $36,000 in wages and deducts $4,150 each for herself and her two kids in personal exemptions (for a total of $12,450). She also takes the standard deduction of $9,550. So her taxable income is $14,000. Most of this is within the current 10% income tax bracket with a small amount in the 15% bracket. Janet's initial federal income tax liability before credits is $1,420.

The nonrefundable regular CTC offsets all of this $1,420, and because she doesn't get to claim the full $1,000 per child of regular CTC before her tax liability gets to $0, the "left over" portion -- $580 -- becomes ACTC and gets refunded to her. Adding in the $2,085 of Earned Income Tax Credit (EITC) she gets from working, Janet's bottom line refund is $2,665.

Now let's look at the Senate plan, which has the more generous CTC expansion.

The Senate plan changes Janet's math in several ways. Gone are the personal exemptions, but the standard deduction almost doubles. The 15% bracket becomes a 12% bracket. The net effect of these changes is that her federal income tax liability before credits rises to $1,888.

Since the child tax credits are larger in the Senate plan, this higher before-credit liability may be offset. But it depends on the order in which the CTC and ACTC are applied.

Put another way, the Senate plan is the equivalent of changing our current CTC, which we can think of in an oversimplified sense as a single credit potentially refundable up to $1,000 per child, into a $900 per child nonrefundable credit and an $1,100 per child refundable credit in 2018.

Thought of in this way, the question then becomes which credit "goes first" in bringing down Janet's $1,888 in federal income tax liability.

If the nonrefundable credit gets drawn down first, as in the second column above, then that means the nonrefundable credit offsets $1,800 in tax liability on its own before it's all exhausted. But Janet can then also get the full $2,200 of the refundable credit, since it doesn't exceed 15% of her income less $2,500 (the income adjustment was also changed in the Senate plan).

But watch what happens if the refundable credit gets drawn down first, in the third column. Janet uses the first $1,888 of her refundable CTC to offset her tax liability, and can then still claim its last $312 as a refund so that she gets all $2,200. But notice how now there's no tax liability left over for the nonrefundable CTC to cover. So Janet gets none of the $1,800 nonrefundable credit.

This ends up making a substantial difference for Janet: her bottom line tax refund either grows by $1,532 or shrinks by $268 depending on how this question is answered.

The $10 Billion Question

Nor is Janet unique. The difference in interpretation here is significant, particularly for working- and middle-class parents. Using the excellent OSPC TaxBrain model [1], I find that the more generous nonrefundable-first interpretation of the Senate bill means roughly $10 billion more in tax relief flows to parents in 2018. More than 96% of this added benefit goes to parents in the $20K-$75K income range. The average tax change among all parents is an almost-$200 larger cut versus the less generous refundable-first approach; for parents between $30K-$50K, their average after-tax income goes up by two percent more under the more generous approach. Roughly 5.6 million fewer parents overall (11% of all parent filers) get a tax hike. For parents making between $40K-$50K, roughly half will go from a hike to cut depending on the credit sequencing.

The "Right" Interpretation

The "nonrefundable-first" interpretation is the more generous one, and based on my own conversations seems to be the one that JCT uses in their scores of the House and Senate bill. For my money, it's also the one I think makes more sense.

But JCT's is not the only interpretation, and other economists have been approaching it the opposite way. OSPC for its part models the refundable credit as being drawn down first by default. One can make either case for the "right" interpretation here: the current law CTC / ACTC sequencing on the IRS Form 1040 suggests the nonrefundable credit should get drawn down first, but this is an untested assumption since hitherto the CTC and ACTC have been in alignment. The fact that greater draw-down of the CTC under current law brings down the ACTC in a zero-sum manner lends itself to a "refundable-first" interpretation.

Either way, the ambiguity here is significant for parents, and greater clarity is needed in the final bill. 

[1] My analysis includes the indirect benefits of cutting the corporate income tax, distributed in a manner consistent with JCT. It does not include any of the primary or secondary effects of the repeal of the ACA individual mandate, as I lack sufficient data to analyze this at the individual level in OSPC's model.