The Earned Income Tax Credit

T HE CENT URY F OUNDA T ION The Earned Income Tax Credit Issue Brief No. 1 Benjamin Aldrich-Moodie Introduction The Earned Income Tax Credit,1 a tax refund available to working families with low incomes, is one of America’s most promising anti-poverty me asures. The credit is given only to those who work and earn income. Eligible people can claim the credit whether or not they pay any federal income tax. In 1996, the credit lifted 4.6 million people (including 2.4 million children) in working families out of poverty. A number of the credit’s features represent substantial improvements over the design of other programs that aid the poor. By linking government support to earned income, the Earned Income Credit encourages employment while circumventing the worst disincentives to work associated with other means-tested benefits. Moreover, the credit does not discriminate according to family structure: two-parent families are just as entitled to the benefit as single -headed households.2 It reaches a very high proportion - an estimated 80 to 86 percent - of those who are eligible, and gives needy people a way to accumulate assets. How the EITC works and who gets it The Earned Income Tax Credit is most significant for families with children. The credit is first ‘phased in’ in proportion with family income, flattens out at a specified maximum, and then is ‘phased out,’ as illustrated in the figure below. 4000 3500 3000 Tax Credit 2500 2000 1500 1000 500 0 0 5000 10000 15000 20000 Earned Income 1 September, 1999 Credit for a one-child family Credit for a multiple-child family 25000 30000 35000 Throughout this issue brief, the Earned Income Tax Credit is referred to as “the EITC,” “the Earned Income Credit,” “the credit,” “the tax credit,” or “the federal credit” for the sake of variety. These terms all refer to the same policy. Note that some state governments administer similar credits within their state income tax system. These tax credits are distinguished accordingly. 2 By contrast, welfare eligibility (and, by extension, Medicaid eligibility for adults) is restricted to single-parent families in half of all U.S. states. 1998 Green Book, Committee on Ways and Means, U.S. House of Representatives, p.465. T he Century Foundation, formerly the Twentieth Century Fund. A research foundation that undertakes timely and critical analyses of major economic, political, and social institutions and issues. Nonprofit and nonpartisan, TCF was founded in 1919 and endowed by Edward A. Filene. Nothing written here is to be construed as necessarily reflecting the views of The Century Foundation or as an attempt to aid or hinder the passage of any bill before congress. (212) 535-4441 s info@tcf.org 41 East 70th Street s s h ttp://www.medicarewatch.org New York, NY 10021 The Century Foundation Issue Brief No.1 The credit gives families with one child up to a 34 percent raise on the income they earn, and multiple-child families get a credit of up to 40 percent of their earned income. A parent earning the minimum wage at a full time job would fall into the credit ‘plateau’ area in which earners can receive the maximum credit available. In tax year 1999, the maximum credit for one -child families is $2,271; for families with more than one child, the maximum is set at $3,756.3 The maximum available credit is indexed to annual inflation, so that it increases slightly from year to year. (The figures cited in the previous paragraph are for tax year 1999). As long as Congress does not reverse indexation, the real value of the tax credit will remain constant.4 The Earned Income Tax Credit significantly increases the value of low-wage work for families with children. The shaded box below shows how the credit would affect a set of different hypothetical families. Cynthia is the mother of two children, aged 2½ and 6. She is separated from their father, and works as a custodian in an apartment building, earning minimum wage ($5.15) on a full time schedule. For 40 hours a week, 52 weeks a year, she earns an income of $9,893 after federal payroll taxes. (She is lucky enough to live in a state where she pays no taxes in her income bracket). Without the earned income tax credit, her family would be below the federal poverty line. She is entitled to a credit of $3,756 at tax return time. This brings her family above the poverty line, although federal law disregards this income for the sake of Medicaid eligibility, so her children are still entitled to Medicaid coverage under federal rules. Jorge and his wife Maria have three children. Jorge earns $21,000 a year (after payroll and state taxes) as a security guard. His wife works part time serving school lunches, earning $4,500 a year. They get $1,173 back in their income credit. Jim, a single father who has been out of work for part of the year and earned $4,617 after taxes as a nursing assistant, lives with his 5 year old son. He is entitled to some welfare support, food stamps, and to Medicaid coverage. His Earned Income Credit payment at tax time is $1,700. There is also a small federal EITC for single individuals. In tax year 1998, the maximum credit available was $341. The credit begins to be withdrawn when single individuals earn more than $5,600 annually, and is phased out entirely at $10,030. In recent years, several states have adopted earned income tax credits that complement the federal credit. While the state programs are generally smaller than the federal credit, they are important because state income taxes are often less progressive than their federal counterpart.5 For instance, half of all states with an income tax levy taxes on two-parent families of four at the poverty line; by contrast, federal income taxation starts above the poverty line. In Iowa, Oregon, and Rhode Island, state earned income credits offset state taxes, and in Kansas, Maryland, Massachusetts, Minnesota, New York, Wisconsin, Vermont, state credits are “refundable :” like the federal Earned Income Credit, the entire tax credit is given to eligible families, even if it exceeds whatever state taxes they owe.6 In states with generous credits, the 3 4 Figures from personal communication with the IRS, March 30, 1999, Mrs. Thelen, badge #39-00518. A proposal to end indexation was aired in Congress when Republicans took control of the House, but the effort failed and the EITC is still pegged to inflation. In contrast, welfare benefits paid by the states, which were not systematically adjusted for inflation, have generally declined in value. 5 Like all federal transfers, the EITC is exempt from taxation by the states. 6 Legislation to introduce a refundable state EITC has passed both houses of Missouri’s legislature. The Earned Income Tax Credit maximum amount of the combined federal and state refund can come to over half the annual salary of some low-income earners.7 Although it is unexpectedly difficult to get precise data on how many eligible people actually receive the Federal Earned Income Tax Credit, Professor John Scholz of the University of Wisconsin, Madison, estimates participation at 80 to 86 percent. According to Scholz’s testimony before the Ways and Means Committee in 1995, this rate of participation exceeds that for welfare and food stamp benefits.8 How the credit affects decisions to work The Earned Income Tax Credit provides a strong incentive for low-skilled heads of families to go to work. In effect, it gives these earners a substantial salary raise when they start working, even if they work only part time. A recent study by Acs, Coe, Watson, and Lerman of the Urban Institute finds that, with the credit, moving from welfare to a minimum wage job, even a part time one, leads to a better standard of living for a family of three.9 Empirical research suggests that the Earned Income Credit has increased employment among single mothers, the demographic group most likely to be on welfare, in particular.10 The credit is very important in ‘making work pay’ in the wake of reforms to the welfare system. By the same token, the EITC increases the effective rate of taxation as the credit is gradually withdrawn for families 100 earning over $12,300 a year. For 80 those in the ‘phase out’ range of the credit, this constitutes a mild 60 disincentive to work. Scholz 40 concludes that this effect is likely to be most significant for 20 secondary earners in families 0 where both parents are 0 5000 10000 15000 20000 25000 30000 35000 employed in low-wage jobs, and -20 research shows a small negative -40 effect on employment among this group.11 For low-income -60 families with both parents -80 working, the credit cushions the loss of income experienced when -100 the secondary earner leaves the workplace to bring up children at home. The work incentive structure of the credit for multiple -child households is shown below. Annual earnings from work EITC subsidy, in cents, per dollar of wages 7 The New York Times, Jason DeParle, “On a Once Forlorn Avenue, Tax Preparers Now Flourish,” March 21, 1999, p. A1. 8 Scholz, Summary of Testimony, p. 2. 9 Gregory Acs, Norma Coes, Keith Watson, and Robert I. Lerman, “Does Work Pay? An Analysis of the Work Incentives under TANF,” The Urban Institute, July 1998, 10 Rebecca Blank, David Card and Philip Robins, NBER Working Paper Series, “Financial Incentives for Increasing Work and Income Among Low-Income Families,” Working Paper 6998, March 1999, p. 36. 11 John Karl Scholz, Summary of Testimony before the Committee on Ways and Means, Subcommittees on Oversight and Human Resources, Thursday, June 15, 1995, p. 4. See Nada Eissa and Hilary Hoynes, NBER Working Paper Series, “The Earned Income Tax Credit and the Labor Supply of Married Couples,” Working Paper 6856, December 1998. The Century Foundation Issue Brief No.1 Getting the Earned Income Tax Credit Broad-based participation in the credit program and the influx of former welfare recipients into the workforce has led to a growing industry of tax preparers in low- and moderate-income neighborhoods.12 Applying for the Earned Income Tax Credit requires the completion of several pages of tax forms, and is difficult for many people to do on their own. Tax help is provided free by volunteers in some locations, although many individuals have their returns processed by private companies for a fee of about $50.13 Some banks offer accelerated returns or loans against expected returns for high fees and interest charges. At one private return service in Milwaukee, 17 percent of people claiming a credit took a high-interest loan against their expected tax return.14 The Earned Income Credit can also be partly disbursed over the course of the year out of payroll tax receipts if employers choose to sponsor such a program. 15 According to IRS figures, only 1 percent of eligible employees make use of this option.16 What the credit does for beneficiaries The Earned Income Tax Credit keeps many working families out of poverty. Over the last 20 years or so, the wages of the lowest earners in the U.S. have declined significantly in value.17 The credit has been effective at helping to counteract this trend. Census Bureau data show that in 1996, the credit lifted 4.6 million low-income workers and their family members (including 2.4 million children) out of poverty. No other income -support program has lifted as many children out of poverty.18 In addition, because the credit cannot be counted as income when eligibility for Medicaid is calculated, the childre n in these families are still eligible for health coverage by the government.19 Most people earning the credit receive their payment from the government in a single lump sum during the tax refund season. For some people, this means that they get a check for a quarter or a third of their annual income all at once. What do people do with such a large windfall? Recent work by Professor Timothy Smeeding and colleagues at Syracuse University suggests that, while some plan to spend the money on immediate expenses or in an impulsive spree, a substantial portion intend to use the funds with an eye to longer-term improvements in their standard of living. Of the Earned Income Tax Credit beneficiaries surveyed in the study, 48 percent planned some use designed to make ends meet: paying utility or rent bills or buying food and clothing. Fiftynine percent intend to use the money on a move or mortgage payments, spending on automobiles, tuition or school fees, or for savings, all of which can lead to improved social 12 13 The New York Times, Jason DeParle, p. A1. ibid., p. A20. 14 ibid., p. A20. 15 This option is available only to EITC beneficiaries with children. (Personal communication with Candace Cromling of the IRS). 16 Personal communication with Candace Cromling of the IRS, 6 April, 1999. 17 Danziger, et. al., (1998), cited in Smeeding et. al., 1999. 18 Robert Greenstein and Isaac Shapiro, “New Research Finding on the Effects of the Earned Income Tax Credit,” Center on Budget and Policy Priorities, March 11, 1998, . 19 1998 Green Book, p. 406. The EITC is ignored as income in calculations of eligibility for food stamps, Supplemental Security Income, and AFDC, (which now serves as an eligibility mechanism for adults to get Medicaid). The states are allowed to make their own determinations of whether the credit counts against TANF eligibility. (Same reference). The Earned Income Tax Credit mobility. Twenty-two percent of respondents planned to use their money both to make ends meet and for uses promoting social mobility.20 While saving and investing in education are common ways for all Americans to improve their economic prospects, moving or buying a car can be equally important routes to upward mobility, especially for residents of poor areas. Research indicates that most people living in impoverished neighborhoods would jump at the chance to move to areas where jobs are more plentiful, schools are better, and crime is lower.21 It is not surprising, then, that some beneficiaries of the credit plan to use their windfall to move. Buying or repairing a car can also provide self -employment or transport to jobs outside of depressed neighborhoods. One 1998 study shows that for low-income welfare recipients, having a car is equivalent to completing high school in its effects on earning power.22 The Smeeding study finds that beneficiaries who are receiving the maximum available credit are the most likely to use their refund for investment-type purposes rather than ongoing expenses.23 This suggests that the sheer size of the refund is important to people’s ability to use it in a maximally constructive way. In this sense, the rather crude lump-sum disbursement of the tax credit is a positive feature of the policy. To the extent that small incomes and impoverished circumstances often hinder financial planning on more than a day-to-day or month-to-month basis, the delivery of the credit in a single annual payment makes it a good way for people near the poverty line to accumulate assets for savings or important large -ticket expenditures. The Earned Income Credit’s effectiveness in encouraging savings or investments in a car or a home is hampered somewhat by the asset limits that are in place for means-tested programs such as TANF (‘welfare’), food stamps, and some eligibility categories in Medicaid. These rules can inhibit precisely the sort of behavior that the credit is designed to encourage, particularly for people who go back and forth between jobs and public assistance.24 The problem of erroneous or fraudulent claims The Earned Income Credit has a high rate of false claims. An IRS study found that in 1994, taxpayers overclaimed the tax credit by $4.4 billion, about 26 percent of total disbursements.25 Erroneous claims are frequently related to misreporting dependent children or using the wrong filing status, such as wrongly claiming head of household status so as to conceal a husband or wife’s income.26 20 Timothy Smeeding, Katherin Ross, Michael O’Connor, and Michael Simon, “The Economic Impact of the Earned Income Tax Credit (EITC),” 1999, unpublished manuscript, Table 5, “Important Uses of the Refund within EITC Range.” 21 Ludwig, Duncan, Hirschfeld, 1998, cited in ibid., p. 12. 22 Danziger et. al., 1998, cited in ibid., p.13. 23 ibid., Table 5. 24 ibid., p. 24. 25 General Accounting Office, “Report to the Chairman, Subcommittee on Oversight, Committee on Ways and Means, House of Representatives: Tax Administration, IRS’ 1998 Tax Filing Season,” December 31, 1998, (GAO/GGD-99-21), p.24. 26 General Accounting Office, “Testimony Before the Committee on Ways and Means, House of Representatives: Tax Administration, Earned Income Credit Compliance,” May 8, 1997, (GAO/T-GGD-97-105), p.5 and fn.9. Note, too, that the income of any other adult in the household (whether or not they are a spouse) must likewise be reported as a part of overall household income for the purposes of the tax credit. Thus, the EITC imposes a ‘cohabitation tax’ rather than a ‘marriage tax,’ as is often reported. (Personal communication with Candace Cromling of the IRS, 6 April, 1999.) The Century Foundation Issue Brief No.1 The IRS has begun new initiatives to improve the ‘noncompliance rate’ -- the proportion of excessive claims -- including cross-checking of Social Security numbers used on returns claiming the credit, increasing audits of claims, and denying earned income credits for 10 years to fraudulent claimants and 2 years for negligent claims.27 There is some evidence that these measures are beginning to make a dent in noncompliance. EITC -related errors dropped between the 1997 and 1998 filing seasons, and the number of detected errors involving Social Security numbers fell by over a third over the same period.28 Because of its limited ability to check the details of claims, however, the IRS is unlikely to reduce erroneous payments to the single -digit percentages of overall spending that are typical of the welfare and food stamp programs.29 By the same token, the latter programs, which operate through extensive face-toface contacts with people seeking aid, have administrative costs that far outstrip the expense of administering the credit.30 The IRS’s increased efforts to control overpayment of the Earned Income Tax Credit are taking place in a context of slackening oversight of high-income individuals. According to a Syracuse University study reported in The New York Times, the IRS audited just one in 60 tax returns from people earning over $100,000 annually, compared to a rate of one in nine a decade earlier.31 A policy of focusing scarce resources on EITC noncompliance risks being both inequitable and unprofitable for the agency: the average tax audit leads to an additional tax assessment of $3,500, while the typical Earned Income Credit refund averages about $1,500.32 The Earned Income Tax Credit in perspective The Earned Income Credit began in 1975 as a modest initiative designed to mitigate the burden of social security payroll taxes on low-wage working parents. At that point, families earning $4,000 were eligible for the maximum credit of $400.33 In 1987, the credit was indexed for inflation. Congress expanded the credit in 1990 and again, most dramatically, in 1993, when the small credit for childless workers was also introduced.34 By 1998, the federal government was paying $23.2 billion a year in Earned Income Credits. Spending on the credit exceeded the $15.5 billion expended on welfare benefits and came to somewhat less than half the amount of tax money lost by the government through the exemption for mortgage interest on owneroccupied homes ($51.7 billion). By way of comparison, the government’s two largest budget items were $375.8 billion for Social Security benefits and $210.3 billion in Medicare payments for elderly and disabled Americans’ health care.35 The Earned Income Tax Credit has grown to be a major component of federal spending on low-income Americans, but it remains a small segment of the budget as a whole. 27 28 GAO/GGD-99-21, p.22 and 26. idid., p.22-23. 29 The most recent figures from the House Ways and Means Committees 1998 Green Book put overpayment rates at 6.1 and 7.0 percent, respectively, for these programs. 30 GAO/T-GGD-97-105, p.6. 31 David Cay Johnston, The New York Times, “I.R.S. Figures Show Drop in Tax Audits For Big Companies,” April 12, 1999, p.A1 and A20. 32 GAO/T-GGD-97-105, p.11. 33 John Karl Scholz, “The Earned Income Tax Credit: Participation, Compliance, and Antipoverty Effectiveness,” 1993, unpublished article, p.1. 34 1998 Green Book, 866. 35 The United States Budget for Fiscal Year 2000, Historical tables, Table 11-3, “Outlays for Payments for Individuals by Category and Major Program: 1940-2004,” p. 200, for spending figures; ibid., Table 2-5, “Composition of ‘Other Receipts: 1940-2004,” p. 41, for estate and gift tax figures; and ibid., Table 5-1 “Total Revenue Loss Estimates for Tax Expenditures in the Income Tax,” p. 107, for mortgage interest deduction revenue losses. The Earned Income Tax Credit Conclusions The tax code is seldom thought of as a suitable vehicle for anti-poverty policy. In general, tax incentives tend to be accessible only to the rich and the middle class. The Earned Income Tax Credit, however, turns conventional wisdom on its head by demonstrating that a fully refundable tax credit can reach America’s poorer families even more effectively than programs administered by large social service bureaucracies. The Earned Income Tax Credit commands broad support across ideological divides. Conservative as well as liberal policy experts, advocates for the poor and business leaders have all expressed support for the credit. Presidents Reagan, Bush, and Clinton have all proposed and signed expansions of the credit, with the most recent increase in the credit, in 1993, being the biggest yet. Bipartisan action has also been important in enacting earned income credits at the state level. 36 Most states still do not have a program, however, and many of the laggards also have comparatively regressive tax systems. One worry about expanding the credit further is that fraudulent claims may increase in proportion to the value of the available refund.37 One way of getting some purchase on this question would be to research whether ‘noncompliance’ is higher in states with supplementary state credits, which augment the value of the federal refund. Increasing the Earned Income Credit also worsens the disincentives to additional work for earners in the ‘phase-out’ zone while intensifying the reward for entering the workplace despite low wages. It is unclear how much higher the Earned Income Credit could be set before the costs of the program began to outweigh its social benefits. When weighing the trade-offs involved, however, it should be kept in mind that even the negative work incentives of the credit are not entirely bad. The people most likely to cut back their work effort because they fall in the credit’s withdrawal range are secondary earners who will gain more time to care for their children. By contrast, the benefits of the credit -- relieving the working poor and encouraging unemployed families to join the workforce -- are unambiguous goods. The Earned Income Tax Credit is the government’s most substantial contribution to date toward ‘making work pay.’ 36 37 Ibid., p.13-14. See John Karl Scholz, Summary of Testimony, June 15, 1995, 8.