CRS REPORTS ON EARNED INCOME CREDIT.

                           James R. Storey

SUMMARY

The earned income tax credit (EITC) is a refundable Federal income tax credit available to families with dependent children in which a family member works and family income is less than $21,245. An eligible parent may receive the credit after the tax year ends or by advance payments during the year (by "negative withholding" in the paycheck). At year's end, if the credit exceeds tax liability, the U.S. Treasury pays the balance to the family.

The EITC has been expanded by two laws during the past 5 years. In the Tax Reform Act of 1986, the maximum credit amount was increased by 55 percent and indexed for annual inflation. In the Omnibus Budget Reconciliation Act (OBRA) of 1990, the maximum credit amount was increased by another 64 percent over 4 years, and added credits were authorized for families with more than one child, those with a child under 1 year of age, and those paying health insurance premiums for their children.

The EITC is the only tax credit that yields a grant when a filer's credit exceeds income tax liability. In 1991, the basic credit equals 16.7 percent of yearly earnings up to an earnings level of $7,140. The maximum credit ($1,192) is reduced by 11.93 cents per dollar of adjusted gross income (AGI) in excess of $11,250. The EITC is reduced to $0 when AGI reaches $21,245.

Additional credit amounts are available if a family has more than one child (+0.6 percent in 1991), a child under age 1 (+5.0 percent), or pays health insurance premiums for its children (+6.0 percent). A family meeting all three criteria could have a total credit of 28.3 percent of $7,140, or $2,023. The combined credit reduction rate for AGI in excess of $11,250 is 20.215 percent.

The 1990 law calls for further increases in the basic credit percentages over 4 years, reaching 23 percent for families with one child and 25 percent for families with two or more children in 1994. Credit reduction rates will increase to 16.43 percent and 17.86 percent, respectively, to maintain the same income eligibility cutoff after adjustment for inflation.

In 1990, 11.3 million families benefited from the EITC; the average annual credit was $623. The total Federal cost in lost revenue and grants paid was $7.0 billion. Federal costs will likely be nearly 20 percent greater in 1991.

The rate of EITC phaseout has the same effect as a tax rate and adds to income and social security tax rates in determining a family's net gain from additional income. The total of these three "tax" rates will rise to as much as 53 percent in 1994, up from 38 percent under the old law.

Future EITC policy concerns may include effects of the higher phaseout rate on work incentives, the role of the nonrefundable dependent care tax credit, and the greater complexity of filing for the EITC.

                              CONTENTS

Until 1975, cash assistance to the poor was directed toward certain categories of people whose poverty largely resulted from the absence of earnings -- the aged, the disabled, and children in families with an absent parent. However, in the late 1960s and early 1970s, interest grew in the plight of the working poor -- families that remain in poverty despite having members in the work force.

There are six basic ways to increase the income of this group: (1) raise wage rates, either through minimum wage hikes or a public wage subsidy; (2) enable additional work by family members, through provision of child care, for example; (3) improve workers' skills through education and training; (4) expand job opportunities; (5) provide direct assistance through welfare grants; or (6) provide assistance through the tax system. All of these approaches have been tried. This report describes the tax system approach, namely, the refundable earned income credits that offset some or all of a family's tax liability and yield direct payments from the Government whenever a family's tax credit exceeds its tax liability.

The tax credit approach has several advantages. It targets money based directly on income. It relies on the existing administrative system of the Federal income tax. Its association with the tax system avoids the stigma of welfare programs.

The tax credit approach to assistance shares a disadvantage with all need-based aid, however. That is, the larger the credit amounts, the greater must be the rate at which the credit is reduced to exclude higher income families from eligibility and keep costs within bounds. This credit reduction, or "phaseout," rate adds to the effective tax rates of eligible families over the affected income range.

The earned income tax credit (EITC), which was first added to the Internal Revenue Code as a temporary measure in 1975, offers cash aid to working parents who have relatively low incomes and who care for dependent children. It is the only type of Federal cash assistance available to all working poor families with children. For many eligible families, the EITC results in lower tax payments to the Internal Revenue Service (IRS). Those who owe no income taxes at year's end or whose tax liability is smaller than the credit receive all or part of the EITC as a direct payment from the U.S. Treasury. A relative few receive EITC benefits regularly through their employers' payrolls as "negative withholding" from paychecks.

In general, the EITC works in the following way. The credit amount rises with earned income as a percent of annual earnings up to a statutory limit on creditable earnings. The maximum credit amount applies to any eligible filer with earnings at or above the creditable limit and adjusted gross income (AGI) (or earnings, if greater) at or below a threshold income level beyond which the credit amount is reduced. The credit amount declines as income rises above the threshold, failing to $0 at the "breakeven" income level, where "excess" income above the threshold completely offsets the maximum credit amount.

Major changes were made to the EITC in the Omnibus Budget Reconciliation Act (OBRA) of 1990 (P.L. 101-508). Credit amounts were increased, and additional credits were added for families with more than one child, families with a child under age 1, and families paying health insurance premiums for their children. The higher credits will be introduced in stages over 4 years.

The next section of this report outlines the legislative history of the EITC. The later sections detail the requirements for eligibility and the benefits provided. The report then presents data on participation and costs, discusses interactions with other programs, and analyzes the effect of the expanded EITC on marginal tax rates. A final section discusses policy issues that may be of concern to Congress.

HISTORY ¹

The idea that became the EITC first arose during congressional consideration of President Nixon's welfare reform proposal. Nixon's proposal, the family assistance plan, would have helped working poor, two-parent families with children through a Federal minimum cash guarantee that would have replaced the Federal-State welfare program of aid to families with dependent children (AFDC).

The Nixon family assistance plan was never enacted, although the House twice approved it. However, Senator Russell Long, then Finance Committee Chairman, expressed interest in 1971 in an alternative to the Nixon plan that would assist the poor who could work by offering them wage supplements instead of welfare payments.

WORK BONUS PLAN

The EITC was patterned after a proposal, then known as a "work bonus" for the working poor, that was recommended by the Senate Finance Committee in April 1972. Though the idea originated as an alternative to a new family welfare program, the work bonus provision was advocated as a "refund" of social security taxes paid by both employers and employees on low annual earnings and was to have been available only for wages subject to social security taxation. Senator Long stated that the purpose of the work bonus was to "prevent the social security tax from taking away from the poor and low-income earners the money they need for support of their families." ² He said the provision would "prevent the taxing of people onto the welfare rolls." ³ He also said that the EITC would provide a "dignified way" to help a low-income working person, "whereby the more he works the more he gets," yet that would be phased out in "such a way as not to decrease the incentive to work." ⁴

The Senate passed versions of the work bonus plan in 1972, 1973, and 1974, but the House did not accept such a plan until 1975.

PASSAGE OF THE EITC

Following the recession of 1974-75, Congress passed the Tax Reduction Act of 1975 (P.L. 94-12). The 1975 act was an attempt to reverse the economic slide. Congress refunded $8.1 billion in 1974 individual income taxes and cut 1975 income taxes for individuals by another $10 billion.

The House Ways and Means Committee report on the Tax Reduction Act of 1975 included a provision that established, in section 32 of the Internal Revenue Code, a refundable credit to taxpayers with incomes below $6,000. This "earned income credit" was to equal 5 percent of the first $4,000 of any earning including those not subject to social security taxation) and thus could not exceed $200 per year. The credit was to be phased out for AGI between $4,000 and $6,000. The Committee report said, "it is appropriate to use the income tax system to offset the impact of the social security taxes on low-income persons in 1975 by adopting for this 1 year only a refundable income tax credit against earned income." ⁵

The Senate Finance Committee raised the maximum credit from $200 to $400 and the phaseout income level from $6,000 to $8,000, and House-Senate conferees agreed to these amounts. The EITC was passed in the Tax Reduction Act of 1975 as a 1-year provision effective for the 1975 tax year.

The Finance Committee report on the Tax Reduction Act of 1975 stated:

THIS NEW REFUNDABLE CREDIT WILL PROVIDE RELIEF TO FAMILIES WHO CURRENTLY PAY LITTLE OR NO INCOME TAX. THESE PEOPLE HAVE BEEN HURT THE MOST BY RISING FOOD AND ENERGY COSTS. ALSO, IN ALMOST ALL CASES, THEY ARE SUBJECT TO THE SOCIAL SECURITY PAYROLL TAX ON THEIR EARNINGS. BECAUSE IT WILL INCREASE THEIR AFTER-TAX EARNINGS, THE NEW CREDIT, IN EFFECT, PROVIDES AN ADDED BONUS OR INCENTIVE FOR LOW-INCOME PEOPLE TO WORK, AND THEREFORE, SHOULD BE OF IMPORTANCE IN INDUCING INDIVIDUALS WITH FAMILIES RECEIVING FEDERAL ASSISTANCE TO SUPPORT THEMSELVES. MOREOVER, THE REFUNDABLE CREDIT IS EXPECTED TO BE EFFECTIVE IN STIMULATING THE ECONOMY BECAUSE THE LOW-INCOME PEOPLE ARE EXPECTED TO SPEND A LARGE FRACTION OF THEIR INCREASED DISPOSABLE INCOMES. ⁶

The Finance Committee report also said that the EITC's most significant objective should be "to assist in encouraging people to obtain employment, reducing the unemployment rate and reducing the welfare rolls." ⁷ Another objective was to lessen the regressivity inherent in the social security payroll tax. Senator Long said that the EITC was needed to "provide tax relief to people who are too poor to pay income tax, but who still pay social security tax and bear the burden of the social security tax paid by their employers." ⁸ Representative Al Ullman, Chairman of the Ways and Means Committee, said, "although we in no way affect or change the social security law, we are in effect rebating to the low-income groups below $6,000 most of the payroll tax that they have already paid." ⁹

The Finance Committee bill also included a provision sponsored by Senator Long that would have required States to reduce AFDC payments to working recipients by amounts equal to their EITC benefits. Senator Edward Brooke, who fought unsuccessfully on the Senate floor to eliminate the provision, argued that it would have the Federal Government take away with one hand what it had given with the other and that it would punish poor welfare recipients who were attempting to better their own lives by working. ¹⁰ Senator Long responded by saying that, without his amendment, working people would be encouraged to go on the welfare rolls to get both AFDC and the EITC. Although the Long amendment was dropped in conference, it was not replaced by language that specifically instructed State welfare agencies to disregard the credit. Consequently, most States counted the 1975 credits as income available to working welfare recipients and reduced AFDC benefits accordingly. ¹¹

Under the 1975 law, the EITC was equal to 10 percent of the first $4,000 of earnings (including net earnings from self- employment), and thus could not exceed $400 per family per year. For each dollar of income above $4,000, the EITC was reduced by 10 cents, thereby reaching $0 at an AGI of $8,000.

EXTENSIONS OF EITC (1975-1977 LAWS)

The Revenue Adjustment Act of 1975 (P.L. 94-164) extended the EITC through the 1976 tax year. It also included a provision requiring that, beginning July 1, 1976, the EITC be disregarded in determining benefit amounts under any Federal or federally supported assistance program but not in determining eligibility.

The Tax Reform Act of 1976 (P.L. 94-455) extended the EITC through the 1977 tax year and required that the EITC be disregarded in determining both the eligibility and benefit amounts of recipients in Federal or federally supported assistance programs. Conferees agreed to the 1-year extension as a compromise between the Senate position to make the credit permanent and the House position to let it lapse after 1976.

The Tax Reduction and Simplification Act of 1977 (P.L. 95-30) extended the EITC through 1978.

PERMANENT STATUS FOR EITC AND RISE IN MAXIMUM CREDIT (1978 LAW)

The Revenue Act of 1978 (P.L. 95-600) made major revisions in the EITC. According to the Joint Committee on Taxation, since the credit had proven to be an "effective way of providing tax relief for low-income families, while at the same time providing work incentives for these individuals," the Congress decided to make the EITC permanent. ¹² The revisions increased the maximum credit to $500 and the eligibility limit to $10,000, provided for EITC payments in advance of the annual tax filing deadline, and simplified eligibility determinations.

Under the 1978 law, the EITC was set equal to 10 percent of the first $5,000 of earnings (including net earnings from self- employment). The maximum credit of $500 was received for earnings between $5,000 and $6,000. For each dollar of AGI above $6,000, the EITC was reduced by 12.5 cents, reaching $0 at an AGI of $10,000.

According to the Joint Explanatory Statement of the Committee of the Conference on the 1978 act, the EITC was to be counted in determining eligibility and benefit amounts in Federal and federally supported assistance programs, effective January 1, 1980. In addition, the statement said that "the Social Security Act will be amended, effective January 1, 1980, to provide specifically that the earned income credit and advance payment of the credit, be treated as EARNED income for purposes of the Aid to Families with Dependent Children (AFDC) and Supplemental Security Income (SSI) programs." ¹³ Treating EITC as earnings meant that only a portion of the credit would be used as an offset to the welfare cash benefit. The Finance Committee report on the 1978 act stated that "the Committee believes that in order for the earned income credit to be an effective incentive to work and a disincentive for being on welfare, the credit should be treated as earned income for purposes of the Aid to Families with Dependent Children and Supplemental Security Income programs." ¹⁴

The actual language of the Revenue Act of 1978, contrary to the intent stated in these reports, required only an end to the practice of disregarding the EITC in determining Federal and federally supported assistance program benefits. The act failed to require that the EITC be treated as earned income by AFDC and SSI.

However, conferees returned to this issue in 1979, and in the Technical Corrections Act of 1979 (P.L. 96-222) required that both advance and lump-sum EITCs be treated as earned income by the AFDC and SSI programs effective January 1, 1980. The Omnibus Budget Reconciliation Act of 1981 (P.L. 97-35) provided that, beginning October 1, 1981, regardless of whether working AFDC recipients applied for advance EITC payments, welfare offices were to assume that EITC eligibles received advance EITC payments and, thus, should have their AFDC benefits reduced.

RISE IN MAXIMUM CREDIT (1984 LAW)

The Deficit Reduction Act of 1984 (P.L. 98-369) raised the maximum credit by 10 percent, from $500 to $550. It established the EITC at 11 percent of the first $5,000 of earnings (including net earnings from self-employment). Earnings between $5,000 and $6,500 qualified for the maximum credit of $550. For each dollar of AGI above $6,500, the law required that the EITC be reduced by 12.22 cents. As a result, the credit was completely phased out when AGI reached $11,000. This law repealed the provision requiring welfare agencies to reduce AFDC benefits to account for EITC payments for which they were eligible regardless of actual receipt. P.L. 98-369 required States to count the EITC only when actually received.

INDEXATION OF EITC AND RISE IN MAXIMUM CREDIT (1986 LAW)

Effective with tax year 1987, the Tax Reform Act of 1986 (P.L. 99-514) increased the EITC from 11 percent of the first $5,000 of earnings to 14 percent of the first $5,714 of earnings, ¹⁵ increased by the percentage rise in the average Consumer Price Index (CPI) from the 12-month period ending August 31, 1984, to the 12- month period ending August 31, 1986. In addition, the starting point of the phaseout income level was increased for 1987 from $6,500 in current dollars to $6,500 in 1984 dollars (current dollars plus the adjustment for inflation described above). For 1988, the income level at which the phaseout began was increased from $6,500 in 1984 dollars to $9,000 in 1984 dollars (current dollars plus an adjustment for inflation occurring between August 31, 1984, and August 31, 1987). P.L. 99-514 also changed the phaseout rate from 12.22 percent to 10 percent beginning with the 1987 tax year.

The increase in the creditable earnings base and the credit rate raised EITC benefits, and the reduction in the phaseout rate reduced the marginal tax rate on recipient earnings. The combination of a higher benefit and a lower phaseout rate ¹⁶ increased the income eligibility level from $11,000 in 1984 to $14,500 (in 1984 dollars) for 1987. During debate on the Tax Reform Act of 1986, it was said that "the liberalization of the earned income credit will help to assure that low-income citizens are no longer taxed into poverty." ¹⁷

RISE IN MAXIMUM CREDIT AND ESTABLISHMENT OF FAMILY-SIZE ADJUSTMENT AND SUPPLEMENTAL CREDITS (1990 LAW)

BASIC EITC

Because the EITC was originally established as a work bonus and advertised as an offset to the social security tax, it had not been designed to vary by family size. Thus, it met less of a family's needs, the larger the family. Proposals were introduced in the 101st Congress to vary EITC credit amounts by number of children, up to a maximum of two, three, or four children depending on the bill. These proposals would have increased EITCs role as a welfare program while it continued to provide payroll tax relief and a work bonus. However, no one proposed that EITC family-size variations be modeled after AFDC, with variations that extend to large family sizes.

The House passed a proposal in 1990 that would have increased the current EITC maximum credit from 14 percent to 17 percent of the first $6,810 of earnings (in 1990 dollars) for a family with one child. The maximum credit would have been 21 percent of the same earnings base for a family with two children and 25 percent of that earnings base for a family with three or more children. The House bill would have increased the phaseout rate from 10 percent to 12 percent for families with one child, to 15 percent for families with two children, and to 18 percent for families with three or more children. The Senate bill, on the other hand, would not have changed the basic EITC credit amounts or phaseout rates.

Final congressional action on the Omnibus Budget Reconciliation Act (OBRA) of 1990 (P.L. 101-508) expanded EITC credits beyond the level proposed in the earlier House-passed bill. This result occurred in part to mitigate the impact on lower income families of certain deficit reduction provisions in OBRA. However, Congress limited the family-size variation, establishing only one family-size adjustment for all families with more than one child.

The first stage of the EITC expansion enacted in OBRA of 1990 began in 1991 The values shown for the new law in table 1 will not be reached until 1994, when the final increase takes effect. The intermediate credit rates for a family with one child will be 16.7 percent in 1991, 17.6 percent in 1992, and 18.5 percent in 1993. For a family with two or more children, the corresponding rates will be 17.3 percent, 18.4 percent, and 19.5 percent. Congress opted to retain approximately the same income range over which the credits are phased out ($11,250 to $21,246 in 1991 dollars), so the phaseout rates must rise each year to the levels necessary to maintain the same phaseout range. ¹⁸

          TABLE 1. EITC CREDIT MAXIMUMS AND PHASEOUT FACTORS

Numerous proposals were also introduced in the 101st Congress to establish refundable tax credits for families with young children. These proposals would have set credit amounts based on earned income and number of qualifying children. Both the House and Senate passed such provisions in competing versions of child care legislation. These measures were seen as aiding lower income families in need of child care for preschool children.

Final action in OBRA of 1990 limited additional credits for young children to those under age 1. The key factors in the "supplemental young child credit" are displayed in table 2.

                 TABLE 2. KEY FACTORS FOR SUPPLEMENTAL

A new refundable credit aimed at helping parents finance health insurance for their children was included in the Senate-passed bill. The House did not include such a provision, but it was incorporated into OBRA of 1990 by House-Senate conferees.

The "supplemental health insurance" credit, effective in 1991 earnings up to the maximum amount to which the EITC applies and is then reduced over the same income range used for the EITC phaseout. The rates set for the child health insurance credit and its phaseout are 6.0 percent and 4.285 percent, respectively. The credit amount cannot exceed the health insurance premiums actually paid by a family during the tax year. Unlike the basic EITC, this supplemental credit cannot be received in advance of the annual tax filing.

ELIGIBILITY

The basic EITC is available in 1991 to persons who have a "qualifying child" and whose AGI and earned income are both less than $21,245. A qualifying child must be the tax filer's natural child, stepchild, adopted child, or foster child. In order to receive the credit, a married couple must be eligible for a dependency exemption (as defined by the Internal Revenue code) for a child and must file a joint return. A child must have the same principal place of abode as the tax filer for more than half the year to qualify. The family must reside in the United States. A further requirement is that the child must be under age 19, or under age 24 and a full-time student, or permanently and totally disabled. If a child qualifies for more than one tax filer, which could happen in a year when parents are divorced, for example, the filer with the larger AGI must claim the child.

An old-law eligibility rule that an unmarried filer must meet the requirements for "head of household" tax filer status to be eligible for the EITC was dropped by OBRA of 1990. This status was difficult for many low-income working mothers to meet since many of them receive more than half their cash income from AFDC, which is not regarded as self-support income by the IRS in determining "head of household" status.

To be eligible for the supplemental young child credit, at least one of a family's qualifying children must be under 1 year of age at the close of the family's tax year. Eligibility for the supplemental health insurance credit is limited to the lesser of actual expenses for health insurance premiums or the allowable health insurance credit amount. Only premiums for coverage that includes a qualifying child are allowed. Out-of-pocket health care expenses other than premiums are not eligible for the credit.

Participating families receive EITC benefits in one of four ways: (1) a reduction in income tax liability; (2) a year-end cash payment from the Treasury if the family has no income tax liability; (3) a combination of reduced taxes and direct payment; or (4) advance payments of the EITC by negative withholding from paychecks. ¹⁹ Most EITC benefits are paid as cash benefits rather than tax liability offsets.

To receive an EITC benefit, a person must file an income tax return at the end of the tax year together with a separate EITC schedule. An eligibility certificate must be filed with the employer to receive advance credits through the employer's payroll.

BENEFITS

BENEFIT LEVELS REFORM 1991

The maximum credit was originally set ai 10 percent of annual earnings up to $4,000 and was reduced for those with AGI above $4,000, reaching $0 at an income of $8,000. The maximum credit amount was increased to $500 in 1979 and to $550 in 1985. In 1987 the credit was increased again and was given automatic inflation protection. This indexed credit reached $953 in 1990. Further increases were enacted in 1990 and began to take effect in 1991.

BENEFIT LEVELS IN 1991

Maximum creditable earnings are $7,140 a year, a figure that rises annually with inflation. The credit rates used to calculate EITC amounts are as follows:

o For a family with one child, 16.7 percent (maximum credit of $1,192);

o For a family with two children, 17.3 percent (maximum credit of $1,235);

o For a family with a child under age 1, an additional 5.0 percent (maximum credit of $357);

o For a family with qualifying expenses for health insurance premiums, an additional 6.0 percent (maximum credit of $428); and

o For a family qualifying for all credits, 28.3 percent (maximum credit of $2,020).

Maximum credit amounts are paid to eligibles with earnings of $7,140 or more and AGI not greater than $11,250. Credits are reduced for AGI above $11,250 and reach $0 at $21,245. The creditable earnings maximum of $7,140 and the phaseout income levels are indexed for inflation and change yearly.

The gross EITC amount for which a family may be eligible is calculated by multiplying the family's credit rate times its earnings up to the maximum creditable amount ($7,140 a year in 1991). If a family is eligible for the supplemental young child credit or the child health insurance credit, these credit rates are added to the family's basic credit rate to obtain the full credit rate for this multiplication. If the family's AGI (or annual earnings, if greater) exceeds $11,250, the excess over this threshold is multiplied by the family's credit phaseout rate. Phaseout rates for the supplemental credits are added to the phaseout rate for the basic EITC to obtain the family's correct phaseout rate. The product of this multiplication is subtracted from the gross EITC amount to obtain the actual EITC benefit the family may claim.

For example, consider the case of a family with one child who is under 1 year of age and that has no health insurance costs. The family's annual income, all from earnings, is $15,000. This family's 1991 credit rate is 16.7 percent plus 5.0 percent, or 21.7 percent. Thus, the family's gross EITC amount is $1,549 (21.7 percent of $7,140). The excess of AGI over $11,250 is $3,750, which is multiplied by the family's phaseout rate of 15.5 percent (11.93 percent plus 3.57 obtain a credit reduction of $581. Thus, this family is eligible for an EITC of $968 ($1,549 minus $581).

HIGHER BENEFIT LEVELS IN 1992-1994

Credit rates will rise each year through 1994 under OBRA of 1990. When fully phased in, the basic credit maximums will be $1,642 and $1,785 for families with one and two children, respectively, in 1991 dollars. The credit phaseout rates will also rise yearly to maintain the same inflation-adjusted income eligibility level. These scheduled changes are shown in table 3.

             TABLE 3. SCHEDULE OF HIGHER EITC CREDIT RATES

            TABLE 4. EITC MAXIMUM CREDIT AMOUNTS, 1975-1995

Despite recent increases, the EITC is still properly viewed as an earnings supplement rather than a floor under income. The relative importance of the EITC to family income depends on the amount of the family's earned income and the level of its income from other sources. For a family with two children, earnings of $7,140 or less, and no other income, the EITC adds to family income by 17.3 percent. At an income level of $11,250, the EITC adds to family income by as much as 11.0 percent. Families above that income level receive smaller credits, the value reaching $0 when income reaches $21,245. The income used to offset the EITC is the greater of AGI or earned income in excess of $11,250.

Above the income level of $11,250, the mix of earnings and other income determines the relative importance of the EITC. For example, as shown in table 5, a family with $10,000 in income, all of which is earned, has an EITC worth 12.4 percent of total income, while a family with $10,000 in income, only half of which is earned, has an EITC worth only 8.6 percent of total income.

        TABLE 5. EITC AS PAYMENT OF FAMILY INCOME FOR DIFFERENT

PARTICIPATION AND COSTS

In 1990, the EITC was claimed by an estimated 11.3 million tax filers (table 6). Ninety percent of benefits were received as checks from Treasury for credits in excess of tax liability. The average yearly credit per filing unit was estimated to be $623.

The real cost of the EITC and the number of participants changed little from start-up in 1975 through 1986. However, 1986 legislation had a major impact. The increased credit amount effective in 1987 prompted a rise of 39 percent in the number of claimants. Benefit costs rose by 96 percent. Further growth occurred from 1987 to 1990, with costs rising another 80 percent and participant families rising by another 30 percent.

More growth is anticipated as a result of the 1990 law. Costs in 1992 are expected to be 34 percent above the 1990 level, although participants in 1992 are expected to exceed the 1990 level by only 2 percent.

      TABLE 6. TRENDS IN EITC COSTS AND BENEFICIARIES, 1975-1990

INTERACTION WITH OTHER PROGRAMS

The EITC amount can be affected by receipt of other types of assistance, since some public benefits are counted in AGI and thus serve to reduce the EITC benefit. For example, half of social security benefits above certain income levels and all unemployment benefits are included in AGI. On the other hand, need-based aid, such as AFDC and food stamps, as well as certain other benefits such as workers' compensation and veterans' benefits, are not included in AGI and do not reduce EITC eligibility.

The major need-based assistance programs have treated EITC benefits in a variety of ways over the life of the EITC. However, under OBRA of 1990, EITC benefits are not counted as either income or assets in determining eligibility or benefit amounts for the following programs: AFDC, ²² food stamps, medicaid, SSI, and low- income housing. Compared to rules applicable before 1988 ²³ that required need-based programs to count EITC as income or an asset, this policy increases the number of families eligible for need-based programs and increases the income available to families from the combination of EITC and need-based aid. As pointed out in the next section, however, this advantage to recipients leaves them facing higher tax rates on additional dollars of income as the higher benefit totals are reduced when income rises.

The dependent care tax credit (DCTC) is a nonrefundable credit that offsets part of the cost of child care for families below certain income levels. Since the Federal DCTC is not refundable, and since being able to spend cash for child care is a prerequisite for credit eligibility, the DCTC mainly serves a middle-class population, many of whom are above the income eligibility levels for the EITC. Those who do qualify for both EITC and DCTC can receive both, although the supplemental young child credit cannot be received by a family that is claiming the DCTC for the care of that same child. Since the EITC affects a lower income group than does the DCTC, the two credits are somewhat complementary in their effects by income class.

Several states have adopted refundable credits similar to the EITC. Wisconsin has a credit that is calculated as a percentage of the Federal EITC. Vermont has a refundable credit aimed at offsetting sales and use taxes for lower income taxpayers. Iowa has a refundable DCTC. Several states have nonrefundable credits that are otherwise similar to the EITC. These various state credits will enhance the work incentives and total incomes of workers below the phaseout income threshold but increase marginal tax rates and, hence, lower the work incentives of workers whose families are within the phaseout range.

Many employers offer employees the option of paying their health insurance premiums with before-tax salary dollars, thereby reducing their tax liability. However, persons who claim the EITC supplemental credit for health insurance premiums cannot also receive the tax preference through their employers. Thus, families will have to determine the best course of action at the beginning of each year, which may be difficult if the family's income for the year is hard to predict, since the amount of the supplemental credit will depend on annual earnings and AGI. The value of the employer tax exclusion for premium payments also depends on income since it is worth more, the higher the family's tax bracket. Another tradeoff has to do with timing. Use of the employer benefit tax preference provides immediate tax relief, while the health insurance tax credit can be claimed only on the end-of-year tax return.

EFFECT ON TAX RATES

The EITC was originally adopted as a work bonus, and it still serves that purpose. That is, it supplements the wages of workers in low-income families with children, adding to the earned income of a family as the worker's hours of work or wage rate rises. This aspect of the EITC reduces the family's effective tax rate and provides a positive incentive to work. However, the credit has to be reduced above some level of income to avoid an unaffordable policy of providing work bonuses for all workers.

When benefits are diminished as income rises, the rate of decrease is in effect an implicit tax rate, because an additional dollar of AGI yields a gain of less than a dollar in net disposable income. In 1991, the EITC has an implicit tax rate of 11.93 percent (12.36 percent for families with at least two children). When the 1990 law is fully implemented in 1994, this implicit EITC tax rate will be 16.43 percent (17.86 percent with two or more children). This tax rate affects eligibles with AGI in excess of $11,250 up to an AGI of $21,245 (in 1991 dollars).

This implicit EITC tax rate adds to the tax rates from Federal and State income taxes and the social security tax and thus diminishes the incentive to increase income over the affected range. For example, a tax filer in the 15-percent Federal income tax bracket ²⁴ who pays the 7.65-percent social security tax and has an effective State tax rate of 5 percent faces a marginal tax rate on the next dollar earned of 27.65 percent. If this person were eligible for the EITC, the implicit tax rate would raise the family's total marginal tax rate to 39.58 percent now, or 44.08 percent in 1994 (40.01 and 45.51 percent, respectively, with two or more children).

Eligibility for the supplemental credits raises these tax rates to higher levels. The phaseout of the young child credit adds another 3.57 percentage points; phaseout of the health insurance credit adds 4.285 points. Thus, in 1994 a family with two children that receives all possible credits will have a total marginal tax rate in the phaseout income range of 53.365 percent.

These new EITC tax rates are higher than those that applied under prior law. The combined tax rate in 1990 was 37.65 percent, or 6.43 percentage points less than the level that will pertain to families with one child in 1994, 7.86 points less than the two-child family's rate, and 15.715 points lower than the rate for a family eligible for all credits.

Welfare programs such as AFDC and food stamps also "tax" income, since the benefits from these programs decline as a recipient's income rises. The 1990 OBRA completes the decoupling of these programs from the EITC in regard to benefit calculation. That is, the EITC is not counted in computing AFDC or food stamp entitlements. One effect of this policy is that the "tax rates" of the welfare programs are additive to that of the EITC since a rise in income offsets both welfare and EITC benefits simultaneously without any compensating interaction between them. This tax rate addition occurs in the EITC phaseout income range, which starts above $11,250. Few AFDC recipients retain AFDC eligibility at that income level (only those with large families living in high-payment states). However, some food stamp recipients do have incomes above that level. Since the food stamp tax rate is about 30 percent, the total marginal tax rate for a person receiving food stamps and in the EITC phaseout range will be about 75 percent in 1994.

POLICY ISSUES

WORK INCENTIVES

The 1990 expansion of the EITC, by raising benefits but keeping income eligibility levels constant, has raised significantly the marginal tax rates faced by families within the phaseout income range. As families in this situation find that obtaining a better paying job or having another family member begin employment gains them less of a marginal increase in after-tax family income than expected, criticism of the new rules may be heard. Congress may come under pressure to alleviate this situation by easing the phaseout rates, which would increase the cost of the EITC.

EXPANSION OF TAX CREDITS TO CREATE INCOME FLOOR

Some people advocate a greater amount of income redistribution within the income tax system. One way to accomplish this goal would be to replace the personal exemption (now $2,150 per person) with a refundable credit. A credit is worth the same to each person, whereas the personal exemption is worth more the higher the tax rate and is worth nothing for those with no tax liability. A large personal credit would provide a substantial floor under the income of all persons defined as eligible for this credit.

Such a reform might call for elimination of the EITC as an offset to the cost of the income floor. However, this approach to income maintenance would differ greatly from the EITC since it would not embody the EITC characteristic of positive work incentives for families with little or no earnings.

EXTENSION OF EITC TO SINGLES AND CHILDLESS COUPLES

The EITC was born in an environment focussed on reforming welfare policies for families with dependent children. (Federal cash welfare is restricted to households with children unless a member is aged, blind, or disabled.) Congress may want to consider adapting the EITC to other groups. Some version of the EITC might be considered to help single people or childless couples in order to provide those who are out of work with a work incentive or to boost the earnings of those who work at low wages.

ROLE OF DEPENDENT CARE TAX CREDIT

Since the DCTC is not refundable, it is of limited use to families with little or no income tax liability. Several bills in the 101st Congress would have made it refundable, including President Bush's child tax credit proposal. The Senate version of H.R. 3 would have made 90 percent of the DCTC refundable. However, final action on OBRA of 1990 left the DCTC unchanged as a nonrefundable credit.

Making the DCTC refundable would force congressional attention to its interaction with the EITC. Some policymakers would argue that a refundable DCTC would be duplicative of the EITC since one argument for expanding the EITC in 1990 was to allow families more disposable income with which to make the child care arrangements of their choosing.

AVAILABILITY OF THE EITC TO MILITARY FAMILIES

Current law restricts the EITC to families residing in the United States. This rule has excluded lower income military families living in foreign countries from EITC eligibility. Legislation was proposed in 1990 to cover families outside the United States if such residence is because of a military assignment.

COMPLEXITY OF TAX RETURNS

The complexity of Federal income tax returns is a problem for many taxpayers, though the process has been simplified for some since the Tax Reform Act of 1986. However, the 1990 law now requires a person to file a separate form to claim the EITC, which adds an extra step for those who want to receive this benefit. The two supplemental credits also make the return more complicated. Some advocates for lower income families fear that complexity of filing will depress program participation.

ERROR RATES IN EITC CLAIMS

In 1990 it was disclosed by IRS that the error rate in filing for EITC was unacceptably high. Tax data from 1985 showed that almost 40 percent of claimants were technically ineligible in that year. Errors in filing seemed to be caused largely by the misunderstanding of a requirement that a filer must have maintained a financially independent household while supporting a child to qualify for EITC.

Legislators attempted to resolve this problem in OBRA of 1990 by eliminating "head of household" tax status as a consideration in deciding EITC eligibility. Instead, a three-part test was established: the relationship of the child to the filer, residency of the child with the filer, and the child's age determine whether a child qualifies a filer for the EITC. Should high error rates persist, Congress will likely take another look at what might be needed to bring error rates under control.

² Congressional Record. Senate. In remarks by Mr. Long. Sept. 30, 1972. p. 33010.

³ Ibid., p. 33010.

⁴ Ibid., p. 33011.

⁵ U.S. Congress. House. Committee on Ways and Means. Tax Reduction Act of 1975. Report Together With Supplemental and Minority Views to Act Company H.R. 2166. Feb. 25, 1975. House Report No. 94- 19, 94th Cong., 1st Sess. Washington, U.S. Govt. Print. Off., 1975. p. 10.

⁶ U.S. Congress. Senate. Committee on Finance. Tax Reduction Act of 1975. Report to Accompany H.R. 2166. Mar. 17, 1975. Senate Report No. 94-36, 94th Cong., 1st Sess. Washington, U.S. Govt. Print. Off., 1975. p. 11.

⁷ Ibid., p. 33.

⁸ Congressional Record. Senate. Mar. 18, 1975. p. 7230.

⁹ Congressional Record. House. Feb. 27, 1975. p. 4601.

¹⁰ Congressional Record. Senate. Mar. 21, 1975. p. 8061.

¹¹ In such States the EITC was treated as earned income and thus was eligible for the AFDC earned income disregards. Therefore, there was no dollar-for-dollar reduction in AFDC benefits for EITC benefits received.

¹² U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Act of 1978. Mar. 12, 1979. Washington, U.S. Govt. Print. Off., 1979. p. 51.

¹³ U.S. Congress. House. Conference Committee. Revenue Act of 1978. Report to Accompany H.R. 13511. Oct. 15, 1978. House Report No. 95-1800, 95th Cong., 2d Sess. Washington, U.S. Govt. Print. Off., 1978. p. 200.

¹⁴ U.S. Congress. Senate. Finance Committee. Revenue Act of 1978. Report to Accompany H.R. 13511. Oct. 1, 1978. Senate Report No. 95-1263, 95th Cong., 2d Sess. Washington, U.S. Govt. Print. Off., 1978. p. 52.

¹⁵ According to congressional staff, the $5,714 figure was chosen because it represented an $800 maximum EITC benefit in 1984 dollars.

¹⁶ The phaseout rate, analogous to a marginal tax rate, is the share of each additional dollar of income that is used to reduce the EITC.

¹⁷ Congressional Record. Senate. In floor statement of Senator Matsunaga. Daily Edition, Sept. 26, 1986. p. S13818.

¹⁸ In this report, the income levels where the EITC is reduced to $0 were computed using the formulas for credit amount and credit phaseout established in the law. These mathematical "break even" income levels may differ slightly from those promulgated by the IRS in the EITC tables that will be developed by IRS for tax filers to use in determining EITC entitlements.

¹⁹ Few workers receive payment this way. Health insurance credits cannot be received in this manner.

²⁰ U.S. Dept. of Commerce. Bureau of the Census. Measuring the effect of Benefits and taxes on Income and Poverty; 1989. Current Reports. Series P-60, No. 169-RD. Washington, U.S. Govt. Print. Off., 1990.

²¹ Scholz, John Karl. The Participation Rate of the Earned Income Tax Credit. Institute for Research on Poverty. Discussion Paper No. 928-90. University of Wisconsin-Madison, Oct. 1990.

²² Before passage of OBRA of 1990, an AFDC parent generally was ineligible for EITC unless her earnings exceeded the AFDC grant, thereby conveying "head of household" tax filer status on the parent.

²³ The Family Support Act of 1988 (P.L. 100-485) and the Hunger Prevention Act of 1988 (P.L. 100-435) ended the counting of EITC for most AFDC and food stamp cases.

²⁴ Some families with AGI above $11,250 have no Federal income tax liability and hence no 15-percent income tax rate. For example, joint filers with two children pay no income tax unless their AGI exceeds $14,300.