CRS REPORTS ON EITC LEGISLATIVE PROPOSALS.

                    THE EARNED INCOME TAX CREDIT:

The earned income tax credit (EITC) is a refundable Federal income tax credit designed to supplement the earnings of lower-income workers. Several proposals are being considered to reduce the EITC's cost, which has grown rapidly in recent years as a result of legislated expansions in 1986, 1990, and 1993. Proposed cuts have been approved in both the House and the Senate versions of the Seven- Year Balanced Budget Reconciliation Act of 1995 (H. R. 2491). The House proposals would save $23.3 billion from the projected cost of the EITC over the next 7 fiscal years; the Senate proposals would save $43.2 billion over that period. One proposal recommended in the President's FY1996 budget to curb EITC costs already has been enacted. It will save $2.0 billion over the next 5 fiscal years. Welfare reform legislation (H.R. 4) now in a House-Senate conference, though not changing the EITC directly, would eliminate a prohibition against States' offsetting families' welfare benefits by the EITC amounts they receive. Finally, action started by Congress to obtain a more accurate measure of annual inflation may have the effect of reducing future costs of benefits such as the EITC that are automatically adjusted for inflation.

BACKGROUND ¹

The EITC, a refundable income tax credit designed to increase the earnings of lower-wage workers, has been increased substantially on three occasions in the past 10 years. In the Tax Reform Act of 1986 (P.L. 99-514), credit amounts were increased and indexed for inflation. In the Omnibus Budget Reconciliation Act (OBRA) of 1990 (P. L. 101-508), credit amounts were increased further, with even higher credit levels set for families with two or more children. In OBRA of 1993 (P.L. 103-66), credit amounts for families with children were increased substantially in response to an initiative by President Clinton to eliminate poverty for families with full-time workers. That law also established small EITC benefits for childless adults ages 25 through 64.

The higher benefits enacted in 1993 were to be phased in over tax years 1994 through 1996. In 1996, the maximum credit for a family with two children will be over six times the maximum that applied in 1986 before the legislated increases noted above. Even after adjusting benefit levels for the effects of inflation, the 1996 benefit level will be 4.5 times that for 1986. The cost to Government of the EITC will be an estimated $25.8 billion for tax year 1996, more than 12 times the 1986 cost.

PROPOSALS IN THE 104TH CONGRESS

Proposals under consideration in the 104th Congress would affect the EITC. First, two different packages of EITC cost-saving initiatives, both of which include a Presidential proposal to keep undocumented workers from qualifying for the EITC, have been included in the House and the Senate versions of the Seven-Year Balanced Budget Reconciliation Act (SYBBRA) of 1995 (H. R. 2491). Second, President Clinton proposed legislation to restrict EITC eligibility for workers with substantial asset income, and a version of his proposal has already been enacted. Third, welfare reform legislation, now in a House-Senate conference, while not changing the EITC directly, could have important indirect effects on EITC by permitting States to offset their welfare costs with Federal EITC funds. Finally, a change in the way inflation is measured is being considered to reduce the budget deficit, and such a change would affect automatic annual adjustments in EITC benefits and eligibility.

EITC Reductions in SYBBRA of 1995

In assembling legislative proposals to comply with the FY1996 budget resolution, Congress considered numerous measures to reduce EITC costs. This legislation, SYBBRA of 1995, was approved by the House on Oct. 26, 1995, and by the Senate on Oct. 27, 1995. The EITC provisions of these bills are described below. The proposals would take effect beginning with the 1996 tax year. The House proposals would save an estimated $23.3 billion over FYs 1996-2002, or about one-eighth of the current-law cost of the EITC. More than three- fourths of these savings ($17.8 billion) would be from reduced outlays, and $5.4 billion would come from increased revenue. ² The Senate proposals would save $43.2 billion over FYs 1996-2002 ($32.6 billion from reduced outlays, $10.7 billion from increased revenue).

ELIMINATE EITC FOR CHILDLESS ADULTS. Both versions of H.R. 2491 would eliminate the small EITC (maximum of $314) available for childless tax filers, ending a benefit that has existed for only 2 years. Its purpose is to offset payroll taxes for low-wage workers between the ages of 25 and 64. Repeal would save $4.2 billion over FYs 1996-2002.

BROADEN DEFINITION OF INCOME FOR EITC PHASEOUT. Currently, the EITC is phased out when the greater of earnings or adjusted gross income (AGI) exceeds a certain threshold level ($11,290 in 1995 for families with children). Broadening the definition of income used in phasing out the EITC would reduce EITC benefits for persons with income from the untaxed sources to be included. The House proposal would count nontaxable Social Security benefits and nontaxable distributions from pension plans, annuities, and individual retirement accounts. The Senate proposal would go further, counting all tax-exempt interest and child support payments in excess of $6,000 a year and excluding net operating losses, capital losses, and net losses from rents and royalties. Critics argue that these changes would lessen incentives to accumulate savings and be unfair to affected beneficiaries. The House proposal would save $9.3 billion over the 7-year projection period; the Senate proposal would save $12.2 billion.

RAISE EITC PHASEOUT RATES. The rate at which the EITC is phased out for filers with income above a certain level specified in law ($11,630 in 1996) would be increased by the House proposal from 15.98% to 18% for families with one child and from 20.16% to 23% for larger families. The Senate proposal would change the phaseout so that the dollar income interval over which the EITC is phased out would remain the same. Thus, the effective phaseout rate would rise over time as the credit amounts grow from inflation adjustments. Both proposals would raise the effective marginal tax rates for affected families and, by lowering the income level at which EITC eligibility ends, decrease the number of families eligible for the EITC. (For example, under the House proposal EITC eligibility for a family with one child in 1996 would end when income reaches about $23,500, compared to $25,000 under current law.) The House proposal would save $8.7 billion over the 7-year projection period; the Senate proposal would save $16.4 billion.

DENY EITC TO UNDOCUMENTED WORKERS. This proposal, a version of which was offered by President Clinton, is in both versions of H.R. 2491. It would require tax filers to have valid taxpayer identification numbers (usually Social Security numbers) to be eligible for the EITC. Social Security numbers are issued only to persons with documentary evidence of age, identity, and U.S. citizenship or legal alien status. The proposal would make it easier for the Internal Revenue Service to obtain compliance from taxpayers lacking valid numbers before accepting their EITC claims. It would save $1.6 billion over the 7-year projection period.

REPEAL OF 1996 CREDIT INCREASE. Legislation passed in 1993 (P. L. 103-66) included a major expansion of the EITC as part of a Clinton Administration initiative to "make work pay." The purpose of the EITC expansion was to assure that a family of four with a full- time worker would have a total income above the poverty level. This expansion was planned in three stages for tax years 1994, 1995, and 1996. Only the last stage remains to be implemented. The Senate proposal would cancel the 1996 EITC increase, thereby retaining the 1995 credit rate for families with two or more children at 36% instead of letting it rise to 40% under current law. The goal of poverty elimination for these working families would not be reached. The maximum credit for these families, $3,110 in 1995, would rise to an estimated $3,556 in 1996 under current law. Without the 1996 increase, the maximum credit would rise only by the amount of inflation, to $3,208. This proposal would have no effect on smaller families, however. This change would save $12.8 billion.

DISQUALIFIED INCOME. Congress acted in March 1995 to disqualify from EITC any claimants with certain "disqualified income," defined to be income in excess of $2,350 a year from taxable interest, tax- exempt interest, dividends, and net rents and royalties. The Senate proposal would include capital gains and passive income in this disqualified income test. Tax-exempt interest and net losses from rents and royalties would be removed from this test and instead counted with AGI for purposes of the EITC phaseout.

PENALTIES FOR TAX PREPARERS. Tax preparers may be penalized under civil law with fines ranging from $50 to $1,000 for errors, omissions, misrepresentations, and malfeasance. The Senate proposal would double these penalties for preparers of returns that claim the EITC illegitimately.

EFFECTS OF SYBBRA PROVISIONS. ³ The immediate effect of these proposals would be to reduce the number of tax filing units eligible for the EITC in 1996 by about one third. Since all childless units would be excluded, the reduction in eligible units with children is only 7% under the House bill and 9% under the Senate bill. This reduction in eligible families with children would grow over time (to 19% in 2002) under the Senate version because of its stricter provision for the credit's phaseout.

The size of the average credit for eligible families with one child would be cut by about one-tenth in 1996, a loss that would grow to 18% by 2002 under the Senate bill. For eligible families with more than one child, the average reduction would be only 7% under the House bill compared to 19% under the Senate bill. This latter estimate would grow to 27% for the Senate bill by 2002.

If the $500 per child tax credit also proposed in SYBBRA of 1995 is taken into account, that new credit would offset the loss in the EITC on average under the House bill for families of all sizes, and it would offset the loss for families with one child under the Senate bill. However, larger families with more than one child would still lose benefits, on average under the Senate bill in 1996, and families of all sizes would lose benefits, on average, by 2002.

DENIAL OF EITC TO WORKERS WITH SUBSTANTIAL INVESTMENT INCOME

The President's FY 1996 budget proposed denying the EITC to workers who, though qualified because of low or modest earnings, have substantial financial assets such as stocks and bonds. The approach proposed was to deny eligibility for filers with taxable interest and dividend income in excess of $2,500 a year, effective in tax year 1996. The $2,500 limit would have been adjusted annually for inflation. The President's budget estimated savings of $1.4 billion from his proposal over the period FYs 1996-2000, of which $1.1 billion would come from reduced outlays and $0.3 billion from increased revenue.

The EITC is reduced currently when a filer's AGI exceeds $11,290. It is phased out completely when AGI reaches $24,396 ($26,673 for families with two or more children). Thus, persons with substantial income from taxable sources are already ineligible for the EITC. The position taken in this policy change is that, despite the existing phaseout of the EITC based on AGI, workers with low earnings who have substantial financial assets should consume part of these assets before receiving the EITC earnings subsidy. Stated another way, policy makers did not consider it important to supplement the income of, or encourage greater work effort by, family heads with substantial financial assets.

A version of the Clinton proposal was included in H.R. 831, a bill to reinstate the tax deduction for health insurance premiums paid by the self-employed. The inclusion of the EITC change served to offset part of the cost of reinstating the health insurance deduction. The House passed this bill on Feb. 21, 1995, and the Senate passed its version on Mar. 24, 1995. The President signed it into law (P.L. 104-7) on Apr. 11, 1995. The Joint Committee on Taxation estimated that the EITC provisions of P.L. 104-7 will reduce EITC costs by $2.0 billion over the period FYs 1996-2000. Most of the savings will be realized in reduced outlays ($1.6 billion), with only $0.4 billion expected from increased revenue.

The enacted version of this EITC proposal differed from the President's proposal in three ways: (1) the phaseout of the EITC begins when asset income exceeds $2,350; (2) this phaseout income threshold will NOT be adjusted for inflation; and (3) the investment income to be considered in reducing the EITC was broadened to include all interest income, INCLUDING TAX-EXEMPT INTEREST, AND NET INCOME FROM RENTS AND ROYALTIES.

This EITC change creates an "income notch." It will cause a family to lose its entire EITC if its interest and dividend income rises from $2,350 to $2,351. The House-passed version of H.R. 831 addressed this notch problem by spreading out the EITC loss over a $650 range of interest and dividend income, but it would not have eliminated the notch completely. The Senate did not address the notch problem, and the final bill did not accept this House provision.

WELFARE REFORM PROPOSALS

The welfare reforms pending before a House-Senate conference committee focus on changes to Aid to Families with Dependent Children (AFDC), but the relationship between welfare and the EITC could also be changed. Federal law requires that the EITC not be counted as income in determining eligibility or benefits for AFDC, Food Stamps, Medicaid, Supplemental Security Income, or assisted housing. Also, lump-sum receipt of EITC must be ignored in comparing an applicant's or recipient's assets to a program's asset limits for the month of receipt and the following month. (The Food Stamp program must ignore lump-sum EITC payments for 12 months.) Pending welfare reforms would change these rules.

The welfare reform bill (H.R. 4) passed by the House on Mar. 24, 1995, would end the AFDC program and, thus, eliminate the law that restricts how States treat the EITC for AFDC recipients. Under this bill, a State could elect to count all or part of the EITC as income available to a family receiving aid from the AFDC-replacement program and reduce those benefits accordingly. Lump-sum EITC receipt could be treated by a State as an asset immediately available to a family receiving State aid, which would exclude families from that aid if inclusion of the EITC with their assets caused their assets to exceed the State's asset ceiling. States might be motivated to count the EITC as available income or assets because this policy would allow them to spend less on aid to needy families from their Federal grants, in effect substituting the federally funded EITC for part of the States' welfare costs and lowering the net income of affected recipients.

The version of H.R. 4 passed by the Senate on Sept. 19, 1995, would yield the same result as the House version for AFDC. In addition, the Senate bill would allow States to include Food Stamps in their block grants, thereby permitting States to offset Food Stamp benefits for EITC received as well.

CHANGES IN THE CONSUMER PRICE INDEX

Benefits from several Federal programs are adjusted automatically each year to offset the effects of inflation on benefit values, as are certain factors important to the determination of Federal income tax liability. It has been suggested that the index used to measure price increases, the Consumer Price Index (CPI), overstates inflation. The CPI reflects the prices for a fixed market basket of goods and services over a 10-year period. It does not capture the reality that consumers constantly change their mix of purchases as relative prices change. Also, it does not reflect the improvements in the quality of purchased goods and services over time.

If the CPI were adjusted accordingly, projected budget deficits would be smaller because indexed spending would be smaller and income tax revenue would be larger than under current practice. The FY1996 congressional budget resolution assumes that a methodology will be developed for the CPI to reduce any overcompensation for inflation and will reduce the budget deficit starting in FY1999. The resolution assumes that the annual change in the revised CPI will be 0.2 percentage point lower than the change in the CPI as now computed.

If the inflation index were changed, the EITC would be affected. Annual adjustments are now made in the maximum earnings subject to the credit and the AGI level above which the EITC is phased out. Compared to current law, measures to limit inflation indexing would: (1) restrain growth in EITC amounts; and (2) reduce the number of eligible filers.

² The EITC is a refundable credit. If the credit exceeds a filer's tax liability, the Government sends a check to the filer. Credits IN EXCESS OF tax liability are treated as outlays in the Federal budget. Credits that serve to REDUCE tax liability are treated as reductions in revenue. Thus, EITC proposals usually affect both outlays and revenue.

³ Based on an analysis of the March 1995 Current Population Survey by Thomas Gabe of the Congressional Research Service.