Prior blogs in our series giving an advance look at the Center for Taxpayer Rights’ Reimagining Tax Administration workshop briefs have covered the characteristics of the Earned Income Tax Credit/Advance Child Tax Credit population and the impact of administrative burden on that population’s ability to claim and receive those credits. You can read the first two blogs here and here.
In Part 1 of this workshop’s coverage, we analyzed whether the eligibility rules for tax benefits targeted to low income households actually fit the characteristics of the target population and whether those rules caused some eligible children not to receive the benefits. Today we explore what are the risks that might arise in using the tax system to deliver these benefits to that population, how other countries have tried to come up with approaches that minimize that risk, and why, even given the risks, we might still want to run such programs through the tax code. All of the workshop sessions are recorded, and the videos are available here on the Center’s website, along with slide decks and other materials.
Avoiding repayment risks in the Child Tax Credit: Lessons from the UK, Australia, New Zealand, and Canada
Presented by Kathleen Bryant, Legal Research Associate & Chye-Ching Huang, Executive Director, The Tax Law Center, New York University
Refundable credits, particularly those with an advance payment feature and eligibility determined retroactively, can pose a “repayment risk.” Based on evidence from United Kingdom, Australia, and New Zealand, repayment risks can create program instability and financial hardship. Taxpayers may be required to pay back some or all of the benefit received due to changes in income or family circumstances. While safe harbors can mitigate some of the financial harm, substantial repayment risk can undermine political and public support for the program.”read
Generally, there are three approaches to minimizing repayment risk that have been employed internationally (or proposed in the United States). (More information on avoiding repayment risks internationally can be found here.)
- The government can require repayment with some protections in place for taxpayers. This is the case in the United Kingdom, Australia, New Zealand, and the United States (for 2021).
In the United Kingdom between 2003 to 2004 and 2005 to 2006, about one-third of all tax credit awards were overpaid, with income fluctuation accounting for 70% of the overpayments and delays in reporting changes in family circumstances accounting for about 30% of repayment obligations. Requiring repayment created financial hardship for families in the UK: as a result, over 25% of overpaid taxpayers owed the government more than £2,500 and 10% owed the government more than £5,000. Seventy-one percent of overpaid taxpayers reported that the obligation to repay the government caused financial difficulty, with some reporting that they went without basic needs so they could make payments back to the government.
In addition to causing financial hardship, credit repayment obligations in the UK discouraged taxpayers from claiming the credit in future years. Credit repayment debt affected the government as well, creating administrative instability with ineffective fixes. Further, while initially UK had large safe harbors to account for income variation from year to year, these safe harbors were reduced over time.
- The government can eliminate income-based repayment obligations but can require reconciliation when family circumstances change. This is the option adopted in Canada.
Unlike that in the UK, the Canadian child tax credit is based on prior year income, meaning that changes in circumstances during the current year do not create repayment obligations during that year. However, if a taxpayer fails to immediately report changes in family circumstances, the delay may cause steep repayment obligations and subsequent financial hardship.
- The government can create presumptive eligibility rules, implement a grace period for reporting updates, and allow for an income lookback period to protect against all repayment methods.
The repayment structure proposed by the House Ways & Means Committee in the Build Back Better Act provides another approach to repayment obligations. The proposal includes monthly eligibility, an income “lookback,” and presumptive eligibility with a grace period for reporting changes in income and family circumstances. (Note that under the proposal, the new caregiver has the responsibility to apply for the monthly credit when the care-giving circumstances change.) Similar to the UK, New Zealand, and Australia, this proposal includes a safe harbor provision that would cover some or all of the excess, meaning a qualifying taxpayer could be protected from repaying any CTC amount overpaid by the government. However, the safe harbor only applies to changes in the number of qualifying children, and not to other changes such as change in filing status or income.
While repayment risks associated with refundable credits are a concern, the administrative remedies can a high burden on honest/accurate filers. Refundable tax credits account for 10% of the tax gap, with EITC constituting only 6% of the tax gap and the CTC/Additional CTC comprising only 2%, yet they receive more negative media attention than other contributors, such as underreporting business income tax (25%). Further, as noted earlier, improper refundable credit payments are reported twice – first as part of the tax gap and then as improper payments. This imbalance in scrutiny leads to adoption of more complex rules which can, in turn, result in more mistakes and overclaims, thereby increasing repayment risk.
District of Columbia Earned Income Tax Credit
Presented by Elena Fowlkes, Program Manager, Office of the Taxpayer Advocate, DC Office of Tax and Revenue
The District of Columbia’s Earned Income Tax Credit (DC EITC) provides an alternate approach to refundable credits that the federal government can study to improve its administration of the EITC and other refundable credits. Although the DC EITC piggybacks off of the federal EITC, the program has been greatly expanded and will continue to grow in the future.
For families with qualifying children, the DC EITC started at 10% of the federal credit in 2001 and increased to 40% in 2009 and more than 75% beginning in 2022. The DC EITC for childless workers has been a particular focus of the DC Council, in response to the DC Tax Revision Commission’s 2014 recommendations, and is more generous than the federal credit. Specifically, in 2015 the DC EITC not only increased the benefit for childless workers (100% of the federal credit as opposed to the prior 40%) but also raised the Adjusted Gross Income (AGI) threshold above the IRS maximum ($25,833 for DC versus $15,820 for IRS, with ongoing inflation adjustments), to account for the higher cost of living in the District of Columbia. Further, the DC EITC includes a component for non-custodial parents. In 2015, after the adoption of the changes for eligible childless workers and non-custodial parents, DC saw an increase of 10,000 claims, or nearly 27%.
The DC EITC is scheduled to expand even further in the coming years. Set at 70% of the federal EITC for Tax Year (TY) 2022, the credit is scheduled to increase to 85% for TY 2025 and 100% of the federal EITC by TY 2026. Additionally, beginning in 2022, 40% of the DC credit will be paid up-front, and the remainder of payments, if over $600, will be paid in eleven monthly installments. Beginning in 2023, all DC EITC refunds over $1,200, including those to childless workers, will be paid out in monthly installments. Recently, DC approved the use of Individual Taxpayer Identification Numbers (ITINs) for taxpayers claiming the DC EITC.
One downside to basing the DC EITC on the federal EITC is that it incorporates all the complexity housed in the federal rules. Moreover, if the IRS disallows the federal EITC as a result of a math error or an audit, DC law requires the DC taxpayer to file an amended return reflecting the IRS disallowance of the EITC. Further, the DC Department of Revenue can independently audit the taxpayer’s DC return and disallow the DC credit. Thus taxpayers navigating the complex credit eligibility rules can face a significant repayment risk, as well as the potential administrative burden of two audits.
Issues with Delivering Benefits Through the Tax Code
Presented by Cathy Livingston, Partner, Jones Day
As the foregoing presentations make clear, there are challenges with delivering family benefit and anti-poverty programs through the tax code. For example:
- Retrospective filing requirements limit the reach of these programs. Generally, most individuals report their income to the IRS once at the end of each year; thus, the agency must rely on outdated information on income, filing status, and the presence of qualifying children. Moreover, low income individuals are not required to file at all, so the IRS lacks even an annual snapshot of these individuals’ household information. Because these individuals may still be eligible for the credits, they will be forced into an affirmative interaction with the tax agency that would otherwise not be required.
- Congress and the IRS view the IRS’s primary role as a revenue collector. Many existing definitions and processes reflect this role, which can be difficult to reconcile with benefit administration.
- The IRS does not have real time information regarding income, marital status, employer health insurance coverage – information that is necessary for targeting benefits more closely to the time of need.
- Even when a taxpayer may be eligible for a tax refund from a benefit program, the IRS may offset that refund against a past federal tax debt and federal law requires the IRS to offset the refund for certain other outstanding federal and state debts unless a specific exception applies.
- Finally, there is the culture issue: a lack of resources (or a lack of willingness to dedicate resources) for education and outreach limits the IRS’ ability to reach the most vulnerable taxpayers. Further, the IRS views itself as an enforcement agency; the emphasis on improper payment reporting plays into the IRS enforcement culture.
Given all these challenges, why even attempt to administer social benefits through the tax code? One answer is found in the U. S. Constitution, Article 1, Section 9, Clause 7, which states that no monies can be drawn on the Treasury except where appropriated. The impact of this appropriation requirement for discretionary spending is that funds are appropriated on an annual basis and are subject to political winds. Even with mandatory spending such as appropriated entitlements, they periodically expire (e.g., Children’s Health Insurance Program expired for 114 days between 2017-2018, and is now funded through FY 2023).
To complicate matters further, Congress at times may “disappropriate” funding for provisions it has previously passed. This happened with the Risk Corridor Payments enacted by the Affordable Care Act (42 USC 18062), which provided for insurers’ net losses attributable to pricing risks to be paid out of program management appropriations. In 2015, Congress passed a rider to the annual appropriations bill prohibiting use of program management appropriations for this purpose. In Maine Community Health Options v. United States, 140 S.Ct. 1308 (2020), the U.S. Supreme Court acknowledged the validity of the rider but held that insurers could sue for payment under the Tucker Act and if successful, the obligations would be paid as a debt of the United States.
In recent years, there have been occasions when all or some of the annual appropriations bills have not been enacted by the start of the fiscal year, leading to what is commonly known as a “government shutdown.” Under 31 USC 1324, certain tax refunds and tax credits are considered “permanent indefinite appropriations” and shall be paid out regardless of a lapse in annual appropriations. These include credits included in the Internal Revenue Code before 1978 (such as the EITC), as well as the Child Tax Credit and the Premium Tax Credit.
Thus, one motivation for running social benefit programs through the Internal Revenue Code is to avoid the disruptions of the annual appropriations process or disappropriation of entitlement spending.
CONCLUSION: How to Balance the Trade-offs?
As currently structured the IRS is in a difficult position for administering social benefit programs: it is set up to collect the pennies owed. It is uncomfortable with designing tax procedures that adopt a “rough justice” approach, whereby IRS can show flexibility in administration toward taxpayers who are acting in good faith and are tripped up by the complexity and rigidity of the law. Moreover, the inflexibility and precise targeting of definitions in current law create repayment risk.
One way to minimize complexity is to provide a universal benefit. This approach eliminates gaming. Another approach is utilized in Australia, where the child benefit can be divided between two main carers, with a default set at 50-50, subject to a different division agreed to between the parties. Such division has the additional benefit of encouraging both parents to be involved with the child.
Canada has adopted a different eligibility rule: the person with primary responsibility for the child’s care is eligible to receive the credit. This approach maximizes access for families in flux rather than adopting rigid relationship and residency rules. But it may also require more administrative capacity than the IRS currently allocates to credit administration as well as program navigators. Even without legislative reform, the IRS can learn from other federal agencies and other countries in order to effectively administer social programs. It needs to increase its administrative capacity, train its staff in social welfare skills, and accept that because it does not have residence or carer information, it must tolerate some improper payments in order to successfully disburse the benefits to the eligible population. (For a discussion of the cultural changes necessary for the IRS to administer social benefit programs, see Workshop VI.)
- Eliminate the requirement to include overpayments of the Earned Income Credit and other family-based refundable credits from reporting as improper payments under the IPIA. (These overpayments are already accounted for in tax gap calculations.)
- Absent making the child tax credit universal, Congress should consider adopting a “primary care giver” definition for purposes of determining eligibility for family tax benefits. Congress should further consider allowing two main carers to receive the tax benefit, to be divided 50-50 unless otherwise agreed to.
- If an advance payment mechanism is enacted, Congress should include a reasonable safe harbor provision; allow a grace period for change-of-circumstances reporting; provide a look-back or income averaging to account for income volatility; authorize the sharing of residency and caring data from state and local agencies; and provide funding for a cross-agency network of navigators that work with beneficiaries of all social benefit programs, including the EITC and CTC.