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Background on the EITC

By Shai Akabas, Brian Collins

Thursday, April 24, 2014

The Earned Income Tax Credit (EITC) is a federal tax provision that supplies a valuable benefit to low-income, working Americans. The credit is held in high esteem by Republicans and Democrats alike because it incentivizes work by subsidizing take-home pay for low-income workers. The EITC’s generosity has been increased under presidents from both parties.

Policymakers have a number of qualms about the program, however, including: its complicated structure; the limited benefit that it provides to workers without children (including non-custodial parents); the fact that its payments are made as a lump sum; the work disincentive that it carries for those who are in the phase-out range of the credit; and its susceptibility to error and fraud.

As a result, although many people believe that the EITC is an important part of the tax code, many of those same people also want to change it. This post provides background on the structure of the current EITC and its strengths and weaknesses.

The Current EITC

The EITC is designed to supplement the wages of low-income workers. The value of the credit is based on the worker’s earnings, and the tax liability of an eligible worker is lowered by this value. Because the ETIC is fully refundable, taxpayers with no income tax liability, or income tax liability less than the value of the credit, receive the balance in the worker’s annual tax refund. The EITC is only available to workers with valid Social Security numbers, so immigrants who are undocumented cannot claim the EITC.

To call the calculation of the EITC complex would be an understatement. The credit is worth a particular percentage of earned income (i.e., income from work, such as wages, tips, and salary) up to the maximum amount, is worth a flat amount up to a certain income threshold, and then gradually phases out past that threshold. The phase-in rate, phase-out rate, and maximum credit are determined by the number of children that the filer has, while the point that the credit begins to phase-out depends on whether the filer is married (along with the number of children).

For example, in 2014, a single parent with one child will get a credit of 34 percent on their first $9,720 of earned income, providing up to a maximum of $3,305. They will receive $3,305 if their income is between $9,720 and $17,830. If they earn more than $17,830, the value of the credit will be reduced by 15.98 percent of any income that they earn above the threshold until the value reaches zero. The graph below illustrates the value of the credit to various cohorts for 2014.

Earned Income Tax Credit

Why to Like the EITC

Policymakers on both sides of the aisle generally like the EITC because it provides significant benefits to low-income families without the work disincentives of some other programs that do the same.1 In 2013, the EITC was worth a total of $60.9 billion to American workers. Of that, the vast majority – $53.2 billion – came in the form of refunds that exceeded workers’ tax liabilities.

Furthermore, the program is a powerful tool for alleviating poverty. The Center on Budget and Policy Priorities estimates that in 2012, the EITC kept 10.1 million Americans out of poverty (according to the supplemental poverty measure), 5.3 million of whom were children. And the positive impacts of the wage subsidy provided by the EITC on employment, labor supply, and earnings for workers with children (particularly single mothers) are well documented.2

There is also significant evidence that the EITC provides benefits that go well beyond putting more money into workers’ pockets. A number of studies have found that parental receipt of the EITC improves infant health, child standardized test scores, and college enrollment.

Why It Might Need Reform

On the other hand, there are a number of controversial parts of the current EITC, including its limited benefit for childless workers, its complicated structure and high error rates, and the fact that payment comes as a lump sum once a year.

As the chart above makes clear, while the EITC provides a significant benefit to families with children, the benefit for workers without children (or those who are non-custodial parents) is extremely modest. The maximum credit for a single person without children in 2014 will be $496 for the year, and the credit will phase out starting at only about two-thirds of the poverty level. For that reason, many of the recent proposals would expand the benefit of the EITC for childless workers (who, as previously mentioned, may be considered childless by the current rules of the EITC, but who could be non-custodial parents who are providing financial support to their children).

In addition, the EITC is one of the most complicated portions of the individual tax code. In 2013, the Internal Revenue Service’s (IRS) documentation to help individuals figure out whether they were eligible ran to 39 pages. This level of complication induces many individuals to file (or not file) for the credit erroneously or to fraudulently claim more than they are owed.

In particular, when parents are separated or divorced, or when a child lives in a multi-generational home, determining who is eligible to claim the child for the EITC can be difficult. Non-custodial parents are not eligible to claim their children for purposes of the EITC, though they may believe otherwise because some can claim dependents for the personal exemption and child tax credit. These details are crucial because claiming a child for the EITC can make a big difference – the maximum credit for someone with a child is more than six times that for an individual without any children.

In 2012, the Inspector General’s audit found an overpayment rate for EITC claims of between 21 and 25 percent. Furthermore, approximately 20 to 22 percent of individuals who are eligible to claim the EITC did not do so. Many more surely were unaware of the credit when making employment decisions, thereby blunting its work incentive.

The audit found that the high overpayment rate is driven by complexity of the law, the difficulty of computation, confusion among claimants, unscrupulous tax return preparers, and fraud. Notably, some previous reviews have found that the methodology used to count overpayments may overstate their prevalence and that most overpayments are the result of error, not fraud.

Some, like Senator Marco Rubio, cite the fact that the credit arrives in annual tax refunds rather than as part of workers’ paychecks as another weakness. The EITC would better help families afford their day-to-day necessities if its benefits boosted every paycheck instead of arriving once a year. Others believe that providing the credit as a one-time windfall is helpful to families because it helps them catch up on bills or debts or to make large and important purchases.

Proposals for Reform

We will follow up this post shortly with another detailing:

  • President Obama’s proposal to expand the EITC for childless workers, which was included in his Fiscal Year 2015 budget.
  • Senator Marco Rubio’s (R-FL) proposal to replace the EITC with low-income wage subsidies.
  • Senate Budget Committee Chairman Patty Murray’s (D-WA) proposal to introduce a deduction for married couples with children and expand the EITC for childless workers.
  • House Ways and Means Chairman Dave Camp’s (R-MI) proposal in his comprehensive tax reform plan to make the EITC refundable against employment-related taxes.
  • The Domenici-Rivlin Debt Reduction Task Force’s proposal to replace the EITC with a refundable earnings credit.

Alex Gold and Samantha Greene contributed to this post.

1Many other income support programs provide a benefit whether or not an individual is working, but are withdrawn at higher income levels. Therefore, individuals are disincentivized from working if they wish to keep their benefits.

2Because the benefit for workers without children is small and relatively few childless workers receive the EITC, less is known about the credit’s impact on their labor supply and employment.