# Presentation: 662088

## The Earned Income Tax Credit

***Hilary W. Hoynes***
- Professor, University of California, Davis
- and NBER

- Presentation to President’s Advisory Panel on
- Federal Tax Reform
- New Orleans, March 23, 2005

## What is the EITC?

- Refundable tax credit for low income families with children
- Must have earned income to be eligible
- In tax year 2003, the credit was received by 19.2 million filers at a cost of $34 billion.
- The average credit per family in 2003 was $1,784.
- The EITC has become an integral part of federal assistance for low income families.
- [There is a much smaller credit for childless filers. My comments will focus on the EITC for families with children.]

## Background and History of EITC

- Started in 1975 as modest “work bonus”; made permanent in 1978
- Substantial expansions have taken place:
- _1986 Tax Reform Act:_ general expansion and indexed for inflation
- _1990 OBRA:_ general expansion and added separate schedule for families with 2 or more children
- _1993 OBRA:_ general expansion (larger expansion for families with 2 or more children) and added EITC for childless filers
- Many states now offer “add on” EITCs
- In 2003, 16 states had EITCs

## Why do we have the EITC?

- Reduce the tax burden and increase incomes of low income families with children
- Originally aim was to offset payroll tax costs for low income individuals.
- Transfers income to working poor
- Encourages work

## EITC Eligibility (for families with children)

- Must have qualifying child
- Must satisfy age, relationship and residency tests.
- Must have earned income
- AGI must be below limit
- In 2004, AGI limit for single filers with one child was $30,338 and single filers with two or more children was $34,458.
- Investment income must be below limit
- In 2004, the sum of interest, dividend, rent & royalty, capital gain, and passive income could not be larger than $2,650.

## EITC Payments

- Credit depends on *earnings* and *number of children*:
- _Phase-in:_ credit is flat percentage of earned income
- _Flat range:_ receive maximum credit
- _Phase-out:_ credit is phased out at a flat rate
- Credit is *refundable* (can receive payment even if there is no tax liability)
- Credit based on *family* earnings
- Until recently EITC parameters were identical for single and married filers.
- _2001 EGTRRA:_  Expansion in flat and phase-out range $1000 for joint filers.  When fully phased in, in 2007, the flat and phase-out range will be $3000 higher for joint filers.

## 2004 EITC Parameters for Single Filers

|  | Number of Children: |  |  |
| --- | --- | --- | --- |
|  | Zero | One | Two or More |
| Phase-in earnings | $0-$5,100 | $0-$7,660 | $0-$10,750 |
| Flat range earnings | $5,100-$6,390 | $7,660-$14,040 | $10,750-$14,040 |
| Phase-out earnings | $6,390-$11,490 | $14,040-$30,338 | $14,040-$34,458 |
| Credit rate, phase-in | 7.65% | 34% | 40% |
| Phase-out rate | 7.65% | 15.98% | 21.06% |
| Maximum credit | $390 | $2,604 | $4,300 |

## 2004 EITC Parameters for Single Filers

|  | Number of Children: |  |  |
| --- | --- | --- | --- |
|  | Zero | One | Two or More |
| Phase-in earnings | $0-$5,100 | $0-$7,660 | $0-$10,750 |
| Flat range earnings | $5,100-$6,390 | $7,660-$14,040 | $10,750-$14,040 |
| Phase-out earnings | $6,390-$11,490 | $14,040-$30,338 | $14,040-$34,458 |
| Credit rate, phase-in | 7.65% | 34% | 40% |
| Phase-out rate | 7.65% | 15.98% | 21.06% |
| Maximum credit | $390 | $2,604 | $4,300 |

## EITC Schedule – Single Parent Families, 2004

- Larger credit, covering higher earners for families with two or more children.

## Who Receives the EITC? 

- Source: Tabulations by income and filing status are from U.S. House of Representatives (2005) for 2003.  Tabulations by number of children are from IRS (2005) for 2002.

## Who Receives the EITC? 

- The majority of benefits go to single parent recipients, those with two children, and taxpayers with AGI under $20,000. For reference, the poverty line for a 3-person family in 2003 was $14,810.

## Interaction with other features of tax code

- EITC recipients may also receive the child tax credit and child care tax credit.
- No direct interaction between EITC and these other credits.
- Personal exemptions
- Standard deduction
- These features are part of an overall patchwork of tax benefits for families with children

## Cost of EITC in Billions of 2003 Dollars

- Source: *Green Book*, 2004, Joint Committee on Taxation, Ways and Means Committee

## Cost of EITC in Billions of 2003 Dollars

- Comparison: EITC reaches more families and costs more than Temporary Assistance for Needy Families (TANF) or Food Stamps:

## The EITC and marginal tax rates more broadly

- Marginal Tax Rates for Families with One Child, No AMT, 2004

- Source: Author's tabulation of NBER's TAXSIM model.

## The EITC and marginal tax rates: Adding FICA

- Marginal Tax Rates for Families with One Child, No AMT, 2004

- Source: Author's tabulation of NBER's TAXSIM model.

## Good tax policy is

- Efficient
- Fair
- Simple
- How does the EITC perform utilizing these criteria?

## Efficiency – EITC gets very good marks

- The popularity of the EITC arises from the fact that it transfers resources to low income families while promoting work  *efficient tax*.
- KEY: EITC provides incentive to enter the labor market.
- Research consistently shows that expansions in EITC have led to increases in labor force participation for single mothers with children.
- For example, one study found that the EITC was responsible for 60% of increase in employment rates of single mothers between 1984 and 1996  (Meyer and Rosenbaum 2001)
- Research also shows that the EITC leads to significant reductions in poverty.

## Example: How does the EITC change the incentive to work?

- Consider a single parent with 1 child  who earns $7.50 per hour
- Her work choices are: no work, part time (20 hrs/wk) or full time (40 hrs/wk)
- How does the EITC affect the income gains to entering work?

|  | Increase in net annual income from entering workforce at: |  |
| --- | --- | --- |
|  | PT work | FT work |
| Without the EITC | $5,356 | $10,712 |
| With the EITC | $7,177 | $13,316 |

## Example: How does the EITC change the incentive to work?

- Consider a single parent with 1 child  who earns $7.50 per hour
- Her work choices are: no work, part time (20 hrs/wk) or full time (40 hrs/wk)
- How does the EITC affect the income gains to entering work?

|  | Increase in net annual income from entering workforce at: |  |
| --- | --- | --- |
|  | PT work | FT work |
| Without the EITC | $5,356 | $10,712 |
| With the EITC | $7,177 | $13,316 |
| Impact of EITC on net income | $1,821/yr  | $2,604/yr |
| Impact of EITC per hour worked | $1.75/hour | $1.25/hr |

## Efficiency – Some caveats

- High marginal tax rates in the phase-out region provide disincentive to increase work (or wage rates) for those already in the labor market.
- Research shows that this negative effect is small for existing workers (Hotz and Scholz 2003).
- May be due to lack of knowledge about phase-out of credit or lack of flexibility in adjusting hours.
- EITC decreases the incentives to enter the labor market for some secondary earners (lower earning parent in married couple).
- Research finds evidence of these effects, but the magnitude is small (Eissa and Hoynes 2004).

## Fairness in the EITC

- Married filers face largely the same schedule (eligibility, benefits) as single filers.
- Passed in 2002, and fully phased in in 2007, the phase-out range of married filers will be extended by $3,000.
- Marriage tax penalty due to EITC—important for low income filers.

- Generosity of EITC by family size
- Small benefit for childless workers
- 2 child EITC 65% larger than 1 child (They were almost identical until 1994. See appendix for more on this.)

| 2004 Max. EITC  |  |
| --- | --- |
| No Children | $390 |
| 1 Child | $2,604 |
| 2 Children | $4,300 |

## Simplicity

- IRS Publication on EITC (Publication 596) is 53 pages long
- Definition of “qualifying child” is main source of complexity in EITC
- New rules concerning pre-certification may add complexity
- The complexity is a direct result of compliance problems.  Main sources of noncompliance
- No qualifying child
- Income over-reporting

## In-Work Credits in Other Countries

- Following the US, eight other OECD countries have recently introduced in-work credits with the goal of reducing poverty and increasing employment (Owens 2005).
- The UK program is the most established
*Working Tax Credit* (replaced WFTC in 2003)
- Differences from EITC: Hours requirement (≥16 hrs/wk) and (relatively) more generous benefit for childless families.
- Similarities to EITC: Phase-out region (no phase-in due to hours requirement)
- Add-on to *Child Tax Credit*, which has no phase-in and a much higher and slower phase-out.

## Concluding comments

- The EITC provides cash assistance to low income working families with children
- The EITC increases employment and reduces poverty
- Problems to address:
- Complexity
- Compliance
- Fairness: Single vs married couples

- Appendix:
- Supplementary tables and charts

## Definition of Qualifying Child

- Age test: Child must be younger than 19 (or 24 if full-time student or any age if totally disabled)
- Relationship test: Filer must be parent, grandparent or foster parent of child
- Residence test: Child must live with filer for at least 6 months during tax year

## 2004 EITC Parameters for Joint Returns

|  | Number of Children: |  |  |
| --- | --- | --- | --- |
|  | Zero | One | Two or More |
| Phase-in earnings | $0-$5,100 | $0-$7,660 | $0-$10,750 |
| Flat range earnings | $5,100-$7,390 | $7,660-$15,040 | $10,750-$15,040 |
| Phase-out earnings | $7,390-$12,490 | $15,040-$31,338 | $15,040-$35,458 |
| Credit rate, phase-in | 7.65% | 34% | 40% |
| Phase-out rate | 7.65% | 15.98% | 21.06% |
| Maximum credit | $390 | $2,604 | $4,300 |

## EITC Benefit for Selected Tax Years, By Real Earnings (1996 dollars)

## EITC Benefit for Selected Tax Years, By Real Earnings (1996 dollars)

## Number of EITC Recipient Families (Millions)

- Source: *Green Book*, 2004, Joint Committee on Taxation, Ways and Means Committee

## The EITC and MTR: Single and married filers with one child

- Marginal Tax Rates for Families with One Child, No AMT, 2004

- Source: Author's tabulation of NBER's TAXSIM model.

## The EITC and MTR: Single and married filers with 2 children

- Marginal Tax Rates for Families with Two Children, No AMT, 2004

- Source: Author's tabulation of NBER's TAXSIM model.

**Notes:**
Note to self: go through this one more time before giving it to RA.  Make sure you understand kinks.

## EITC and gains to increasing work, Single Families, 2004

## EITC and gains to increasing work, Married Couples, 2004

## In-work Credits in OECD Countries in 2001

## References

- Eissa, N. and H. Hoynes (2004). “Taxes and the Labor Market Participation of Married Couples: The Earned Income Tax Credit,” *Journal of Public Economics*, Volume 88, Issues 9-10, Pages 1931-1958.
- Hotz, V. and J. Scholz (2003). “The earned income tax credit.” In R. Moffitt, ed, *Means-Tested Transfer Programs in the United States*. University of Chicago Press, Chicago.
- Meyer, B. and D. Rosenbaum (2001). “Welfare, the earned income tax credit, and the labor supply of single mothers.” *Quarterly Journal of Economics* 116(3).
- Owens, J. (2005). “Fundamental Tax Reform: The Experience of OECD Countries,” Background Paper Number 47, Tax Foundation.
- U.S. House of Representatives (2004). *Background Materials and Data on Programs within the Jurisdiction of the Committee on Ways and Means*. Government Printing Office, Washington, DC.
- Internal Revenue Service (2005). *Individual Complete Report 2002*, Statistics of Income, Publication 1304.