Table 1.--Data on Earned Income Tax Credits Claimed, 1975-2000

Number of Refunded
Calendar year families who Total amount portion of Average
to which received of credit credit credit per
credit applies (thousands) (millions) (millions) per family
1975 6,215 $1,250 $900 $201
1976 6,473 1,295 890 200
1977 5,627 1,127 880 200
1978 5,192 1,048 801 202
1979 7,135 2,052 1,395 288
1980 6,954 1,986 1,370 286
1981 6,717 1,912 1,278 285
1982 6,395 1,775 1,222 278
1983 7,368 1,795 1,289 224
1984 6,376 1,638 1,162 257
1985 7,432 2,088 1,499 281
1986 7,156 2,009 1,479 281
1987 8,738 3,391 2,930 450
1988 11,148 5,896 4,257 529
1989 11,696 6,595 4,636 564
1990 12,612 6,928 5,303 549
1991 13,105 10,589 7,849 808
1992 14,097 13,028 9,959 926
1993 15,117 15,537 12,028 945
1994! 18,059 19,647 16,549 1,088
1995! 18,425 23,310 19,779 1,265
1996? 18,716 25,825 21,880 1,380
1997! 18,907 26,947 22,810 1,425
1998! 19,104 28,134 23,819 1,473
1999! 19,369 29,417 24,839 1,519
2000! 19,638 30,809 25,942 1,569

" Projected

Source: Internal Revenue Service, Statistics of Income, various years



hours per week for 20 weeks a year, the increase in labor force participation would more than fully
offset the reduction in hours from those already in the labor force.°

Some commentators have stressed that one should not look at the EITC as an isolated
program but rather as one part of a system of transfers to lower-income individuals.” The interaction
with other programs can affect labor supply. Other transfer programs, such as Aid to Families with
Dependent Children (AFDC), food stamps, and Supplemental Security Income (SSI), contain
significant implicit marginal tax rates in the form of the phaseout of benefits as income increases. For
individuals whose income puts them in the phasein range of the EITC, the wage subsidy in the phasein
range may offset some of the implicit marginal tax from the reduction in other benefits. For
individuals whose income puts them in the phaseout range of the EITC, the phaseout of the EITC
may exacerbate any implicit marginal tax from the loss of other benefits. On balance, one set of
simulations suggest that the combined marginal tax rate (explicit and implicit) on lower-income
individuals does not exceed 40 percent, but the variance across individuals may be large.”

Targeting of the EXEC to its intended beneficiari

Because it is delivered through the tax system, the EITC may have better participation rates
than other transfers, perhaps because there is less stigma to claiming the credit. The EITC may also
involve less intrusion into claimants’ lives. Individuals can file a claim by filling out a tax return in
the privacy of their own home rather than by standing in line at a disbursement office and being
subject to questions. Scholz estimated that in 1990, between 75 and 90 percent of the taxpayers
eligible to receive the EITC actually claimed the credit.’* By comparison, the percentage of eligible
individuals claiming food stamps, SSI, and AFDC have generally been lower.”?

° Ibid.

See, for example, Anne L. Alstott, “The Eamed Income Tax Credit and Some
Fundamental Institutional Dilemmas of Tax-Transfer Integration,” National Tax Journal, 47,
September 1994, pp. 609-619, and Anne L. Alstott, “The Earned Income Tax Credit and the
Oversimplified Case for Tax-Based Welfare Reform,” Harvard Law Review, 108, January 1995.

1 Stacy Dickert, Scott Houser, and John Karl Scholz, “Taxes and the Poor: A
Microsimulation Study of Implicit and Explicit Taxes,” National Tax Journal, 47, September
1994, pp. 621-638.

TM John Karl Scholz, “The Eamed Income Tax Credit: Participation, Compliance, and
Antipoverty Effectiveness,” National Tax Journal, 47, March 1994, p..65-72. Scholz used a
number of methods to estimate the participation rate; the extreme values of the estimate are
listed above. His preferred estimate is 80 to 86 percent.

® Robert H. Haveman estimated participation rates for food stamps and SSI of 50-60
percent in the late 1970s and for AFDC from 56 percent in Arizona to 95 percent in the District

-12-



State

Alabama
Alaska
Arizona
Arkansas
California

Colorado
Connecticut
Delaware

District of Columbia
Florida

Georgia
Hawaii
Idaho
Mlinois
Indiana

lowa
Kansas
Kentucky
Louisiana
Maine

Maryland
Massachusetts
Michigan
Minnesota
Mississippi

Number of

Table 4, -- State Data on Earned Income Tax Credits Claimed, 1992

% of Total

Amount

Returns = Returns (Thousands)

362,084
18,101
249,461
194,502
2,118,514

164,193
77,638
34,538
48,840

847,682

512,534
37,486
60,978

575,354

270,062

111,443
110,464
219,252
376,267

55,605

233,430
167,745
368,166
149,133
297,985

20.1%

5.1%
14.9%
19.6%
15.4%

9.9%
49%
10.5%
16.0%
13.6%

17.2%

6.6%
13.2%
10.7%
10.7%

8.8%
9.9%
14.3%
22.2%
10.1%

10.0%
6.0%
8.9%
7.2%

28.7%

$367,936
13,645
236,700
187,324
2,032,135

148,839
63,193
32,206
45,678

812,582

499,658
31,185
56,129

525,275

246,561

97,888
97,206
199,832
367,212
47,586

212,476
142,124
316,447
128,558
304,280

Number of

% of EITC

Amount

Returns = Returns = (Thousands)

298,544
12,284
203,745
154,709
1,808,964

123,312
51,826
26,424
38,449

671,924

409,619
25,605
46,023

449,236

201,861

78,674

- 80,640
168,907
313,162
39,351

173,127
116,308
279,250
104,861
253,247

Source: Intemal Revenue Service, Statistics of Income Bulletin , Winter 1994-95, pp. 178-204

82.5%
67.9%
81.7%
79.5%
85.4%

75.1%
66.8%
16.5%
78.7%
79.3%

79.9%
68.3%
75.5%
78.1%
TA1%

10.6%
73.0%
71.0%
83.2%
10.8%

TA2%
69.3%
715.8%
10.3%
85.0%

$292,761
8,540
188,442
142,258
1,668,477

108,061
40,805
24,444
35,662

611,789

386,393
20,446
40,949

402,958

181,126

66,051
69,013
146,097
294,847
30,740

153,402
93,736
231,438
84,507
248,536

Refundable Portion as
% of EITC

Amount

19.6%
62.6%
19.6%
75.9%
82.1%

72.6%
64.6%
75.9%
78.1%
75.3%

713%
65.6%
73.0%
16.71%
73.5%

67.5%
71.0%
73.1%
80.3%
64.6%

72.2%
66.0%
T3.1%
65.1%
81.7%


will also increase if there is inflation. Earned income consists of wages, salaries, other employee
compensation, and net self-employment income.

For 1996 and after, the credit rate will be 40 percent and the phaseout rate will be 21.06
percent for taxpayers with two or more qualifying children. For 1996 and after, the credit rate and
the phaseout rate for taxpayers with one qualifying child or no qualifying children will be the same
as those listed in the table above.

A worker may elect to receive the EITC on an advance basis by furnishing an advance
payment certificate to his or her employer. For such a worker, the employer makes an advance
payment of the credit at the time wages are paid. The amount of advance payment allowable in a
taxable year is limited to 60 percent of the maximum credit available to a taxpayer with one qualifying
child. The advance payment of the EITC is not available to taxpayers with no qualifying children.

In order to claim the EITC, a taxpayer must either have a qualifying child or must meet other
requirements. A qualifying child must meet a relationship test, an age test, an identification test, and
a residence test.

In order to claim the EITC without a qualifying child, a taxpayer must not be a dependent and
must be over age 24 and under age 65. In addition, the taxpayer’s principal place of abode must be
located in the United States for more than one-half of the taxable year. For purposes of this test, a
member of the Armed Forces stationed outside the United States on extended active duty is
considered to be maintaining a principal place of abode in the United States.

Qualifying child

Under the relationship and age tests, an individual (or married couple) is eligible for the EITC
with respect to another person only if that other person: (1) is a son, daughter, or adopted child (or
a descendent of a son, daughter, or adopted child); a stepson or stepdaughter; or a foster child of the
taxpayer (a foster child is defined as a person for whom the individual cares for as the individual’s
child; it is not necessary to have a placement through a foster care agency); (2) is under the age of
19 at the close of the taxable year (or is under the age of 24 at the end of the taxable year and was
a full-time student during the taxable year), or is permanently and totally disabled; and (3) shares the
same place of abode as the person claiming the credit for more than one-half the year (the entire year
for foster children). Also, if the qualifying child is married at the close of the year, the individual may
claim the EITC for that child only if the individual may also claim that child as a dependent.
Taxpayers who are married (as defined in Code sec. 7703) may claim the EITC only if they file a joint
return.

In addition to the above criteria, two “tiebreaker” rules apply:

(1) If more than one individual may claim the EITC (if any) with respect to any
qualifying child, then only the individual with the highest AGI may claim the EITC with

-3-


Table 2.--Earned Income Tax Credit Parameters, 1975-1996
(dollar amounts unadjusted for inflation)

Minimum
income for Phaseout range:
Calendar year Credit maximum Maximum Phaseout Beginning Ending
rate credit credit rate income income
1975-78 10.00% $4,000 $400 10.00% $4,000 $8,000
1979-84 10.00 5,000 500 12.50 6,000 10,000
1985-86 11.00 5,000 550 12.22 6,500 11,000
1987 14.00 6,080 851 10.00 6,920 15,432
1988 14.00 6,240 874 10.00 9,840 18,576
1989 14.00 6,500 910 10.00 10,240 19,340
1990 14.00 6,810 953 10.00 10,730 20,264
1991:
One child 16.70 7,140 1,192 11.93 11,250 21,250
Two children 17.30 7,140 1,235 12.36 11,250 21,250
1992:
One child 17.60 7,520 1,324 12.57 11,840 22,370
Two children 18.40 7,520 1,384 13.14 11,840 22,370
1993:
One child 18.50 7,750 1,434 13.21 12,200 23,050
Two children 19.50 7,750 1,511 13.93 12,200 23,050
1994:
No children 7.65 4,000 306 7.65 5,000 9,000
One child 26.30 7,750 2,038 15.98 11,000 23,755

Two children 30.00 8,425 2,528 17.68 11,000 25,296


Chart 2

Comparison of EITC for taxpayers with one child

(1996 levels)

$4,000

$3,500

$3,000

$2,500

$2,000

EITC amount

$1,500

$1,000

$500

Source: JCT Calculations

$15,000 $20,000 $25,000

Earned income

—?OBRA '93
~~ OBRA '90
—O—TRA '86



Table 3.--Earned Income Tax Credit Parameters, 1975-1995 in 1995 Dollars

Adjusted to 1995 dollars by CPI-U

Minimum Total
income for Phaseout range amount Average

Calendar maximum Maximum Beginning Ending ofEITC credit per
year credit credit income income (millions) per family
1975 $11,352 $1,135 $11,352 $22,704 $3,548 $570
1976 10,734 1,073 10,734 21,467 3,475 537
1977 10,078 1,008 10,078 20,157 2,840 504
1978 9,367 937 9,367 18,734 2,454 473
1979 10,516 1,052 12,619 21,031 4,316 606
1980 9,265 926 11,118 18,530 3,680 530
1981 8,399 840 10,078 16,797 3,212 479
1982 791 791 9,493 15,822 2,808 440
1983 7,665 766 9,198 15,330 2,752 343
1984 7,348 735 8,817 14,695 2,407 378
1985 7,095 780 9,224 15,609 2,963 399
1986 6,966 166 9,055 15,324 2,799 391
1987 8,172 1,144 9,301 20,742 4,558 605
1988 8,054 1,128 12,700 23,975 7,610 683
1989 8,004 1,121 12,609 23,814 8,121 694
1990 7,956 1,113 12,535 23,673 8,093 641
1991 11,871 906

One child 8,004 1,336 12,612 23,822

Two children 8,004 1,384 12,612 23,822
1992 14,178 1,008

One child 8,184 1441 12,885 24,345

Two children 8,184 1,506 12,885 24,345
1993 16,417 999

One child 8,189 1,515 12,891 24,356

Two children 8,189 1,597 12,891 24,356
1994 20,242 1,121

No children 4,121 315 5,151 9,272

One child 7,985 2,100 11,333 24AT4

Two children 8,680 2,605 11,333 26,062
1995 23,310 1,265

No children 4,100 314 5,130 9,230

One child 6,160 2,094 11,290 24,396

Two children 8,640 3,110 11,290 26,673

Source: JCT Calculations


Another proposal is to replace the EITC with a floor on FICA taxes.” The theory behind
this proposal is that the EITC was initially designed as an offset of FICA taxes for the working poor.
The proponents of this proposal claim that this is a more direct solution to the problem of work
disincentives caused by high payroll taxes. They contend that it should also be easier than to
administer present law and not subject to the same fraud and filing complexity as the EITC. It also
frees IRS resources for other productive work because the repeal of the EITC would eliminate over
10 million tax returns annually. This proposal could apply to all taxpayers or could only be available
to low-income taxpayers. Some contend that limiting the benefit from a floor on FICA taxes to
lower-income taxpayers is more consistent with the original EITC goal of a FICA tax offset for the
working poor than is granting more general relief from FICA taxes for all taxpayers regardless of
income level. Besides the additional complexity involved, a phaseout of the exclusion for all or only
some taxpayers will effect the revenue cost significantly. Opponents of the FICA tax floor argue that
the EITC serves as more than a payroll tax offset; it also serves the goal of lifting many working poor
above the poverty line. This additional goal would not be served by the replacement of the EITC
with a FICA tax floor. Also, this proposal could have the effect of reducing amounts allocated to the
Social Security Trust Fund and thereby reducing the solvency of the social security program unless
corresponding changes are made to social security benefit payments.

® Testimony of Professor George K. Yin before the Senate Committee on Governmental
Affairs (April 4, 1995).

-16-



IM. DESCRIPTION OF PROPOSALS

A. Administration’s Fiscal Year 1996 Budget Proposal

Taxpayers would not be eligible for the EITC if they do not include their taxpayer
identification number (and, if married, their spouse’s taxpayer identification number) on their tax
return. Solely for these purposes and for purposes of the present-law identification test for a
qualifying child, a taxpayer identification number would be defined as a social security number issued
to an individual by the Social Security Administration other than a number issued under section
205(c)(2)(B)(i)(D) (or that portion of 205(c)(2)(B)(i)(IID) relating to it) of the Social Security Act
(regarding the issuance of a number to an individual applying for or receiving Federally funded
benefits). Thus, if an individual obtained a social security number solely because that individual is an
applicant for, or a recipient of, Federally funded benefits, the individual would be ineligible to claim
the EITC.

If a taxpayer fails to provide a correct taxpayer identification number, such omission would
be treated as a mathematical or clerical error. Thus, any notification that the taxpayer owes additional
tax because of that omission would not be treated as a notice of deficiency.

A taxpayer would not be eligible for the EITC if the aggregate amount of interest and
dividends includible in his income for the taxable year exceeds $2,500. For taxable years beginning
after 1996, the $2,500 limit would be indexed for inflation with rounding to the nearest multiple of
$50.

Effective date

These proposals would be effective for taxable years beginning after December 31, 1995.

B. Senate Budget Resolution (S.Con.Res. 13)

The Senate Budget Resolution for fiscal years 1996-2002 (S.Con.Res. 13; S.Rept. 104-82),
as passed by the Senate on May 25, 1995, contains a provision that would achieve savings in the
EITC. That provision would (1) accept the Administration proposal that would deny the EITC to

3 Included in S. 453, “Tax Compliance Act of 1995,” as introduced by Senators Daschle
and Moynihan on February 16, 1995.

* Public Law 104-7 (H.R. 831) enacted a similar provision with more stringent limits.

-8-



eeradw s

period weighted toward the present year (the “substantial presence test”). (An individual who
is present in the United States for fewer than 183 days and establishes that he has a closer
connection with a foreign country than with the United States is generally not subject to tax
as a resident alien on account of the substantial presence test.)

Individuals who are nonresident aliens for any portion of the taxable year are not eligible to
claim the EITC for taxable years beginning after December 31, 1994, unless an election under Code
section 6013(g) or (h) is in effect for the taxable year.

Under section 6013(g), a nonresident alien who is married to an individual who is either a
citizen or resident alien of the United States at year end may elect to be treated as a resident for the
entire year. The election applies to the year for which it is made and all subsequent years until
terminated. The election will be suspended, however, if neither spouse is a U.S. citizen or resident
at any time during a taxable year.

Under section 6013(h), an individual who (1) is a nonresident alien at the beginning of the
year and a resident alien at the end of the year and (2) is married to an individual who is either a
citizen or resident of the United States at the end of the year may elect to be treated as a resident for
the entire year. Thus, this election can be made by a foreign married couple who arrive in the United
States during the taxable year and who are resident aliens at year end.

Mathematical errors

The IRS may summarily assess additional tax due as a result of a mathematical error without
sending the taxpayer a notice of deficiency and giving the taxpayer an opportunity to petition the Tax
Court. Where the IRS uses the summary assessment procedure for mathematical or clerical errors,
the taxpayer must be given an explanation of the asserted error and a period of 60 days to request that
the IRS abate its assessment. The IRS may not proceed to collect the amount of the assessment until
the taxpayer has agreed to it or has allowed the 60-day period for objecting to expire. If the taxpayer
files a request for abatement of the assessment specified in the notice, the IRS must abate the
assessment. Any reassessment of the abated amount is subject to the ordinary deficiency procedures.
This procedure is the only one a taxpayer may use for contesting an assessment arising out of a
mathematical or clerical error.


respect to the child. For example, assume a hypothetical household comprised of a
grandmother, mother (age 25), and child (age 2). Both the grandmother and the mother are
eligible to claim the credit with respect to the child. In this case, however, only the individual
with the higher AGI is eligible to claim the credit (assuming the other requirements are met).

(2) An individual who is himself or herself a qualifying child may not claim the EITC.
If in the above example, the mother is age 17 (instead of age 25), then she is a qualifying child
of the grandmother. In this case, only the grandmother could claim the EITC, with respect
to her own child (mother, age 17) and her grandchild (child, age 2).

To satisfy the identification test, taxpayers must include on their tax return the name and age
of each qualifying child. For returns filed with respect to tax year 1995, taxpayers must provide a
taxpayer identification number (TIN) for all qualifying children who were born on or before October
31, 1995. For returns filed with respect to tax year 1996, taxpayers must provide TINs for all
qualifying children born on or before November 30, 1996. For retums filed with respect to tax year
1997 and all subsequent years, taxpayers must provide TINs for all qualifying children, regardless of
their age. A taxpayer’s TIN is generally that taxpayer’s social security number. Some taxpayers are
exempt from social security taxes because of their religious beliefs. These taxpayers do not have a
social security number; instead, the Internal Revenue Service administratively assigns them a taxpayer
identification number.

The residence test requires that a qualifying child must have the same principal place of abode
as the taxpayer for more than one-half of the taxable year (for the entire taxable year in the case of
a foster child), and that this principal place of abode must be located in the United States. For
purposes of determining whether a qualifying child meets the residence test, for any period during
which a member of the Armed Forces is stationed outside the United States while serving on
extended.active duty, the member is not subject to the requirement that the principal place of abode
for a qualifying child and the member be in the United States.

Nonresidents and the EITC

The EITC may be claimed by a taxpayer meeting the above requirements if the taxpayer is a
U.S. citizen or a resident alien.

Section 7701(b) defines a resident alien for income tax purposes. Aliens who do not meet this
definition are nonresident aliens. For income tax purposes, an individual is generally considered a
resident if the individual:

(1) has entered.the United States as a lawful permanent U.S. resident (the “green card
test”), or

(2) is present in the United States for 31 or more days during the current calendar
year and has been present in the United States for 183 or more days during a three-year

-4-



APPENDIX
The Appendix contains tables and charts providing additional information about the EITC.

Table 1 is based on data from the Internal Revenue Service’s Statistics of Income Division
and shows over the history of the credit the number of families who received the credit, the total
amount of EITC claimed, and the portion of EITC in excess of tax liability. The dollar amounts are
not adjusted for inflation. Information for 1994 through 2000 are projections.

Table 2 shows the EITC parameters over the history of the credit in dollar amounts
unadjusted for inflation.

Table 3 converts the information for the earnings limit, the maximum credit, and the phaseout
ranges from Table 2 into 1995 dollars. It is also converts the information on the total amount of
EITC and the average credit per family from Table 1 into 1995 dollars.

Table 4 is drawn from Internal Revenue Service, Statistics of Income Bulletin, Publication
1136, vol. 14, no. 3, Winter 1994-1995, pp. 178-204. These data pertain to tax year 1992 and come
from the aggregate of all returns filed and processed through the Individual Master File during
calendar year 1993. They are not edited for Statistics of Information purposes and thus may not be
directly comparable to the information in Table 1. The first set of columns show by State the number
of returns claiming the EITC (in aggregate and as a percentage of all returns) and the amount of
EITC claimed. The second set of columns show the number of returns claiming an EITC that exceeds
the taxpayer’s tax liability (i.e., at least some portion of the EITC is received as a refundable credit).
The number of returns with some refundable credit is shown in aggregate and as a percentage of
returns claiming the EITC. The amount of refundable credit is shown, in aggregate and as a
percentage of the total amount of EITC claimed.

Charts 1 and 2 show the effects of the EITC changes in OBRA 1990 and OBRA 1993 on the

size of the credits that would be available in 1996. For purposes of these charts, all income of the
individual is assumed to be wage income.

-17-


iaihar uae pEratss

reduced by 17.68 percent of earned income (or AGI, if greater) in excess of $11,000. The credit rate
increases over time and equals 36 percent for 1995 and 40 percent for 1996 and thereafter. The
phaseout rate is 20.22 percent for 1995 and 21.06 percent for 1996 and thereafter.

OBRA 1993 also extended the EITC to taxpayers with no qualifying children. This credit for
taxpayers with no qualifying children is available to taxpayers over age 24 and below age 65. Finally,
OBRA 1993 repealed the supplemental young child credit and the supplemental health insurance
credit.

The implementing legislation for the General Agreements on Tariffs and Trade enacted in
1994 made four modifications to the EITC. First, it removed from the definition of earned income
in Code sec. 32(c)(2) any amount received for services provided by an inmate of a penal institution.
Second, it generally made nonresident aliens ineligible to claim the EITC. Third, it deemed that a
member of the Armed Forces stationed outside the United States while serving on extended active
duty would satisfy test that the principal place of abode be within the United States. Fourth, it
required that members of the Armed Forces receive annual reports from the Department of Defense
of earned income (which includes nontaxable earned income such as amounts received as basic
allowances for housing and subsistence).

Under Public Law 104-7 (H.R. 831), effective for taxable years beginning after December
31, 1995, a taxpayer is not eligible for the EITC if the aggregate amount of disqualified income (i.c.,
taxable and tax-exempt interest, dividends, and (if greater than zero) net rent and royalty income) of
the taxpayer for the taxable year exceeds $2,350.


State

Missouri
Montana
Nebraska
Nevada

New Hampshire

New Jersey
New Mexico
New York
North Carolina
North Dakota

Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina

South Dakota
Tennessee
Texas

Utah
Vermont

Virginia
Washington
West Virginia
Wisconsin
Wyoming

Number of

Table 4. -- State Data on Earned Income Tax Credits Claimed, 1992

% of Total

Returns Returns = = Amount

279,121
44,932
74,031
75,332
37,915

338,193
127,900
830,710
503,333

26,848

472,901
202,588
142,147
465,021

36,204
295,057

37,156
361,580
1,413,644
79,094
24,024

316,935
203,952
96,848
182,151
23,260

12.2%
12,0%
10.0%
11.2%

71%

8.9%
18.6%
10.4%
16.3%

9.5%

9.3%
15.2%
10.5%

8.6%

8.1%
18.8%

11.7%
16.3%
18.4%
10.8%

9.1%

10.8%
8.5%.
14.0%
8.0%
11.0%.

$253,795
40,011
66,586
68,600
32,947

304,798
119,459
746,967
487,277

23,853

416,539
185,897
128,433
405,066

31,836
292,147

34,060
341,522
1,363,423
72,520
20,339

298,600
178,446
87,197
160,737
20,585

Number of % of EITC
Returns Returns Amount

212,029
33,586
53,996
57,351
25,669

254,625
105,008
621,532
393,652

19,176

350,625
157,299
107,380
334,553

26,431
237,751

27,348
283,006
1,156,176
59,584
16,546

244,386
152,388
74,193
132,655
17,556

Source: Internal Revenue Service, Statistics of Income Bulletin , Winter 1994-95, pp. 178-204

76.0%
14.1%
229%
16.1%
67.7%

75.3%
82.1%
148%
78.2%
114%

TAG
716%
75.5%
19%
73.0%
80.6%

73.6%
78.3%
81.8%
75.3%
68.9%

TI1%
TA1%
71.2%
T2.8%
75.5%

$186,120
27,700
46,257
51,453
21,015

224,217
93,801
537,930
367,745
15,883

300,959
137,837
94,597
283,034
22,397
229,009

23,281
256,134
1,068,357
53,015
12,661

223,904
130,412
65,419
111,636
14,917

Refundable Portion as
% of EITC
Amount

73.3%
69.2%
69.5%
75.0%
63.8%

73.6%
78.5%
T2.0%
75.5%
66.6%

72.3%
TANG
73.1%
69.9%
04%
784%

68.4%
75.0%
784%
73.1%
62.2%

75.0%
73.1%
75.0%
69.5%
72.5%



PRESENT LAW AND ISSUES
RELATING TO THE
EARNED INCOME TAX CREDIT

Scheduled for a Public Hearing
Before the
SENATE COMMITTEE ON FINANCE

on June 8, 1995

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
June 7, 1995

JCX-24-95



IV. DISCUSSION OF ISSUES

As mentioned earlier (see Part II), two of the stated goals of the EITC when it was enacted
were to provide targeted tax relief to working low-income taxpayers with children and to improve
those individuals’ work incentives. This part discusses the effect of the EITC on work incentives,
the EITC’s effectiveness at reaching the targeted population, and the IRS’s administrative measures
to reduce noncompliance. It then concludes with a brief discussion of some proposed alternatives
to the EITC.

Effect of the EITC on labor supply

In general, a program like the EITC can have two effects on work effort. First, since it
changes the after-tax wage (i.e., the return to each additional hour of work), people might choose
to work a different number of hours. With a higher after-tax wage, it is more expensive for
individuals not to work, so they may substitute hours of work for hours of leisure. Second, since it
increases people’s disposable income, they might choose to work less — for instance, by working
fewer hours per week, taking more leisure time, or giving up a part-time job. The direction of the
first effect (the “substitution effect”) depends upon whether the individual’s income puts him in the
phasein, plateau, or phaseout range of the credit. The direction of the second effect (“the income
effect”) is to reduce hours worked for all individuals receiving the credit.

For individuals in the phasein range, the EITC increases the after-tax wage, so the substitution
effect is in the opposite direction of the income effect. The net change in work effort depends upon
the relative magnitude of the two effects. For individuals in the plateau range, there is no effect on
the after-tax wage. Since the credit is at the maximum amount, the EITC operates like a lump-sum
grant, and work effort would tend to fall because of the income effect. For individuals in the
phaseout range, the EITC reduces the after-tax wage, since an additional dollar of earnings will result
in a reduction in the EITC received (by the phaseout rate times the additional earnings). In this case,
the substitution effect reinforces the income effect, and a reduction in work effort could be expected.

In the aggregate, the effect of the EITC depends upon the relative sizes of the work incentives
or disincentives for individuals in the different income ranges and the relative number of EITC-eligible
individuals in each of the those ranges. Estimates suggest that just under one-quarter of recipients
are in the phasein range, just over three-fifths are in the phaseout range, and the remainder (about
one-sixth) are in the plateau range.° So for the vast majority of individuals, the marginal effect of the
credit is unambiguously to reduce work incentives. Using estimates from the economics literature
of the response of labor supply to changes in after-tax wages, a number of researchers have simulated

§ Estimates are from John Karl Scholz, “The Earned Income Tax Credit: Participation,
Compliance, and Antipoverty Effectiveness,” National Tax Journal, 47, March 1994, p. 78, and
Janet Holtzblatt, Janet McCubbin, and Robert Gillette, “Promoting Work through the EITC,”
National Tax Journal, 47, September 1994, p. 598.

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individuals not authorized to be employed in the United States, (2) repeal the credit for individuals
with no qualifying children, and (3) set the EITC for 1996 at 30.15 percent of the first $7,150 of
earned income (for taxpayers with one qualifying child‘) and at 35 percent of the first $8,910 of
earned income (for taxpayers with two or more qualifying children). The phaseout rate for 1996
would be set at 15.98 percent for taxpayers with one qualifying child and 19.37 percent for taxpayers
with two or more qualifying children.

* The combination of the reduction in the credit rate and the increase in the earned
income threshold would leave the maximum credit for taxpayers with one qualifying child
virtually unchanged from present law.

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IL LEGISLATIVE HISTORY

The earned income tax credit (Code sec. 32) was enacted in 1975 as a means of targeting tax
telief to working low-income taxpayers with children, providing relief from the Social Security payroll
tax for these taxpayers, and improving incentives to work. As originally enacted,” the credit equaled
10 percent of the first $4,000 of earned income (i.e., a maximum credit of $400). The credit began
to be phased out for taxpayers with earned income (or AGI, if greater) above $4,000, and was
entirely phased out for taxpayers with income of $8,000.

The Revenue Act of 1978 increased the maximum credit to $500 (10 percent of the first
$5,000 of earned income). Also, the income level at which the phaseout began was raised to $6,000,
with a complete phaseout not occurring until an income level of $10,000. The Deficit Reduction Act
of 1984 increased the maximum credit to $550 (11 percent of the first $5,000 of earned income) and
the credit was phased out beginning at $6,500 of income and ending at $11,000.

The Tax Reform Act of 1986 increased the maximum credit to $800 (14 percent of the first
$5,714 of earned income), beginning in 1987. The maximum credit was reduced by 10 cents for each
dollar of earned income (or AGI, if greater) in excess of $9,000 ($6,500 in 1987). These $5,714 and
$9,000 amounts (stated above in 1985 dollars) were indexed for inflation.

The Omnibus Budget Reconciliation Act of 1990 (OBRA 1990) substantially increased the
maximum amount of the basic credit and added an adjustment to reflect family size. OBRA 1990 also
created two additional credits as part of the EITC: the supplemental young child credit and the
supplemental health insurance credit. Both of these supplemental credits used the same base as the
basic EITC.

OBRA 1990 also modified the definition of taxpayers eligible for the EITC. Under prior law,
taxpayers were required to file a joint return or file as a head of household or surviving spouse in
order to be eligible for the EITC. OBRA 1990 generally broadened the set of eligible taxpayers and
set out uniform requirements for qualifying children. The definition of “qualifying child” enacted in
OBRA 1990 is described in the present-law section.

The Omnibus Budget Reconciliation Act of 1993 (OBRA 1993) expanded the EITC in several
ways. For taxpayers with one qualifying child, the EITC was increased to 26.3 percent of the first
$7,750 of earned income in 1994. For 1995 and thereafter, the credit rate was increased to 34
percent. In 1995, the maximum amount of earned income on which the credit could be claimed is
$6,160 (this is a $6,000 base in 1994, adjusted for inflation). The phaseout rate for 1994 and
thereafter is 15.98 percent.

For taxpayers with two or more qualifying children, the EITC was increased to 30 percent
of the first $8,425 of earned income in 1994. The maximum credit for 1994 was $2,527 and was

* Table 2 in the Appendix shows the parameters of the EITC over its history.

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Table 2.--Earned Income Tax Credit Parameters, 1975-1996
(dollar amounts unadjusted for inflation)

Minimum
income for Phaseout range:
Calendar year Credit maximum Maximum Phaseout Beginning Ending
rate credit credit rate income income
1995:
No children 7.65% $4,100 $314 7.65% $5,130 $9,230
One child 34.00 6,160 2,094 15.98 11,290 24,396
Two children 36.00 8,640 3,110 20.22 11,290 26,673
1996:
No children 7.65 4,230 324 7.65 5,290 9,520
One child 34.00 6,340 2,156 15.98 11,630 25,119
Two children 40.00 8,910 3,564 21.06 11,630 28,553

Source: Compiled by staff of the Joint Committee on Taxation


I, DESCRIPTION OF PRESENT-LAW EARNED INCOME TAX
CREDIT PROVISIONS

In general

Under present law, certain eligible low-income workers are entitled to claim a refundable
earned income tax credit. The amount of the credit an eligible taxpayer may claim depends upon
whether the taxpayer has one, more than one, or no qualifying children and is determined by
multiplying the credit rate by the taxpayer’s earned income up to an earned income threshold. The
maximum amount of the credit is the product of the credit rate and the earned income threshold. For
taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the phaseout
threshold, the credit amount is reduced by the phaseout rate multiplied by the amount of earned
income (or AGI, if greater) in excess of the phaseout threshold. For taxpayers with earned income
(or AGI, if greater) in excess of the phaseout limit, no credit is allowed.

As enacted in Public Law 104-7 (H.R. 831), for taxable years beginning after December 31,
1995, a taxpayer is not eligible for the EITC if the aggregate amount of “disqualified income” of the
taxpayer for the taxable year exceeds $2,350. Disqualified income is the sum of:
(1) interest (taxable and tax-exempt),
(2) dividends, and
(3) net rent and royalty income (if greater than zero).

The parameters for the EITC depend upon the number of qualifying children the taxpayer
claims. For 1995 the parameters are as follows:

Two or more One qualifying No qualifying
qualifying child-- children--
children--

Credit rate 36.00% 34.00% 7.65%
Phaseout rate 20.22% 15.98% 7.65%
Earned income

threshold $8,640 $6,160 $4,100
Maximum credit $3,110 $2,094 $314
Phaseout threshold $11,290 $11,290 $5,130
Phaseout limit $26,673 $24,396 $9,230

The earned income threshold and the phaseout threshold are indexed for inflation; because
the phaseout limit depends on those amounts, the phaseout rate, and the credit rate, the phaseout limit



At the same time, the EITC may also be more prone to improper claims, because unlike such
programs as food stamps and AFDC, there are no caseworkers to process the claims and check up
on claimants. Instead, any monitoring of the ETIC must come through the IRS tax enforcement
process. Estimates using data from the IRS’s Taxpayer Compliance Measurement Program (TCMP)
suggest that in 1988, 32 percent of the EITC claimants were ineligible for the credit and 34 percent
of the credit amount was claimed inappropriately. Data from earlier TCMP audits were roughly
similar. Data from the 1985 TCMP suggest that 38 percent of the EITC claimants were ineligible for
the credit and 37 percent of the credit amount was claimed inappropriately, while data from the 1982
TCMP suggest that 27 percent of the EITC claimants were ineligible for the credit and 29 percent
of the credit amount was claimed inappropriately.’

No TCMP audits of individual taxpayers have been conducted since the 1988 panel, so there
has not been a chance to update these estimates, which come from a sample representative of all
EITC claimants. Also, there have been substantial changes to the EITC since 1988, which makes it
difficult to extrapolate the findings from TCMP data from the 1980s to the present. For example,
one of the contributing factors to erroneous claims of the credit was taxpayer confusion about filing
status. On the 1985 TCMP, over half of the EITC returns that were disallowed were a result of
taxpayers erroneously claiming a child exemption. Upon audit, over half of those disqualified claims
had the filing status changed from one that would have allowed the EITC to be claimed to one that
did not (e.g., from head of household to single).'* The simplification of the qualifying child rules in
OBRA 1990 could have helped to reduce this type of erroneous EITC claim. The filing of a separate
Schedule EIC (also a result of OBRA 1990) may also have reduced the error rate. On the other hand,
the increase in the credit rate and the maximum credit may have encouraged more individuals to claim
the credit erroneously.

The IRS studied a sample of EITC returns that were filed electronically during a two-week
period in January 1994 in order to look at erroneous EITC claims. Unlike the TCMP data, which
provide a sample of the entire EITC population, this sample is only generalizable to the returns filed
electronically in that two-week period. The IRS’s preliminary analysis of this sample indicated that

of Columbia in 1975-1976. Rebecca M. Blank and Patricia Ruggles estimated participation rates
for food stamps of 54 to 66 percent and for AFDC of 62 to 72 percent (both in 1986-1987).

Both studies are cited in Scholz, “The Earned Income Tax Credit: Particpation, Compliance, and
Antipoverty Effectiveness,” op. cit., at p. 71.

“* Scholz, “The Eamed Income Tax Credit: Participation, Compliance, and Antipoverty
Effectiveness,” op. cit., at p. 68-69.

S Janet Holtzblatt, “Administering Refundable Tax Credits: Lessons from the EITC
Experience,” Proceedings of the 84" Annual NTA-TIA Conference, 1991, pp. 180-186.

-13-



United States.” Some observers believe that the IRS could take additional steps to improve
participation in the free electronic filing program.

Another administrative reform that could be effective against EITC fraud would be matching
of third-party wage and withholding records (e.g., W-2s) against the tax returns before refunds are
issued. Because currently this matching generally is only performed after the refunds are issued, if
the IRS determines that a refund that was paid should not in fact have been paid, it must then go to
the taxpayer directly to attempt to collect the money. It is inefficient to try to collect relatively small
sums of money from a large number of relatively poor individuals. On the other hand, delaying the
issuance of refunds until tax returns could be matched against third-party wage data would be a major
change to the current system of processing tax returns. It could result in delays of many months
between the filing of tax returns and the issuance of refunds, unless significant administrative changes
were made to accelerate the processing of third-party wage data. Another course of action would
be to make the EITC nonrefundable, but that course might be objectionable to some on policy
grounds. The annual refundable portion of the EITC is estimated to exceed $20 billion per year
beginning in 1996.

Repl f the EITC with another deli

To address the issue of EITC fraud, some have argued that the EITC should be replaced with
a direct expenditure program. While no one contends that fraud can be eliminated by a direct
expenditure program, two other arguments are made in support of the direct expenditure program.
First, it is argued that the IRS is ill-prepared institutionally to administer a program that puts a
premium on the overstatement of income. In almost all other cases, the IRS seeks to attribute income
to a taxpayer and the taxpayer has an incentive to minimize reported income. The second argument
is that it could take several filing seasons before the IRS can establish effective matching during the
filing season.

Opponents of the direct expenditure alternative respond that no goverment program is
immune from fraud and suggest that the EITC should be fixed, not abandoned. They contend that
one way to partially offset the problem of overstatement of income may to set up some sort of proxy
for effective matching before paying the EITC. One alternative would be to use wage information
from the third quarter of the previous calendar year for a filing season rather than the annual year-end
information."

20 Supra.

21 Testimony of Finn M. W. Caspersen before the Senate Committee on Governmental
Affairs (April 4, 1995).

-15-



INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on June 8, 1995, on the
earned income tax credit (“EITC”) and proposals to modify the EITC.

This document,’ prepared by the staff of the Joint Committee on Taxation, provides a
description of the present-law EITC, its legislative history, proposals, and a discussion of related
issues.

Part I of the document is a description of present law, Part II is a legislative history of the
EITC, Part Ill describes certain legislative proposals, and Part IV is a discussion of related issues.
The Appendix provides certain data relating to the EITC.

' This document may be cited as follows: Present Law and Issues Relating to the Earned
Income Tax Credit (JCX-24-95), June 7, 1995.

-1-


Chart 1

Comparison of EITC for taxpayers with two or more children
(1996 tevels)

$4,000

$3,500

$3,000

$2,500
z
3 —~OBRA 93
A $2,000 ~®~OBRA 90
2 —O—TRA '86
i

$1,500

$1,000

$500

$0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000

Earned income

$0

Source: JCT Calculations


INTRODUCTION ... 2.2... ee cece cece cence eee e eee teceeeeenes

i. DESCRIPTION OF PRESENT-LAW EARNED INCOME TAX
CREDIT PROVISIONS ...........ceeceecsceccncesenceeeee

Il. LEGISLATIVE HISTORY ............. cs eeceeceeneeenceee

Il. DESCRIPTION OF PROPOSALS .............2eeseeeeeeees

IV. DISCUSSION OF ISSUES ...........---++- see eeeeeeeeeeees

APPENDIX

10

17



the effects on aggregate labor supply of recent changes in the EITC.” In general, they find that hours
worked increase for individuals in the phasein range (where the theoretical effect is ambiguous) and
decrease for individuals in both the plateau and phaseout ranges (in accord with the theoretical
prediction). The effects on labor supply are generally larger for secondary earners in two- Parent
families than for primary eamers or single-parent families.

One caveat with these findings is that they presume that individuals correctly perceive the
effect of the credit on their after-tax wage. Most of the EITC claimants receive their credit in a lump-
sum at the time they file their tax returns. If they do not make the connection between the amount
they receive in credit and their eared income, these estimates of labor supply effects may be
incorrect. A second caveat is that the studies did not examine directly the effects of the EITC on
labor supply. The studies generally simulated the effects of the EITC using behavioral parameters
from the economics literature, in some cases, from the negative income tax experiments from the
1970s, in other cases from other labor supply studies. Thus, the accuracy of the simulation results
depends upon whether the parameters from other labor supply studies accurately reflect the behavior
of EITC participants.

Most of the estimates of the EITC’s effect on labor supply focus on the individuals already
receiving the credit and do not attempt to model individuals’ decisions of whether or not to work.
One study* that does look at the question of labor market participation suggests that the OBRA 1993
changes would, on average, increase the after-tax wage of single-parent families by 15 percent, «
leading to a 6.2 percent increase in the probability of working. For secondary earners in two-parent
families, the OBRA 1993 changes would, on average, decrease the after-tax wage by five percent,
leading to a decrease in the probability of working. These changes in labor force participation, which
on balance increase the labor force, may offset the reduction in work effort by those already in the
labor force. Dickert, Houser, and Scholz calculate that if the new entrants worked an average of 20

7 The following sources use labor supply estimates from the Seattle and Denver negative
income tax experiments: U.S. General Accounting Office, Earned Income Tax Credit: Design
and Administration Could Be Improved, GAO/GGD-93-145, September 1993 (looking at the
EITC in 1988 and as it would have been in 1994 had the OBRA 1993 changes not been made);
Holtzblatt, McCubbin, and Gillette (looking at the OBRA 1990 and OBRA 1993 changes); Saul
D. Hoffman and Laurence S. Seidman, The Earned Income Tax Credit: Antipoverty Effectiveness
and Labor Market Effects, (Kalamazoo, Mich.: W.E. Upjohn Institute for Employment
Research), 1990 (looking at the EITC in 1988). Stacy Dickert, Scott Houser, and John Karl
Scholz, “The Earned Income Tax Credit and Transfer Programs: A Study of Labor Market and
Program Participation,” in James M. Poterba (ed.), Tax Policy and the Economy, vol. 9,
(Cambridge, Mass.: National Bureau of Economic Research and MIT Press), 1995, pp. 1-50
(looking at the OBRA 1993 changes) used another set of estimated labor supply responses.

® Dickert, Houser, and Scholz, “The Earned Income Tax Credit and Transfer Programs:
A Study of Labor Market and Program Participation,” op. cit.

-ll-


29 percent of the 1.3 million EITC returns filed during the two-week period claimed too large a
refund. About 13 percent of the 1.3 million retums were classified as intentional error."®

Administrati limit fraud

There has been concern that the IRS’s institutional goal to process returns and pay refunds
quickly have made it susceptible to fraud, in particular where returns are filed electronically and are
consequently processed more rapidly. Electronic filing has been fairly widespread among taxpayers
claiming the EITC.

The IRS has to date taken some steps to reduce its exposure to EITC fraud. For example,
the IRS has instituted a system of matching names and taxpayer identification numbers listed on tax
returns with the Social Security Administration’s database and lengthened processing time for certain
returns by up to eight weeks to allow this matching before issuing refunds. Prior to this filing season,
the IRS was unable to match TINs with the Social Security Administration database on a nationwide
basis before processing tax returns.'” This matching may significantly reduce fraud, but it may also
substantially delay the issuance of refunds to taxpayers who are entitled to claim the EITC but who
do not report their names and TINs on their tax returns identically to the records in the Social
Security Administration database.

A possibile way to help limit fraud would be increased scrutiny of the approximately 40,000
electronic return originators (EROs). Some EROs do not comply fully with IRS requirements for
electronic filing, and several have been convicted of criminal activity in schemes to defraud the
government through false EITC claims."* Through March 5, 1995, the IRS conducted 3,600
monitoring visits of EROs, resulting in 103 suspensions and 303 wamings.”’ If the ratio of EROs
with compliance problems uncovered to date held true for all EROs, it would mean that more than
4,000 EROs are not in complete compliance with IRS Tequirements. (This would not, however,
necessarily be indicative of widespread fraud among EROs.) Another way to reduce dependence
upon EROs while still encouraging electronic filing would be expanded use of free electronic filing.
As of March 24, 1995, only 122,000 filers used any of the 1,200 free electronic filing sites in the

' U.S. General Accounting Office, Earned Income Credit: Targeting to the Working
Poor, GAO/GGD-95-122BR, March 1995, pp. 14-15.

*” Testimony of IRS Commissioner Richardson before the Senate Committee on
Governmental Affairs (April 4, 1995).

*8 Ways and Means Subcommittee on Oversight hearing of February 10, 1994.

© Testimony of IRS Commissioner Richardson before the Senate Committee on
Governmental Affairs (April 4, 1995).

-14-