in the administration of the credit (for example, in determining how to stack wage income and self-
employment income in calculating the credit).

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.

Replacement of the EITC with another delivery system

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 government 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.”

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

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

*” Testimony of Professor George K. Yin before the Senate Committee on Governmental
Affairs (April 5, 1995).

-18-



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 the effects on aggregate labor supply of recent
changes in the EITC.’ In general, they find that hours worked increase for individuals in the phase-
in 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 earners 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 earned 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,

” 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.

-12-



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 1730 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


the phaseout rate for taxpayers with one qualifying child or no qualifying children will be the same
as those listed in the table above.

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 will also increase if there is inflation.

Earned income consists of wages, salaries, tips, other employee compensation, and net
self-employment income. To calculate eamed income for purposes of the EITC a taxpayer must take
into account several sources of income. First, the taxpayer must take the amount reported on line
7 of the Form 1040. This amount is the total of wages, salaries and tips for the taxpayer (and, if
married, the taxpayer’s spouse) for the taxable year. Second, the taxpayer then subtracts any taxable
scholarship or fellowship grants. Third, the taxpayer adds nontaxable earned income. Examples
listed in the IRS instructions to the Form 1040 include: basic quarters and subsistence allowance and
the value of in-kind quarters and subsistence received from the U.S. military, housing allowances
or the rental value of parsonage for clergy members, meals and lodging provided for the convenience
of the employer, certain voluntary salary deferrals (e.g., contributions to a 401(k) plan), excludable
dependent care benefits, certain voluntary salary reductions, and excluded combat zone pay.

In the case of a self-employed taxpayer, the self-employment income of the taxpayer (and,
on a joint return, the self-employment income of the taxpayer’s spouse) must be included. To
compute self-employment income, the taxpayer adds net profit or loss from Schedule C, Schedule °
C-EZ, Schedule F, and Schedule K-1 (Form 1065). There are special rules for ministers and
members of religious orders.

A worker with qualifying children 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.

In order to claim the EITC, a taxpayer must either have a qualifying child or 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.


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.

Some of those who argue that the EITC is a mechanism to raise low-income families above
the poverty line argue that an increase in the minimum wage” would serve that purpose without the
administrative complexity. It would also free IRS resources for other productive work by
eliminating over 10 million tax returns annually. On the other hand, the class of individuals who
would benefit from an increase in the minimum wage are not the same as the class of individuals
who currently receive the EITC.

An increase in the minimum wage would transfer the cost of providing relief from the
general taxpayer (through the government transfer) to the employers of the individuals subject to
the minimum wage. But it would not be without its effects on the labor market. Economists
generally argue that increases in the minimum wage would reduce demand for low-skilled workers
and could result in fewer of such workers being employed.”

bad Testimony of Robert Greenstein before the Senate Committee on Finance (June 8,
1995).

® For a discussion of the effect of the minimum wage on employment, see Charles
Brown, “Minimum Wage Laws: Are They Overrated?”, Journal of Economic Perspectives, 2,
Summer 1988, pp. 133-145, Lawrence F. Katz and Alan B. Krueger, “The Effect of the
Minimum Wage on the Fast Food Industry,” Industrial and Labor Relations Review, 46, October
1992, pp. 6-21; and David Card and Alan B. Krueger, “Minimum Wages and Employment: A
Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American Economic
Review, 84, September 1994, pp. 772-793.

Another alternative to the EITC that could avoid some of the negative effects on labor
supply would be a subsidy to wage rates. For a discussion of the relative efficiency effects of a
wage credit and the EITC, see Edgar K. Browning, “Effects of the Earned Income Tax Credit on
Income and Welfare,” National Tax Journal, 48, March 1995, pp. 23-43.

-19-



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

Average Earned Income Credit Credit in excess of tax liability Refundable Portion as

AGI Number of —% of Total Amount Number of  % of EITC Amount % of EITC
State (All returns) Returns Returns (Thousands) Returns Returns (Thousands) Amount
Alabama $27,426 362,084 20.7% $367,936 298,544 82.5% $292,761 79.6%
Alaska 27,642 18,101 5.1% 13,645 12,284 67.9% 8,540 62.6%
Arizona 28,338 249,461 14.9% 236,700 203,745 81.7% 188,442 79.6%
Arkansas 25,016 194,502 19.6% 187,324 154,709 79.5% 142,258 75.9%
California 33,083 2,118,514 15.4% 2,032,135 1,808,964 85.4% 1,668,477 82.1%
Colorado 31,378 164,193 9.9% 148,839 123,312 75.1% 108,061 72.6%
Connecticut 42,671 77,638 4.9% 63,193 51,826 66.8% 40,805 64.6%
Delaware 33,668 34,538 10.5% 32,206 26,424 76.5% 24,444 75.9%
District of Columbia 33,478 48,840 16.0% 45,678 38,449 78.7% 35,662 78.1%
Florida 30,095 847,682 13.6% 812,582 671,924 79.3% 611,789 75.3%
Georgia 29,988 512,534 17.2% 499,658 409,619 79.9% 386,393 771.3%
Hawaii 32,316 37,486 6.6% 31,185 25,605 68.3% 20,446 65.6%
Idaho 27,048 60,978 13.2% 56,129 46,023 75.5% 40,949 73.0%
IHlinois 33,800 575,354 10.7% 525,275 449,236 78.1% 402,958 16.7%
Indiana 29,791 270,062 10.7% 246,561 201,861 14.7% 181,126 73.5%
Towa 27,450 111,443 8.8% 97,888 78,674 10.6% 66,051 67.5%
Kansas 30,064 110,464 9.9% 97,206 80,640 73.0% 69,013 71.0%
Kentucky 27,193 219,252 14.3% 199,832 168,907 71.0% 146,097 73.1%
Louisiana 26,564 376,267 22.2% 367,212 313,162 83.2% 294,847 80.3%
Maine 27,182 55,605 10.1% 47,586 39,351 70.8% 30,740 64.6%
Maryland 36,048 233,430 10.0% 212,476 173,127 TA2% 153,402 72.2%
Massachusetts 35,536 167,745 6.0% 142,124 116,308 69.3% 93,736 66.0%
Michigan 31,993 368,166 8.9% 316,447 279,250. 15.8% 231,438 73.1%
Minnesota 32,564 149,133. 7.2% 128,558 104,861 10.3% 84,507 65.7%
Mississippi 23,353 297,985 28.7% 304,280 253,247 85.0% 248,536 81.7%

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


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: 1975-1993: Internal Revenue Service, Statistics of Income, various years;
1994-2000: JCT calculations



Another possible way to target the credit is by expanding the definition of income used in
phasing out the EITC. The rationale for this approach is that the definition of AGI used currently
in phasing out the EITC is too narrow and disregards other components of ability-to-pay. Examples
of possible additions would be untaxed Social Security benefits and untaxed IRA, pension and
annuity distributions. In addition, one could deny losses reported on Schedules C, D, E, and F to
conform the phaseout more closely to the concept of “total positive income.” One difficulty with
expanding the definition of income used in phasing out the EITC is that it may make the caiculation
of the credit more complex.

Administrative measures to limit fraud

There has been concern that the IRS’s institutional goal to process returns and pay refunds
quickly has 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, both for
electronically filed returns and paper returns. 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 possible 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 warnings.” 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 requirements. (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.

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

7! 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).

-16-



teduced by 17.68 percent of eamed 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 a number of modifications to the EITC. First, it removed from the definition of earned
income in Code section 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 the 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). Fifth, it phased in a requirement
that taxpayers provide a TIN for each qualifying child regardless of the dependent’s age. Prior to
the legislation, taxpayers had to provide a TIN only for qualifying children who attained the age of
one before the close of the taxpayer’s taxable year.

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.e.,
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.



Chart 2

Comparison of EITC for taxpayers with one child
(1996 levels)

$4,000

$3,500

$500

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

Earned income

Source: JCT Calculations

—*- OBRA '93
—#— OBRA '90

—O— TRA '86


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 th Cc

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
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

-5-


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 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
Tespect 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 returns filed with Tespect 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.

-4-


As of March 24, 1995, only 122,000 filers used any of the 1,200 free electronic filing sites in the
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.

Even if the IRS were able to match tax returns against third-party wage and withholding
records on a more rapid basis than it does currently, there could still be a problem with
noncompliance regarding self-employment income, where there are no independent third-party
records. In the case of individuals who have qualifying children and whose income puts them in the
phase-in range for the EITC, the extra credit on another dollar of earned income exceeds the tax
liability on that income under the Self-Employment Contributions Act (SECA). Thus, such
individuals may have an incentive to claim enough self-employment income to raise their reported
income at least to the earned income threshold.” Note that this incentive to claim self-employment
income need not involve fraud. Two individuals who normally mow their own lawns could arrange
to mow each other’s lawn for a fee. The fees would represent earned income for the individuals.
By transforming nonmarketed leisure activity (mowing one’s own lawn) into marketed labor income
(mowing one’s neighbor’s lawn for a fee) EITC amounts could be generated in excess of SECA
liability, even though there were no change in aggregate economic activity.

As a possible remedy for these problems with the EITC and self-employment income, one
commentator has suggested restricting the EITC credit rate for self-employment income to the
employer and employee shares of payroll taxes.** The higher credit rate under current law would
continue to be available for income that is subject to third-party withholding and reporting. Such
a proposal could reduce the incentives for overreporting self-employment income, but at the cost
of creating an inequity in the treatment of self-employed and wage income and creating complexity

3 Supra.

> Eugene Steuerle has referred to these incentives as encouraging a “superterranean
economy.” See George K. Yin, “Summary of EITC Conference Proceedings,” The American
Journal of Tax Policy, 11(2), Fall 1994, pp. 305-306.

> Testimony of John Karl Scholz before the Senate Committee on Governmental Affairs
(April 5, 1995).

-17-


IL LEGISLATIVE HISTORY

The earned income tax credit (Code sec. 32) was enacted in 1975 as a means of targeting tax
relief 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 eamed income (i.e., a maximum credit of $400). The credit
began to be phased out for taxpayers with eamed 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 eamed 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 eamed 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.
-7-



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


DESCRIPTION OF PRESENT LAW AND
DISCUSSION OF ISSUES
RELATING TO THE
EARNED INCOME TAX CREDIT

Scheduled for a Public Hearing
Before the
SUBCOMMITTEE ON OVERSIGHT
and the
SUBCOMMITTEE ON HUMAN RESOURCES
of the
HOUSE COMMITTEE ON WAYS AND MEANS

on June 15, 1995

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
June 14, 1995

JCX-27-95



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.

-10-



Ui. DESCRIPTION OF PROPOSALS

A. Administration’s Fiscal Year 1996 Budget Proposal

Earned income tax credit denied to individuals not authorized to be employed in the United

States?

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) (or that portion of 205(c)(2)(B)(i)(II) 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.

Ifa 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.

Earned income tax credit denied to individuals with substantial unearned income’

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

; 5 Included in H.R. 981, “Tax Compliance Act of 1995,” as introduced by Representatives
Gephardt and Gibbons (by request) on February 16, 1995.

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

-9-



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. The request for abatement of the assessment is the only procedure a taxpayer
may use prior to paying the assessed amount in order to contest an assessment arising out of a
mathematical or clerical error. Once the assessment is satisfied, however, the taxpayer may file a
claim for refund if she believes the assessment was made in error.



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 by the staff of the Joint
Committee on Taxation.

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.

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

Average Earned Income Credit Credit in excess of tax liability Refundable Portion as
AGI Number of  % of Total Number of % of EITC % of EITC
State (All returns) Returns Returns Amount Returns Returns Amount Amoun\

Missouri $29,097 279,121 12.2% $253,795 212,029 76.0% $186,120 73.3%
Montana 24,528 44,932 12.0% 40,011 33,586 74.7% 27,700 69.2%
Nebraska 27,580 74,031 10.0% 66,586 53,996 72.9% 46,257 69.5%
Nevada 32,816 75,332 11.2% 68,600 57,351 76.1% 51,453 75.0%
New Hampshire 33,484 37,915 71% 32,947 25,669 67.7% 21,015 63.8%
New Jersey 39,298 338,193 8.9% 304,798 254,625 75.3% 224,217 73.6%
New Mexico 25,010 127,900 18.6% 119,459 105,008 82.1% 93,801 78.5%
New York 36,690 830,710 10.4% 746,967 621,532 74.8% 537,930 72.0%
North Carolina 28,472 503,333 16.3% 487,277 393,652 78.2% 367,745 75.5%
North Dakota 25,465 26,848 9.5% 23,853 19,176 114% 15,883 66.6%
Ohio 29,161 472,901 9.3% 416,539 350,625 74.1% 300,959 72.3%
Oklahoma 26,437 202,588 15.2% 185,897 157,299 771.6% 137,837 T4.1%
Oregon 29,456 142,147 10.5% 128,433 107,380 75.5% 94,597 73.7%
Pennsylvania 31,090 465,021 8.6% 405,066 334,553 71.9% 283,034 69.9%
Rhode Island 31,438 36,204 8.1% 31,836 26,431 73.0% 22,397 10.4%
South Carolina 295,057 18.8% 292,147 237,751 80.6% 229,009 78.4%
South Dakota 25,361 37,156 11.7% 34,060 27,348 73.6% 23,281 68.4%
Tennessee 28,338 361,580 16.3% 341,522 283,006 78.3% 256,134 75.0%
Texas 29,256 1,413,644 18.4% 1,363,423 1,156,176 81.8% 1,068,357 78.4%
Utah 28,861 79,094 10.8% 72,520 59,584 75.3% 53,015 73.1%
Vermont 28,188 24,024 9.1% 20,339 16,546 68.9% 12,661 62.2%
Virginia 33,598 316,935 10.8% 298,600 244,386, T11% 223,904 75.0%
Washington 33,636 203,952 8.5% 178,446 152,388 74.1% 130,412 73.1%
West Virginia 26,329 96,848 14.0% 87,197 74,793 71.2% 65,419 75.0%
Wisconsin 30,569 182,151 8.0% 160,737 132,655 12.8% 111,636 69.5%

Wyoming 29,246 23,260 11.0% 20,585 17,556 75.5% 14,917 72.5%

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


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%
Eamed 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

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

-2-


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 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 (SSD),
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 phase-in range of the EITC, the wage
subsidy in the phase-in 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 EITC to its intended beneficiaries

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

° Ibid.

© See, for example, Anne L. Alstott, “The Earned 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.

"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.

-13-


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 retums 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 retums filed
electronically in that two-week period. The IRS’s preliminary analysis of this sample indicated that
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 returns were classified as intentional error."* The IRS’s
final analysis of the sample indicated that 26.1 percent of the dollar amount of the credit was
claimed inappropriately.’”

As enacted in Public Law 104-7 (H.R. 831) for taxable years beginning after December 31,
1995, taxpayers with “disqualified income” in excess of $2,350 will not be eligible for the earned
income credit. One might argue that individuals with substantial assets could use proceeds from the
sale of those assets in place of the EITC to support consumption in times of low-income. Transfer
programs such as AFDC, food stamps, and Medicaid have asset tests for determining eligibility."
Such programs also have caseworkers available to make determinations about the assets owned by
a potential claimant. In the case of the EITC, the IRS does not have caseworkers to assess the
balance sheets of millions of taxpayers, and it does not currently have information on most
taxpayers’ asset-holdings. Therefore, in order to apply a proxy for an asset-based test, Public Law
104-7 concentrates on the returns generated by those assets. Interest, dividend, and net rental and
royalty income represent flows of income from assets that represent wealth of the taxpayer.” Any
proposed additions to this test could be evaluated on whether they represent returns from an asset
that can be liquidated without much difficulty. Examples of possible additions are net capital gains
and other passive income.

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

7 Internal Revenue Service, “Study of EIC Filers for Tax Year 1993,” June 1995, pp. 4-
5. This study was provided as an appendix to the testimony of IRS Commissioner Richardson
before the Senate Committee on Finance (June 8, 1995).

*® For a discussion of the effect on saving behavior of asset-based means testing of
welfare programs, see R. Glenn Hubbard, Jonathan Skinner, and Stephen P. Zeldes,
“Precautionary Saving and Social Insurance,” Journal of Political Economy, 103, April 1995,
pp. 360-399.

® Because there is no adjustment for liabilities of the taxpayer, a taxpayer could be
denied an EITC on the basis of unearned income even when net wealth is zero.

-15-


INTRODUCTION

The Subcommittee on Oversight and the Subcommittee on Human Resources of the House
Committee on Ways and Means have scheduled a joint public hearing on June 15, 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 IT is a legislative history of the
EITC, Part III 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: Description of Present Law and Discussion of
Issues Relating to the Eammed Income Tax Credit (JCX-27-95), June 14, 1995.

-1-


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 of EITC 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 7911 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 6,966 766 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
199] 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 1,441 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 24,474

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



CONTENTS

Page

INTRODUCTION ... 20.00 te cece e cece 1
I. DESCRIPTION OF PRESENT-LAW EARNED INCOME TAX

CREDIT PROVISIONS |... 20... 2
Tl. LEGISLATIVE HISTORY ..........00...00..000.00 000 eee 7
TI. DESCRIPTION OF PROPOSALS ..............0.00000. 0000 9

A. Administration’s Fiscal Year 1996 Budget Proposal ......... 9

B. Senate Budget Resolution (S.Con.Res.13)................. 9
IV. DISCUSSION OF ISSUES ..............00. 000. cece cece 11
APPENDIX occ e cece ee eeeeeees 20

Table 1.--Data on Earned Income Tax Credits Claimed, 1975-2000
Table 2.--Earned Income Tax Credit Parameters, 1975-1996
(dollar amounts unadjusted for inflation)
Table 3.--Earned Income Tax Credit Parameters, 1975-1995,
in 1995 Dollars
Table 4.--State Data on Earned Income Tax Credits Claimed, 1992

Chart 1--Comparison of EITC for taxpayers with two or more children
(1996 levels)

Chart 2--Comparison of EITC for taxpayers with one child
(1996 levels)


$4,000

Chart 1

Comparison of EITC for taxpayers with two or more children

(1996 levels)

$3,500

$3,000

$2,500

¢

EITC amount

$1,500

$1,000

$500

Source: JCT Calculations

$5,000

$10,000

$15,000 $20,000 $25,000 $30,000

Earned income

—@— OBRA '93
—@ OBRA '90
—O— TRA '86



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 the work effort of individuals
already in the labor force. 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, for example, 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 phase-in, 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 not currently in the labor force, the EITC increases
the average wage and can induce them to enter the labor force.

For individuals who are in the labor force and whose income puts them in the phase-in 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 on those already in the labor force 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 phase-in 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

® 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.

-1l-



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.

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 EITC 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. Thirty-four
percent of the credit amount claimed that year was claimed inappropriately (this measure includes
excess amounts claimed by individuals entitled to the credit as well as the entire amounts claimed
by individuals who were not entitled to the credit). 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
tules in OBRA 1990 could have helped to reduce this type of erroneous EITC claim. The filing of

” John Karl Scholz, “The Earned Income Tax Credit: Participation, Compliance, and
Antipoverty Effectiveness,” National Tax Journal, 47, March 1994, pp. 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
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: Participation, Compliance, and
Antipoverty Effectiveness,” op. cit., at p. 71.

* Scholz, “The Earned Income Tax Credit: Participation, Compliance, and Antipoverty
Effectiveness,” op. cit., at pp. 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.

-14-