As America replaces welfare with work, we continue to be plagued
by the law of unintended consequences. Here's an illustration:
A single mother and the father of her two children have been living together
for five years -- now they want to get married. She earns $12,000, he earns
$20,000. Because of her low income, the mother will get an Earned Income
Tax Credit (EITC) of $3,888, the legal maximum in 2000. They're confused
about the tax laws but want to do the right thing for their children.
So they seek advice from a minister and an accountant.
The couple: Should we get married?
The minister: Yes. You love each other. You want to get married. You
owe it to your children, your faith, and God to stop living in sin and
take wedding vows.
The accountant: But if you do, your earnings for EITC purposes will
rise from $12,000 to $32,000, your credit will drop from $3,888 to zero,
and you'll be taking thousands of dollars out of the mouths of the children
you love.
The couple: Sounds like it would be immoral for us to get married.
The minister: Why does the U.S. government do this to me?
This, in one of its most brutal forms, is a prime example of the marriage
penalty. In 2000, Congress passed a bill aimed at eliminating the marriage
penalty for people with middle class incomes -- but it was vetoed by President
Clinton because of its cost. A fundamental flaw in the legislation was
that it barely touched one of our tax code's biggest and most socially
damaging taxes on matrimony: the penalty for low--income workers eligible
for the EITC.
The EITC is a refundable tax credit that supplements the earnings of
low-income workers. President Clinton in 1993 got Congress to approve
a dramatic, $21 billion expansion of the credit as the cornerstone of
his efforts to "make work pay." As a result, the once obscure
tax credit has blossomed into the federal government's largest and most
effective anti-poverty initiative. But the way it is structured imposes
a heavy fine on marriage for millions of low-income workers with children.
The EITC marriage penalty, in fact, is part of a larger conundrum that
has caught the attention of policy analysts and lawmakers: In our largely
successful efforts to replace welfare with work, we've unwittingly created
a new trap -- a giant earnings tax. Here's how it works: As low-income
families earn more money, the value of various public supports -- the EITC,
food stamps, and certain state tax breaks -- begins to decline and eventually
reaches zero. Meanwhile, low-income families are often required to make
co-payments, often a percentage of their income, to retain child care and
health insurance. Economists see this phasing-out of public subsidies
and phasing-in of co-payments as tantamount to a tax on someone's private
earnings and therefore a disincentive to further effort.
The earnings tax affects America's poor and "near poor" working
families and even a large segment of the middle class. If a worker earns
less than $6.25 per hour or $12,500 per year, work does indeed pay. Earnings
get a 40 percent to 60 percent boost from a combination of the EITC, food
stamps, and free or cheap child care and health care, which are also augmented
by such state tax devices as supplemental state EITCs, Homestead Credits,
and exemptions from taxation altogether. This pushes up a worker's disposable
income to the equivalent of $8 to $9 per hour, or $16,000 to $18,000 per
year. But once earnings rise above $6.25 per hour or $12,500 per year,
work doesn't continue to pay for a huge segment of American families.
Above $6.25 per hour, earnings increases translate for many into very
sluggish growth in disposable income. At certain income notch points,
where an extra $1 of earnings spells the loss of an entire benefit or
the onset of a copayment, higher earnings actually yield lower overall
income. The problem persists until about $15.75 per hour or $31,500 per
year -- a spread of $19,000 that encompasses a vast swath of the U.S. population.
The very programs that help workers under $6.25 per hour get above (or
closer to reaching) the poverty line simultaneously punish workers making
from $6.25 to $15.75 per hour, in the sense of causing their work to not
continue to pay. The heart of the problem is the basic structure of the
EITC, food stamps, child care and health care subsidies, and various state
tax provisions that help the poor. All these programs have one thing in
common. They impose a high tax on earnings, hitting hardest those making
between $6.25 and $15.75 per hour.
For the EITC alone, the effective tax rate for a working mom with two
kids is 21 cents for every dollar earned. Most of the other programs --
food stamps, child care copays, health care copays, and state tax breaks
-- impose lower taxes on earnings, but they still pinch. Each program's
separate tax on earnings might be tolerable if standing alone. But their
combined tax rate is huge. Including the federal payroll tax that automatically
takes 7.65 percent of every dollar, the cumulative tax rate often exceeds
50 percent, at times rises to near 70 percent. These high effective tax
rates remain in place until as much as $15.75 per hour, at which point
the EITC -- and the huge portion of the combined earnings tax it imposes
-- disappears. If a wage earner has children, work doesn't pay much. Sometimes
it doesn't pay at all.
When two people combine their incomes by getting married, the earnings
tax becomes a marriage penalty. Because the EITC is based on total family
earnings and drops rapidly when family earnings exceed the start of the
EITC "phase-out range" ($12,690 in 2000), a worker with children
often ends up worse off if she gets married to another worker. Especially
if she's already living with him and they're sharing their incomes and
household expenses, getting married frequently means a big EITC loss with
few offsetting economic gains. Why marry?
Supporters of the EITC, food stamp advocates, and proponents of expanded
child care and health care must begin to talk more openly and honestly
about the unintended but very negative side effects built into the very
structure of these programs. If we don't curb the powerful work and marriage
disincentives that these programs create, then those who don't care about
the poor will exploit program flaws to try to block further help for the
working poor and the near poor.
Only a radical solution is possible. Just as welfare was so fundamentally
flawed that it could not be reformed but required a complete replacement,
the solution to the structural defects inherent in these programs is to
eliminate entirely the current policy of phasing out benefits. Ultimately,
we should also stop imposing co-payments for child care and health care.
The logical starting point is the federal EITC. First, it is the biggest
part of the problem. The EITC phase-out rate is the cause of the system's
biggest work and marriage penalties. Second, today's bipartisan interest
in cutting federal taxes offers a once-in-a-lifetime opportunity to fix
the EITC's work and marriage penalties as an integral part of a popular
middle class tax cut.
While minor adjustments in the EITC have merit, the only way to cure
the huge work and marriage penalties built into the credit's phase-out
is to abolish the EITC phase-out entirely. Just get rid of it. Let everyone
who reaches the maximum credit -- $2,353 for a family with one child and
$3,888 for a family with two children -- continue to qualify for the maximum
credit whether they're poor, working class, middle class, or wealthy.
Extending the maximum EITC credit to the middle class (and beyond) would
thus become the heart of the middle class tax cut that Congress enacts.
From a Democratic perspective, this combination of EITC reform with a
middle class tax cut is far more equitable than trimming the tax rate.
The group that Democrats claim a special concern for, the poor and near
poor, benefit twice: Their work is rewarded by rising incomes and their
marriages aren't discouraged. But ordinary Americans -- the Democrats'
working and middle class political base -- also win big. They get a big
tax cut, and they get the exact same dollar tax cuts as the wealthy.
EITC reform also makes sense for Republicans who see it as a vehicle
for cutting taxes. It cuts the taxes of the upper middle class. It cuts
the taxes of the wealthy. It eliminates the penalty on both marriage and
work, which they say they care about.
Obviously, ending the EITC's phase-out will be costly. But Congress seems
poised to spend a lot of the surplus on tax cuts anyway. The question
is not whether the federal government will cut Americans' taxes, but whether
a large tax cut will perpetuate or end the current anti-work and anti-marriage
bias of the tax code. Do we keep on punishing the poor and near poor or
do we reward them for working and marrying as we lower taxes on the middle
class and the wealthy?
If we end the EITC phaseout, everybody wins.
