The earned-income tax credit (EITC) is one of the
most successful social policies of the last two
decades. President Clinton's five-year, $21 billion
expansion of the EITC in 1993, based on proposals from
the Progressive Policy Institute (PPI), represents his
greatest social policy accomplishment and provides the
foundation for any serious welfare reform.1 The
expanded credit will help 1.4 million families-
including close to 3 million children-escape poverty
by 1996.2
Yet the EITC is a target for cuts as the
Republican-controlled Senate attempts to balance the
budget by the year 2002. Despite the GOP's strong past
support for the EITC, some Republicans now charge that
the program is too costly, ineffective, and rife with
fraud. The evidence shows that these charges are
exaggerated or plainly incorrect, and it is time to
set the record straight. If conservatives are serious
about promoting work by low-income families and
ensuring that full-time workers escape poverty-
prerequisites for successful welfare reform-they will
help preserve this program.
PURPOSE OF THE EITC. The EITC's fundamental purpose is
to "make work pay," by supplementing the earnings of
those working for poverty-level wages. As opposed to
less well-targeted approaches such as the minimum
wage, the EITC benefits only those below a certain
income level-and the vast majority of working families
with children that are poor or near-poor. When the
1993 reforms are fully implemented next year, the EITC
will bring the income of a family of four with a full-
time, year-round worker at least up to the poverty
line, taking into account the value of the family's
food stamps and the burden of its payroll taxes.
The program accomplishes this goal by matching
each dollar earned with a refundable tax credit of
between 7.65 cents and 40 cents, depending on family
size, until an income ceiling is reached. For a family
with two or more children, the refundable credit
reaches a maximum level of $3,370 when a worker earns
$8,425, remains at that level through earnings of
$11,000, and then gradually declines to zero when
earnings reach $27,000.3 The size of the credit varies
according to family size since the poverty level
varies with family size.
The EITC embodies both progressive and
conservative values by: (1) rewarding those who work,
rather than those who live on public assistance; (2)
targeting the greatest benefits to those with the
greatest need; (3) offsetting the tax burden on
families struggling to make ends meet; (4) providing
incentives for people to enter the workforce who
otherwise might not do so; and (5) achieving these
ends with virtually no government bureaucracy.
Moreover, the EITC supports the private market, rather
than interfering with it. In fact, it is the only
program specifically designed to help poor people who
choose to work.
PPI's first policy report, published in June
1989,4 analyzed the EITC and the minimum wage as
alternative strategies for helping working poor
families. Raising the minimum wage, it was found,
would help mainly second and third workers in middle-
income families, ignore poor workers who are self-
employed, and be financed through higher prices on
everyone, including poor people. By contrast, a
redesigned EITC could be targeted exclusively to
lower-income people, cover all the working poor, and
be financed through the progressive income tax. Having
established the superior value of the EITC, it is now
troubling to see such a sensible program come under
such thoughtless attack.
Opponents have leveled the following criticisms of
the program, all misleading or inaccurate:
Criticism #1: The program's sharply rising costs have
created another "out-of-control entitlement" that
needs to be reigned in.
Criticism #2: The credit is poorly targeted: It
assists only a small minority of Americans below the
poverty line, while simultaneously helping many who
are not poor.
Criticism #3: The program is subject to unacceptably
high rates of fraud.
Criticism #4: On balance, it discourages work because
so many recipients qualify in the phase-out range of
the credit.
Criticism #5: The program discourages marriage,
because low-income couples who marry face sharp cuts
in their total benefits.
We will demonstrate why none of these criticisms is
well-founded.
RISING COSTS. The total costs of the EITC have grown
significantly-from $6.9 billion in 1990 to a projected
$24.6 billion in 1996. Sens. Don Nickles (R-OK) and
Judd Gregg (R-NH) have criticized this aspect of the
EITC, arguing that cuts the program are justified
because Congress must "restrain its unsustainable
rates of growth." This contrasts sharply with past GOP
positions, when EITC expansions were preferred to
regular increases in the minimum wage.
What critics conveniently ignore is that the
recent expansions were specifically endorsed by
Congress. While growth in the major entitlements
(Medicare, Medicaid, and Social Security) is driven by
rising health care costs and shifting demographics,
the cost of the EITC has grown quickly because
Congress has voted to expand its scope and benefits
twice in the last five years. Moreover, the purpose it
served was clear and compelling: ensuring that
families with full-time workers would not live in
poverty. In fact, once the 1993 changes are fully
phased in next year, the annual program costs will
start to decline as a percentage of the gross domestic
product (GDP), again in contrast to the major
entitlement programs serving the elderly.
TARGET POPULATION. Republicans have criticized the
EITC for reaching only a small minority of poor
Americans: Of all families below the poverty line,
only about 35 percent are eligible for the EITC.
This statistic simply reflects the fact that the
EITC is designed to target not all poor families, but
only low-income working families. By this measure, the
program is remarkably successful: Of all families
eligible to receive the EITC in 1990, between 80
percent and 86 percent did receive it. The EITC
participation rate, therefore, is higher than that for
Aid to Families with Dependent Children (AFDC), which
reaches 62 percent to 72 percent of eligible families,
or food stamps, which reaches 54 percent to 66
percent.5 Furthermore, analysts predict that the
participation rate could easily exceed 90 percent when
the 1993 reforms are fully implemented.
WASTE, FRAUD, AND ABUSE. As benefits and participation
have expanded, the number of fraudulent claims has
also increased. Some GOP senators, most notably
William Roth (R-DE) and Nickles, aim to cut the EITC
because they claim the program has a fraud rate of 35
percent to 45 percent, thereby costing taxpayers
billions of dollars in fraudulent refunds and
penalizing honest working families whose earnings do
not pull them up to the poverty line.
Critics have made an important mistake by
repeatedly citing this statistic. It is based on a
January 1994 study by the Internal Revenue Service
(IRS) of returns filed electronically during the first
few weeks of the tax filing season, and it is
inaccurate and misleading for the following reasons:
The 35 percent to 45 percent statistic from that
study is an error rate, not a fraud rate. If a worker
claimed the credit but was $1 off-either high or low-
in the calculations, this was included in the "error"
statistic. Many of these unintentional errors are
corrected by the IRS and result in no overpayment of
credit. The IRS estimates that nearly half of the
supposed fraudulent claims were actually unintentional
errors of this type.6
While the remaining half of the erroneous returns
were instances of the EITC being claimed in error,
this number also overstates the current fraud rate for
several reasons:
-- The number refers to the percentage of erroneous
claims, not the percentage of overpayments. A 20
percent fraud rate, for example, does not mean that $4
billion of a $20 billion program are fraudulent
refunds; it means that one-fifth of all families
claiming the credit significantly overestimated their
refunds.
-- Some taxpayers who claimed the credit in error, when
they do not qualify, may also have done so
unintentionally due to the complexity of the tax laws.
-- Returns filed electronically early in the filing
season are widely believed to have higher EITC fraud
rates than returns filed overall.7
-- The study was based on returns for tax year 1993.
Since then, the IRS has implemented new procedures to
cut down on EITC fraud, such as double-checking the
Social Security numbers of all dependents to make sure
that each exists and that the same child is not
claimed on multiple returns.
Thus the true fraud rate was never 35 percent to
45 percent; rather, perhaps 20 percent of claims
contained error or fraud-and again, this does not mean
that 20 percent of all refunds were erroneous or
fraudulent. (In fact, an accurate dollar amount of
losses due to fraud has not been calculated since the
1990 expansion.) A 20-percent error and fraud rate is
still unacceptably high, but the new prevention
procedures undertaken by the IRS for the 1994 tax year
should reduce the rate significantly. While these
procedures have delayed tax refunds for many Americans
this year, the efforts of the IRS have saved millions
of dollars; most importantly, delays and fraud will be
reduced in future years as IRS verification strategies
are improved.
In sum, there are problems with error and fraud
that should be addressed, and the IRS is working on
this problem. The challenge is to reduce fraud without
resorting to a solution that will eliminate incentives
for the poor to work.
WORK DISINCENTIVE. Some critics assert that the EITC
is actually a net work disincentive, because once
poverty-level income is achieved, the EITC support
begins to phase out. For example, the credit declines
by 21 cents for each dollar of additional earnings
between $11,600 and $28,500 for a family of four (in
1996), in effect applying an additional 21 percent tax
rate to these earnings. Some Republicans charge that
this provision discourages work, thus reducing the
labor efforts of low-income workers.
Effective marginal tax rates are high in the
phase-out range. For example, at the lower end of the
range, where families are eligible for food stamps but
not yet subject to federal or state income taxes, the
marginal tax rate can be as high as 65 percent for
families with two children. (This is the sum of
marginal tax rates resulting from sales and excise
taxes, payroll taxes, the phase-out of the food-stamp
program, and the phase-out of the EITC). At the high
end of the range, where families pay income taxes but
are not eligible for food stamps, the marginal rate
approaches 60 percent for two-child households.8
We also agree that the maximum allowable income
has been set higher than necessary. For example,
recent data show that more than 60 percent of families
receiving the credit fall in the phase-out range,9
which shows that the credit is not perfectly targeted
and could be improved.
Nevertheless, recent research shows that the
incentive to enter the labor force provided by the
newly expanded EITC outweighs any disincentives in the
phase-out range. Some people probably do choose not to
work extra hours as a result of the high marginal
rates. On balance, however, the expanded program will
provide a net positive work impact equal to 20 million
hours per year by 1996 if labor market entrants work
400 hours annually.10 In the final analysis, the total
net benefit may be larger since the average EITC
recipient worked 1,300 hours in 1993.11 The
problematic disincentives in the phase-out range a
feature of any tax provision that phases out as income
rises-can be addressed without resorting to the
shortsighted solution of cutting the program.
MARRIAGE DISINCENTIVE. Critics of the EITC say the
credit discourages marriage, because when two single,
low-income workers choose to marry, the dollar value
of their EITC can fall dramatically. Consider a single
man with two children and a single woman with two
children, each earning $11,000 a year. Separately,
each would be eligible for a 1996 EITC of $3,370. If
they marry and both continue to work, their EITC drops
to one payment of $1,054-a drop of $5,700, or more
than 25 percent of their combined earned income.
A closer look, however, deflects this criticism.
The EITC actually serves as a marriage incentive for
low- or no-income taxpayers with children, especially
when only one member of the prospective couple has a
child, or unmarried couples who plan to have children.
For example, a single man with earnings of $11,000
marrying a non-working mother with two children would
receive a 1996 tax credit of $3,370, money he would
not have received had he remained single. The high
cost of health care and child care-hard to afford in
the private sector but readily available in the
welfare system-encourage low-earning women with young
children to choose welfare over work. Therefore, it
seems more likely that on the lower rungs of the
economic ladder, the EITC would encourage, not
discourage, marriage.
As a foundation for welfare reform, a nonbureaucratic
work incentive, and one of the few social programs
that actually works, the EITC is a cornerstone of a
progressive social policy for the 21st century. We can
get people to move from welfare to work only if work
pays, and the EITC ensures that it will.
The program is not perfect, however, and needs
some minor adjustments. Unlike the new GOP critics, we
believe in improving a valuable program rather than
cutting it because it doesn't work perfectly. Some
social programs are worthwhile investments; they need
repair, not the budget axe.
Some suggested reforms:
Require firms to notify their low-wage workers in
writing that the credit can be applied to each
paycheck, rather than collected at year's end. Less
than 1 percent of EITC recipients use this option.
Applying the credit to each paycheck would provide
better assistance to working families and would likely
reduce fraud, because firms have an incentive to
correctly report hours worked and income earned.
Adjust the phase-in and phase-out ranges to maximize
the number of families in the former and minimize the
number in the latter. There is a trade-off here, as
there is in any program with a phase-out range:
Shortening the phase-out range requires that income in
this range be taxed at even higher rates. Nonetheless,
it may be preferable to have a smaller number of
workers pay a high tax rate than have many more
workers pay a slightly lower tax rate. We recommend
that Congress: (1) lengthen the phase-in range; (2)
shorten the phase-out range (thus increasing the
marginal tax rate); and (3) reduce the maximum
allowable income to qualify, in order to better target
the credit. These changes will place more families in
the work incentive range of the EITC without
increasing its total cost.
Implement further policies designed to reduce fraud.
We should deny the EITC to undocumented workers.
Currently, they are eligible for the EITC if they meet
the credit's eligibility rules-a policy at cross
purposes with immigration policy. Revisions to the
EITC criteria would ensure that undocumented workers
would no longer qualify for the credit.
With compelling evidence that the EITC is a success-it
will help 25 percent of eligible workers with below-
poverty incomes escape poverty by 199612 -cuts in the
program are the equivalent of raising taxes on low-
income working families to help balance the budget.
These cuts will have the effect of pushing more
families into poverty, thus making real welfare reform
much more difficult. In their quest to slash or block
grant every social program, Republican senators have
acted hastily by endorsing cuts in the EITC; they are
removing the foundation for welfare reform and
condemning many of America's low-income workers to
poverty.
1.
The current design of the credit is based on an
approach developed by PPI vice president Robert J.
Shapiro, who advanced the idea that no family with a
full-time, year-round worker should have to live in
poverty. For example, see "An American Working Wage:
Ending Poverty in Working Families," PPI, Policy
Report No. 3, February 1990.
2.
John Karl Scholz, "The Earned Income Tax Credit:
Participation, Compliance, and Anti-Poverty
Effectiveness," NATIONAL TAX JOURNAL, March 1994, pp.
59-81.
3.
Credit rates and dollar figures are for 1996 and
beyond, when the 1993 expansion will be fully phased
in.
4.
Robert J. Shapiro, "Work and Poverty: A Progressive
View of the Minimum Wage and the Earned Income Tax
Credit," PPI, Policy Report No. 1, June 1989.
5.
Scholz, op. cit., and John Karl Scholz, "Testimony
Before the Senate Committee on Governmental Affairs,"
April 5, 1995.
6.
Margaret Milner Richardson, Commissioner of Internal
Revenue, "Testimony Before the Senate Committee on
Governmental Affairs," April 4, 1995.
7.
Center on Budget and Policy Priorities, "The Earned
Income Tax Credit and Calls to Reduce It," May 2,
1995.
8.
Edgar K. Browning, "Effects of the Earned Income Tax
Credit on Income and Welfare," NATIONAL TAX JOURNAL,
March 1995, pp. 23-43. Browning concedes that it is
theoretically possible for a family to receive food
stamps and be subject to income taxes, but he
considers the two mutually exclusive to simplify the
analysis.
9.
Janet Holtzblatt, Janet McCubbin, and Robert
Gillette, "Promoting Work Through the EITC," NATIONAL
TAX JOURNAL, September 1994, pp. 591-608.
10.
Scholz, 1995, op. cit., and "The Earned Income Tax
Credit and Transfer Programs: A Study of Labor Market
and Program Participation," prepared for the National
Bureau of Economic Research.
11.
James Bovard, "Clinton's Biggest Welfare Fraud," THE
WALL STREET JOURNAL, May 10, 1994, p. A18. Bovard
suggests that the EITC should be targeted to full-
time, year-round workers (i.e., 2000 hours per year or
more). Other analysts, however, including PPI's
Shapiro, challenge this view, noting that most working
poor people cannot control their ability to work year-
round. Many poor workers are employed in seasonal
occupations such as agriculture, and the employment of
all low-skilled workers is sensitive to changes in
business conditions over which they have no control.
Limiting the EITC to full-time, year-round workers,
Shapiro notes, would in effect exacerbate the poverty
of working families whose breadwinners lose their jobs
or are forced to cut back their hours through no fault
of their own.
12.
Scholz, 1994, op. cit.
M. Jeff Hamond is economic policy analyst and Lyn A.
Hogan is social policy analyst for the Progressive
Policy Institute.
|
 |
