Part 1 of 3 in TCF’s Tax-Week Series on the EITC
The April 15 income tax filing deadline is not the most popular day on the calendar for most Americans. But for the the working poor, it’s one of the most important—thanks to the Earned Income Tax Credit (EITC).
Originally created as a small offset to Social Security payroll taxes for low-income families, the EITC has grown to become the largest means-tested cash welfare program in the United States. In 2013, 28 million American households (technically, tax-filing units) received $66 billion in earned income credits, an average of $2,400 each.
But as instrumental as the EITC has been in lifting millions of families out of poverty each year, it remains underappreciated. Obscured in tax code, it occupies an isolated corner of the safety net, detached—in structure, if not substance—from the traditional “bricks-and-mortar” public assistance programs, such as food stamps and cash welfare (TANF), that loom large in the popular consciousness.
The EITC’s aloofness has been both a blessing and a challenge. While its status as a tax expenditure rather than an appropriation has afforded it a measure of protection from the annual budget process, its dependence on tax returns has both suppressed take-up rates and created misunderstandings that have proven costly to government and individuals alike.
With tax day just days away, there’s no better time to get to know the EITC’s intent, features, achievements, and opportunities for improvement. And so this blog post is the first of three—explaining how the EITC works, why it has worked so effectively, and what it needs to work on—all in an attempt to provide a roadmap that will benefit social policy reformers as well as potential beneficiaries.
A Tax Credit Is Born
Gerald Ford and Ronald Reagan are names not typically topping lists of safety net champions, yet it is to them, largely, that the EITC owes its existence. Created by the Tax Reduction Act of 1975 as a small, temporary, 10 percent credit for a family’s first $4,000 in income, the “earned income credit” was made permanent in 1978 and strengthened by the Tax Reform Act of 1986, which expanded eligibility, increased the maximum credit to $800, and indexed it to inflation.
Once established, the EITC has, as far as social programs go, proved singularly popular among lawmakers of both parties. Congress has passing substantive improvements with impressive regularity, and every subsequent president has put their stamp on the program.
George H. W. Bush signed into law an adjustment for family size (one or two children) in 1990. Bill Clinton—not to be outdone by his Republican predecessors—presided over a major EITC expansion in 1993, increasing credit rates to as high as 40 percent for some families and, for the first time, providing a nominal credit to childless adults. And, in yet another testament to the EITC’s bipartisan appeal, both George W. Bush and Barack Obama approved legislation reducing the credit’s “marriage penalty” (the situation where couples filing jointly receive smaller benefits than they would individually). Obama’s contribution was enacted as part of the 2009 stimulus law, which also provided for a fourth tier of benefits, for families with three or more children. However, both the marriage penalty reduction and the third child bonus are scheduled to expire December 31, 2017, unless Congress acts to make them permanent. (For a more detailed discussion of the EITC’s history, see this helpful Congressional Research Service report.)
How the EITC Is Structured
From its earliest days, the EITC took on its characteristic “plateau” shape, consisting of three regions: the upward sloping phase-in range, where the credit increases at a fixed rate with every additional dollar of income; the plateau, where the credit remains fixed at its maximum while earnings continue to increase; and the downward-sloping phase-out range, where the credit decreases at a fixed rate as earnings grow.
The size of these three regions—as well as the overall shape of the EITC plateau—are jointly determined by the credit’s four key parameters: (1) the phase-in rate, (2) the maximum credit, (3) the phase-out origin, and (4) the phase-out rate. And it’s through tweaking these parameters that most EITC policy is made.
For example, for tax year 2014 (the year you’re filing for now, in April 2015), the phase-in rate for families with two children is 40 percent, up to a maximum credit of $5,460; in other words, eligible families get a credit of 40 cents on the dollar for their first $13,650 in earnings. The third parameter—phase-out origin—is $17,830 for single tax filers; this means that all single-parent, two-child families earning between $13,650 and $17,830 get the maximum $5,460 credit. The final parameter, the phase-out rate, is 21.06 percent; for every dollar in earnings above $17,830, the credit is reduced by 21 cents. At this rate of reduction, the credit reaches zero at $43,756 in earnings; put differently, two-child families headed by a single parent earning up to this amount qualify for the credit (assuming they meet the other requirements, outlined below).
Two additional features, previously alluded to, slightly complicate the picture. First, for married taxpayers filing jointly, the phase-out origin is slightly higher—$5,430 higher—in 2014 (for families of all sizes). So, a married family with two children can earn up to $23,260 and still receive the maximum credit; up to $49,186 in earnings, they remain eligible for some credit. Thus, filing as a married couple does not change the maximum credit amount, but instead extends the plateau further into the income spectrum, and thus delays the phase-out origin.
Second, parameters differ by family size, with the value of the credit increasing with each child up to three. In 2014, a married couple filing jointly with three children could receive a maximum credit of $6,143, while a childless one would be eligible for at most $496. Taken together, these two features means there is not one EITC plateau, but eight (corresponding to four family sizes for each of single and married filers).
Reducing Poverty while Promoting Work
The EITC’s tripartite structure—up, flat, down—reflects its dual goals of reducing poverty while at the same time promoting work.
In its upward sloping phase, the EITC directly subsidizes wages, making work more rewarding, and, it is hoped, more attractive. (As a theoretical matter, whether the recipient of a wage subsidy works more hours as a result depends on whether the increased value of an extra hour of labor is worth more to her than the extra leisure she can “buy” now that she is richer; as a practical matter, the phase-in range of the EITC occurs at low enough levels of income that the attractiveness of working more wins out for most people.)
Similarly, the flat portion allows recipients to retain their gains as earnings increase, so as not to penalize raises and promotions. Things get trickier, however, on the downslope, where the phase-out creates a high marginal tax rate, meaning that workers may perceive the tension between earning more income yet receiving less subsidy. The hope is that the slope is imperceptible enough that workers do not become discouraged about earning too much to receive the maximum credit (or in any case, do not have sufficiently precise control over their work schedules to make a reduction in hours realistic).
Just as the EITC’s format promotes work, its status as a credit maximizes its ability to attenuate poverty. Unlike deductions, which reduce the amount of income subject to taxation, tax credits offer a one-for-one offset. The distinction is a big deal: for someone in the 15 percent tax bracket, a $100 deduction is worth $15 ($100 x 0.15), while a credit puts the full $100 back in his pocket. The EITC is doubly valuable because it is refundable, which means tax filers for whom the credit eliminates all tax liability get the balance paid back to them as a refund.
Emulating the EITC
Over time, the EITC’s approach of rewarding low-wage work has caught on at lower levels of government as well. Twenty-five states and the District of Columbia offer their own EITCs; the most generous is D.C.’s, which is set at 40 percent of the federal credit. Even two localities, New York City and Montgomery County, Maryland, also offer EITC supplements.
The challenge of encouraging self-sufficiency while offering protections against penury is a dilemma all safety net programs must navigate; by taking the plateau form, the EITC finesses the question better than most—and that is the question to which we’ll return tomorrow, in Part 2 of TCF’s tax-week series on the EITC.
The EITC—Our Biggest Program for the Working Poor
Part 1 of 3 in TCF’s Tax-Week Series on the EITC
The April 15 income tax filing deadline is not the most popular day on the calendar for most Americans. But for the the working poor, it’s one of the most important—thanks to the Earned Income Tax Credit (EITC).
Originally created as a small offset to Social Security payroll taxes for low-income families, the EITC has grown to become the largest means-tested cash welfare program in the United States. In 2013, 28 million American households (technically, tax-filing units) received $66 billion in earned income credits, an average of $2,400 each.
But as instrumental as the EITC has been in lifting millions of families out of poverty each year, it remains underappreciated. Obscured in tax code, it occupies an isolated corner of the safety net, detached—in structure, if not substance—from the traditional “bricks-and-mortar” public assistance programs, such as food stamps and cash welfare (TANF), that loom large in the popular consciousness.
The EITC’s aloofness has been both a blessing and a challenge. While its status as a tax expenditure rather than an appropriation has afforded it a measure of protection from the annual budget process, its dependence on tax returns has both suppressed take-up rates and created misunderstandings that have proven costly to government and individuals alike.
With tax day just days away, there’s no better time to get to know the EITC’s intent, features, achievements, and opportunities for improvement. And so this blog post is the first of three—explaining how the EITC works, why it has worked so effectively, and what it needs to work on—all in an attempt to provide a roadmap that will benefit social policy reformers as well as potential beneficiaries.
A Tax Credit Is Born
Gerald Ford and Ronald Reagan are names not typically topping lists of safety net champions, yet it is to them, largely, that the EITC owes its existence. Created by the Tax Reduction Act of 1975 as a small, temporary, 10 percent credit for a family’s first $4,000 in income, the “earned income credit” was made permanent in 1978 and strengthened by the Tax Reform Act of 1986, which expanded eligibility, increased the maximum credit to $800, and indexed it to inflation.
Once established, the EITC has, as far as social programs go, proved singularly popular among lawmakers of both parties. Congress has passing substantive improvements with impressive regularity, and every subsequent president has put their stamp on the program.
George H. W. Bush signed into law an adjustment for family size (one or two children) in 1990. Bill Clinton—not to be outdone by his Republican predecessors—presided over a major EITC expansion in 1993, increasing credit rates to as high as 40 percent for some families and, for the first time, providing a nominal credit to childless adults. And, in yet another testament to the EITC’s bipartisan appeal, both George W. Bush and Barack Obama approved legislation reducing the credit’s “marriage penalty” (the situation where couples filing jointly receive smaller benefits than they would individually). Obama’s contribution was enacted as part of the 2009 stimulus law, which also provided for a fourth tier of benefits, for families with three or more children. However, both the marriage penalty reduction and the third child bonus are scheduled to expire December 31, 2017, unless Congress acts to make them permanent. (For a more detailed discussion of the EITC’s history, see this helpful Congressional Research Service report.)
How the EITC Is Structured
From its earliest days, the EITC took on its characteristic “plateau” shape, consisting of three regions: the upward sloping phase-in range, where the credit increases at a fixed rate with every additional dollar of income; the plateau, where the credit remains fixed at its maximum while earnings continue to increase; and the downward-sloping phase-out range, where the credit decreases at a fixed rate as earnings grow.
The size of these three regions—as well as the overall shape of the EITC plateau—are jointly determined by the credit’s four key parameters: (1) the phase-in rate, (2) the maximum credit, (3) the phase-out origin, and (4) the phase-out rate. And it’s through tweaking these parameters that most EITC policy is made.
For example, for tax year 2014 (the year you’re filing for now, in April 2015), the phase-in rate for families with two children is 40 percent, up to a maximum credit of $5,460; in other words, eligible families get a credit of 40 cents on the dollar for their first $13,650 in earnings. The third parameter—phase-out origin—is $17,830 for single tax filers; this means that all single-parent, two-child families earning between $13,650 and $17,830 get the maximum $5,460 credit. The final parameter, the phase-out rate, is 21.06 percent; for every dollar in earnings above $17,830, the credit is reduced by 21 cents. At this rate of reduction, the credit reaches zero at $43,756 in earnings; put differently, two-child families headed by a single parent earning up to this amount qualify for the credit (assuming they meet the other requirements, outlined below).
Two additional features, previously alluded to, slightly complicate the picture. First, for married taxpayers filing jointly, the phase-out origin is slightly higher—$5,430 higher—in 2014 (for families of all sizes). So, a married family with two children can earn up to $23,260 and still receive the maximum credit; up to $49,186 in earnings, they remain eligible for some credit. Thus, filing as a married couple does not change the maximum credit amount, but instead extends the plateau further into the income spectrum, and thus delays the phase-out origin.
Second, parameters differ by family size, with the value of the credit increasing with each child up to three. In 2014, a married couple filing jointly with three children could receive a maximum credit of $6,143, while a childless one would be eligible for at most $496. Taken together, these two features means there is not one EITC plateau, but eight (corresponding to four family sizes for each of single and married filers).
Reducing Poverty while Promoting Work
The EITC’s tripartite structure—up, flat, down—reflects its dual goals of reducing poverty while at the same time promoting work.
In its upward sloping phase, the EITC directly subsidizes wages, making work more rewarding, and, it is hoped, more attractive. (As a theoretical matter, whether the recipient of a wage subsidy works more hours as a result depends on whether the increased value of an extra hour of labor is worth more to her than the extra leisure she can “buy” now that she is richer; as a practical matter, the phase-in range of the EITC occurs at low enough levels of income that the attractiveness of working more wins out for most people.)
Similarly, the flat portion allows recipients to retain their gains as earnings increase, so as not to penalize raises and promotions. Things get trickier, however, on the downslope, where the phase-out creates a high marginal tax rate, meaning that workers may perceive the tension between earning more income yet receiving less subsidy. The hope is that the slope is imperceptible enough that workers do not become discouraged about earning too much to receive the maximum credit (or in any case, do not have sufficiently precise control over their work schedules to make a reduction in hours realistic).
Just as the EITC’s format promotes work, its status as a credit maximizes its ability to attenuate poverty. Unlike deductions, which reduce the amount of income subject to taxation, tax credits offer a one-for-one offset. The distinction is a big deal: for someone in the 15 percent tax bracket, a $100 deduction is worth $15 ($100 x 0.15), while a credit puts the full $100 back in his pocket. The EITC is doubly valuable because it is refundable, which means tax filers for whom the credit eliminates all tax liability get the balance paid back to them as a refund.
Emulating the EITC
Over time, the EITC’s approach of rewarding low-wage work has caught on at lower levels of government as well. Twenty-five states and the District of Columbia offer their own EITCs; the most generous is D.C.’s, which is set at 40 percent of the federal credit. Even two localities, New York City and Montgomery County, Maryland, also offer EITC supplements.
The challenge of encouraging self-sufficiency while offering protections against penury is a dilemma all safety net programs must navigate; by taking the plateau form, the EITC finesses the question better than most—and that is the question to which we’ll return tomorrow, in Part 2 of TCF’s tax-week series on the EITC.