Earned income tax credit (EITC)

1. Earned income tax credit (EITC)

2. Reading Assignment • Greenstein, “The Earned Income Tax Credit: Boosting Employment, Aiding the Working Poor,” http://www.cbpp.org/7-19-05eic.htm • DeParle, Ch. 17: Money: Milwaukee, Summer 1999

3. Additional EITC Links • IRS EITC information: http://www.irs.gov/individuals/article/0,,id=96406,00.html • Thresholds and maximum credits: http://www.irs.gov/individuals/article/0,,id=150513,00.html • Q & As: http://www.irs.gov/individuals/article/0,,id=96466,00.html • EITC’s reach: http://www.taxpolicycenter.org/publications/url.cfm?ID=1000467

4. Today’s Questions • What is the EITC and how does it work? • Who receives the EITC? • How large are the credits? • Which States supplement the credit? • Why is the EITC politically popular? • Will this popularity last?-- problems with the EITC

5. What is the EITC and how does it work? • A tax reduction and wage supplement for low- and moderate-income families • Available to both single parent, two parent families, and childless low-income workers • Must work to be eligible • A refundable credit, which means that if the credit amount is larger than a family’s income tax bill, the family receives a refund check equal to the difference. • Usually claimed when the income tax return is filed. Can opt for equal monthly payments.

6. 2008 EITC Parameters

7. Source: Center for Budget and Policy Priorities, http://www.cbpp.org/cms/?fa=view&id=2505

8. ARRA and the Earned Income Tax Credit • The American Recovery and Reinvestment Act (ARRA) provides a temporary increase in the earned income tax credit (EITC) for taxpayers with three or more qualifying children. The maximum EITC for this new category is $5,657. ARRA also increases the beginning point of the phaseout range for the credit for all married couples filing a joint return, regardless of the number of children. These changes apply to 2009 and 2010 tax returns. • Source: irs.gov

9. Example • A single parent with two children working nearly full-time--52 weeks per year at 38 hours per week--at the minimum wage of $7.25 per hour has an annual income of about $14,326. After subtracting $1,095 in federal payroll taxes and adding the $4,842 federal EITC for which the family qualifies, the family’s cash income totals $18,054, or $708 above the 2008 poverty line for a family of three ($17,346).

10. Who Receives the EITC? • 5.4 million poor families with at able-bodied parents • 3.3 million or 66 percent had at least one parent in the labor force • Among poor families with children in which one or both parents worked anytime during the year, the parents worked at combined 44 weeks. • About 75 percent of the families on welfare (TANF, SSI, or GA) had a parent working in 2004

12. Who Receives the EITC? Source: Holt, 2006

13. Who Receives the EITC? Source: Holt, 2006

14. Who Receives the EITC?

15. Who Receives the EITC? Source: Holt, 2006

16. How large are the credits? Source: Nagle and Johnson, 2006

17. Source: Levitis and Johnson, 2006

18. Source: Levitis and Johnson, 2006

19. Which States supplement the credit? • 24 States (counting the District of Columbia as a State) supplement with Federal EITC. • See http://www.cbpp.org/cms/index.cfm?fa=view&id=462 for details.

20. Why is the EITC Politically Popular? • Encourages work • More people enter the labor force • Workers work more hours • Reduces welfare costs • Grogger concluded that the EITC “may be the single most important policy for explaining recent increases in work and earnings and declines in receipt of cash welfare assistance among female-headed families.” Source: Greenstein, 2005

21. Why is the EITC Politically Popular?, Cont. • Reduces poverty • By 4.4 million in 2003 • The poverty rate among children would be 1/4 higher without EITC • Lifts more children out of poverty than any other program

24. Child Credit • a $1,000 tax credit per child on your tax return for children who are under 17 as of the end of the tax year • Phased out for taxpayers with modified adjusted gross income • reduced (but not below zero) by $50 for each $1,000 (or fraction thereof) by which the taxpayer's modified adjusted gross income exceeds the threshold amount. • Threshold amounts: • $110,000 in the case of a joint return • $75,000 in the case of an unmarried individual • $55,000 in the case of a married individual filing a separate return

25. Will this popularity last?-- problems with the EITC • Fraud • Overpayments to eligibles • Fraudulent claims from ineligibles • Nonparticipation • Marriage penalty encourages cohabitation • A two earner, two-child couple making $35,000 (with a 60/40% earnings split) can save $3,923 a year in federal income taxes by avoiding marriage (EITC: $4,400 vs. $476).

26. Will this popularity last?-- problems with the EITC, cont. • High cumulative marginal tax rates • When earnings are in the phase-out range, the combined marginal tax rates for the may create a substantial work disincentive • Federal income taxes 15% • Payroll tax 7% • EITC phase-out 21% • Add a State income tax (3 to 6%) to this 43% marginal tax rate if relevant. • Add 24% phase-out rate for Food Stamps. • Cumulatively the marginal tax rate face by low-income Americans is in the range of 43- 73% !

27. Will this popularity last?-- problems with the EITC, cont. • Subsidy to low-wage employers • w0, L0 initial equilibrium • w1, L0 equilibrium with EITC • EITC = w0 - w1 • Final equilbrium is at w2, L2 wages S S’ w0 w2 w1 D L0 L2 workers

28. Will this popularity last?-- problems with the EITC, cont. • The EITC is an entitlement!

29. Proposed Improvements • Increase tax credit for low-income workers without children • Increase tax credit for families with three or more children  • Eliminate the marriage penalty • Simplify filing procedures

30. EITC Marriage Penalty Source: Iris J. Lav, Extending Marriage-Penalty Relief to Working Poor and Near Poor Families, http://www.cbpp.org/6-10-99tax.htm

31. EB = G/t + D

32. labor force participation for individuals, cont.Budget Constraints Y • Budget constraint ADE The individual has higher nonwage income (Z2 = AD) and the same market wage rate E F • Budget constraint ADF The individual has higher nonwage income (Z2 = BD) but a lower market wage (DF is less steep). C D Z2 Z1 B A O leisure hours hours of work

33. labor force participation for individuals, cont.Individual Chooses To Work U3 Income (Y) U2 Utility is maximized at D where MRCS = w U1 C D Y1 B A L1 0 Leisure hours (maximum work hours) 0 Work Hours (maximum leisure hours) Leisure hours (l) Work hours (L)

34. labor force participation for individuals, cont.Individual ChoosesNotTo Work when nonwage income increases Income (Y) Utility is maximized at F where: MRCS = w = reservation wage F is a corner solution Work hours fall from L1 to 0 (pure income effect: Yl) Un U2 U1 C F D Y1 B A 0 Leisure hours (maximum work hours) L1 0 Work Hours (maximum leisure hours) Leisure hours (l) Work hours (L)

35. labor force participation for individuals, cont.Individual Chooses To Work Less as Wage rate falls U3 • Utility is maximized at E • Hours worked falls from L1 to L2 Income (Y) U2 U1 C • income effect: L1 -LY • Substitution effect L2 - LY D Y1 Y2 E B A LY L1 L2 0 Work Hours (maximum leisure hours) 0 Leisure hours (maximum work hours) Leisure hours (l) Work hours (L)