Earned income tax credit (EITC)

Reading Assignment Greenstein, The Earned Income Tax Credit: Boosting Employment, Aiding the Working Poor, DeParle, Ch. 17: Money: Milwaukee, Summer 1999

Additional EITC Links IRS EITC information: Thresholds and maximum credits: Q & As: EITCs reach:

Todays 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

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 familys 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.

2008 EITC Parameters Type of Return (No. of children) Maximu m Eligible Earnings Maximum Credit Begin Phase- out Breakeve n Point Credit Rate Phase- out Rate Childless$ 5,750$ 438$7,250$12, % 1$ 8,600$2,917$15,750$33, %15.98% 2$12,100$4,824$15,800$38, %21.06% 3 or more* $5, % Note: Married Filing Jointly have Phase-out and Breakeven point $3,000 above listed values. * Applies to 2009 and 2010 tax returns. Source:

Source: Center for Budget and Policy Priorities,

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

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 familys cash income totals $18,054, or $708 above the 2008 poverty line for a family of three ($17,346).

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

Who Receives the EITC? Source: Holt, 2006

Who Receives the EITC? Source: Holt, 2006

Who Receives the EITC?

Source: Holt, 2006

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

Source: Levitis and Johnson, 2006

Which States supplement the credit? 24 States (counting the District of Columbia as a State) supplement with Federal EITC. See view&id=462 for details. view&id=462

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

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

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

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).

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 taxes15% Payroll tax 7% EITC phase-out21% –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 % !

Will this popularity last?-- problems with the EITC, cont. Subsidy to low-wage employers –w 0, L 0 initial equilibrium –w 1, L 0 equilibrium with EITC –EITC = w 0 - w 1 –Final equilbrium is at w 2, L 2 workers wages S S D w1w1 w0w0 L0L0 L2L2 w2w2

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

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

Source: Iris J. Lav, Extending Marriage-Penalty Relief to Working Poor and Near Poor Families, EITC Marriage Penalty

GtD Adequacy Cost Minimization Work incentives E B = G/t + D

labor force participation for individuals, cont. Budget Constraints D B A Y C Z2Z2 Z1Z1 hours of work leisure hours E F Budget constraint ADE The individual has higher nonwage income (Z 2 = AD) and the same market wage rate O Budget constraint ADF The individual has higher nonwage income (Z 2 = BD) but a lower market wage (DF is less steep).

labor force participation for individuals, cont. Individual Chooses To Work 0 Work Hours (maximum leisure hours) Leisure hours (l) Work hours (L) Income (Y) 0 Leisure hours (maximum work hours) U3U3 U2U2 U1U1 A B C D Utility is maximized at D where MRCS = w L1L1 Y1Y1

labor force participation for individuals, cont. Individual Chooses Not To Work when nonwage income increases 0 Work Hours (maximum leisure hours) Leisure hours (l) Work hours (L) Income (Y) 0 Leisure hours (maximum work hours) UnUn U2U2 U1U1 A B C D Utility is maximized at F where: MRCS = w = reservation wage F is a corner solution Work hours fall from L 1 to 0 (pure income effect: Y l) L1L1 Y1Y1 F

labor force participation for individuals, cont. Individual Chooses To Work Less as Wage rate falls 0 Work Hours (maximum leisure hours) Leisure hours (l) Work hours (L) Income (Y) 0 Leisure hours (maximum work hours) U3U3 U2U2 U1U1 A B C D Utility is maximized at E Hours worked falls from L 1 to L 2 Y2Y2 L2L2 L1L1 Y1Y1 E LYLY income effect: L 1 - L Y Substitution effect L2 - LY