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Earned income tax credit

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Jonathan Barry Forman
University of Oklahoma College of Law

A refundable income tax credit for low-income working taxpayers.


The earned income tax credit (EITC) was originally enacted in 1975, and over the years it has grown to be one of the principal antipoverty programs in the federal budget. The credit underwent significant expansions in 1990 and 1993. In 2003, some 19 million taxpayers were expected to claim more than $34 billion of earned income credits, with an average credit per taxpayer of $1,784 per year (U.S. Congress 2004). In 2004, some families will be entitled to claim an earned income credit of up to $4,300 per year (IRS 2003).

Unlike most other tax credits for individuals, the earned income credit is refundable. That is, if the earned income credit exceeds the taxpayer’s tax liability, the Internal Revenue Service (IRS) will refund the difference. In 2003, of the roughly $34 billion of earned income credits claimed, almost $31 billion was attributable to the portion of the credit that exceeds taxpayers’ tax liabilities (U.S. Congress 2004).

The statute provides that a taxpayer’s earned income credit will equal a specified percentage of the taxpayer’s earned income up to a maximum dollar amount (U.S. Code, Title 26, Section 32). The maximum credit amount is available to taxpayers over a certain income range and is phased out as a taxpayer’s income increases beyond a specified phaseout floor. The IRS publishes tables each year to help taxpayers and their employers determine the proper amount of credit.

Six separate schedules apply, depending on how many qualifying children the taxpayer has and the marital status of the taxpayer. For 2004, a family with two or more qualifying children is entitled to claim an earned income credit of up to $4,300 (IRS 2003). The credit is computed as 40 percent of the first $10,750 of earned income. For married couples filing joint returns, the maximum credit is reduced by 21.06 percent of earned income (or adjusted gross income, if greater) in excess of $15,040 and is entirely phased out at $35,458 of income. For heads of household, the maximum credit phases out over the range from $14,040 to $34,458.

Similarly, a family with one child is entitled to an earned income credit of up to $2,604. The credit is computed as 34 percent of the first $7,660 of earned income. For married couples filing joint returns, the maximum credit is reduced by 15.98 percent of earned income (or adjusted gross income, if greater) in excess of $15,040 and is entirely phased out at $31,338 of income. For heads of household, the maximum credit phases out over the range from $14,040 to $30,338.

Childless individuals between the ages of 25 and 65 are entitled to an earned tax income credit of up to $390. The credit is computed as 7.65 percent of the first $5,100 of earned income. For married couples filing joint returns, the maximum credit is reduced by 7.65 percent of earned income (or adjusted gross income, if greater) in excess of $7,390 and is entirely phased out at $12,490 of income. For heads of household and single individuals, the maximum credit phases out over the range from $6,390 to $11,490.

These maximum earned income credit amounts will expand even beyond 2004, as the applicable earned income and phaseout amounts are indexed for inflation.

To be a "qualifying child" within the meaning of the earned income credit, an individual must satisfy three tests: relationship, residency, and age. The relationship test is satisfied if the child is the taxpayer’s child, stepchild, or a descendant of a child or of a sibling or stepsibling. The residency test is satisfied if the child has lived with the taxpayer at least onehalf of the taxable year, in a household located in the United States. The age test is satisfied if the child is (1) under age 19, (2) a full-time student under age 24, or (3) permanently and totally disabled. Also, to be eligible for the credit, childless taxpayers must be at least age 25 but under age 65. One result is that many low-income workers, even those who pay taxes, may be left out of the EITC.

The earned income credit is available to both employees and independent contractors, as the term "earned income" is defined to include wages, salaries, tips, and other employee compensation, and the net earnings from self-employment. To claim the credit, a taxpayer must file IRS Form 1040 or Form 1040A. Taxpayers with children must also fill out Schedule EIC to claim the credit.

Taxpayers with children may elect to receive advance payment of a portion of their earned income credit in their paychecks throughout the year. To receive the credit in advance, a taxpayer must fill out IRS Form W-5, the Earned Income Credit Advance Payment Certificate, and give it to his or her employer. The employer then includes a portion of the employee’s advance earned income credit amount along with wages, and the remainder of the credit is refunded only after the taxpayer files an income tax return. The IRS publishes tables to help employers determine the proper amount of advance payment. For example, an employee earning between $147 and $270 a week in 2004 gets a $30 per week paycheck increase by electing to receive advance payment of the credit. In practice, this option is rarely used, in part because it leads to added complexity since the taxpayer must also still file the EITC form; the General Accounting Office reports that fewer than 1 percent of those eligible for the EITC elect advance payment.

History of the credit

The earned income credit grew out of the welfare reform efforts of the early 1970s (Forman 1988). The credit was originally added to the Internal Revenue Code by the Tax Reduction Act of 1975. Over the years, the credit has been expanded, and it is now one of the principal antipoverty programs in the federal budget for working families.

As originally adopted in 1975, the earned income credit was intended to offset the Social Security taxes of low-income workers with children and to provide those taxpayers with an increased incentive to work. An eligible taxpayer could claim a refundable credit equal to 10 percent of the taxpayer’s earned income for the taxable year, which did not exceed $4,000 (a maximum credit of $400). That $400 maximum credit was reduced $1 for each $10 of income in excess of $4,000. Thus, the credit was completely phased out at an income level of $8,000. As enacted, the original earned income credit was available to taxpayers only for calendar year 1975.

Subsequent revenue acts extended the credit, and the Revenue Act of 1978 made it a permanent part of the Internal Revenue Code. The Deficit Reduction Act of 1984 increased the maximum amount of the earned income credit and renumbered it to its current location in the Internal Revenue Code (U.S. Code, Title 26, Section 32). The Tax Reform Act of 1986 expanded the credit significantly, and it has been indexed for inflation since 1987.

The Omnibus Budget Reconciliation Act of 1990 also expanded the credit and added a supplemental credit amount for families with two or more children. The Omnibus Budget Reconciliation Act of 1993 expanded the credit even further and made a small credit available to certain childless workers (up to $390 in 2004). The Taxpayer Relief Act of 1997 added provisions to improve compliance, and the Economic Growth and Tax Relief and Reconciliation Act of 2001 made changes to provide marriage penalty relief and promote simplification. By 2003, more than 19 million families were expected to claim over $34 billion of earned income credits, with an average credit per family of $1,784 (U.S. Congress 2004).

Analysis

The earned income credit is an income transfer program that provides significant financial assistance to low-income workers, especially those with children. Unlike increasing the minimum wage, the expansion of the earned income credit over the past two decades has provided benefits targeted to help the working poor. Also, unlike most other welfare programs or a negative income tax, the earned income credit provides significant work incentives to low-income workers (Forman 1988).

The earned income credit is not without its problems. For example, the General Accounting Office has estimated that only about 75 percent of households eligible for the credit actually claimed it in 1999 (U.S. General Accounting Office 2001). Households with one or two qualifying children had the highest participation rates - 96 and 93 percent, respectively. But only 62.5 percent of eligible households with three or more children claimed the credit in 1999, and only 44.7 percent of eligible childless households claimed it. While these are still relatively high participation rates when compared with other transfer programs such as food stamps and Temporary Assistance for Needy Families (TANF), it still means that some 4.3 million eligible households failed to claim the credit in 1999. Moreover, remarkably few taxpayers elect to receive their credits by means of the advance payment mechanism.

Compliance with the earned income credit is also a problem. For example, IRS audit data for 1999 show earned income credit overclaim rates estimated to be between 27 and 32 percent of dollars claimed or between $8.5 billion and $9.9 billion (U.S. General Accounting Office 2003). Compliance with the advance payment rules is also problematic. For example, an estimated 49 percent of the individuals who filed income tax returns in 1989 and who had definitely received the advance payment failed to report that receipt on their return, and an estimated 45 percent of those who had received advance payment of the credit failed to even file returns (U.S. General Accounting Office 1992).

Finally, the earned income credit has also been implicated in some perverse disincentives for work and marriage. While the credit unequivocally increases the incentive to work in the phase in range of the credit (up to $10,750 of earnings for workers with two children in 2004), the combination of income and Social Security taxes and the phaseout of the credit may discourage work by an even greater number of relatively lowincome workers falling in the applicable phaseout ranges (e.g., from $15,040 to $35,458 of earnings for married workers with two or more children in 2004) (Eissa 1996). Lowering the phaseout rate could reduce this work disincentive, but it would also stretch out the phaseout range, which in turn would subject more taxpayers to the lowered phaseout rate.

Worse still is the earned income credit’s impact on marriage. For example, in 2004, if a single father with two children and $15,000 of earnings marries a single mother with two children and $15,000 of earnings, the couple will face a huge marriage penalty. Before the marriage, each could claim a refundable earned income credit of $4,098 (in 2004). After the marriage, the couple would only be able to claim a single earned income credit of just $1,149. So far, however, the empirical research has not been able to find much impact of the earned income credit’s marriage penalties and bonuses on marriage and divorce (Dickert-Conlin and Houser 2002).

Given the concerns about participation, compliance, and disincentives for work and marriage, it seems likely that Congress will reconsider the credit’s operation in coming years. One option would be to replace the current earned income credit with an exemption from Social Security taxes for the first $10,000 of wages, and to supplement the exemption with a refundable family allowance tax credit based upon the number of children in the family (Yin et al. 1994). This approach would reduce marginal tax rates and their disincentive effects on low-income workers. Moreover, a Social Security tax exemption would reach 100 percent of low-income workers, and it would be less complicated than first collecting Social Security taxes and then using the earned income credit to refund them.

ADDITIONAL READINGS

  • Dickert-Conlin, Stacy, and Scott Houser. "EITC and Marriage." National Tax Journal 55, no. 1 (March 2002): 25-40.
  • Eissa, Nada. "Tax Reforms and Labor Supply." In Tax Policy and the Economy 10, edited by James Poterba (119-51). Cambridge, MA: MIT Press, 1996.
  • Forman, Jonathan Barry. "Improving the Earned Income Credit: Transition to a Wage Subsidy Credit for the Working Poor." Florida State University Law Review 16, no. 1 (1988): 41-101.
  • Internal Revenue Service. "Revenue Procedure 2003-85." Internal Revenue Bulletin 2003-49 (2003): 1184-90.
  • U.S. Code, Title 26, Section 32.
  • U.S. Congress, House of Representatives, Committee on Ways and Means. 2004 Green Book: Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means. Washington, DC: U.S. Government Printing Office, 2004. http://waysandmeans.house.gov/Documents.asp?section=813.
  • U.S. General Accounting Office. "Earned Income Tax Credit: Advance Payment Option Is Not Widely Known or Understood by the Public." GAO/GGD-92-26. Washington, DC: U.S. General Accounting Office, 1992.
  • ---. "Earned Income Tax Credit Participation." GAO-02-290R. Washington, DC: U.S. General Accounting Office, 2001.
  • ---. "Earned Income Tax Credit: Qualifying Child Certification Test Appears Justified, but Evaluation Plan Is Incomplete." GAO-03-794. Washington, DC: U.S. General Accounting Office, September 2003.
  • Ventry, Dennis J., et al. "Special Issue: The Earned Income Tax Credit." National Tax Journal 53, no. 4 (December 2000): 973-1265.
  • Yin, George K., John Karl Scholz, Jonathan Barry Forman, and Mark J. Mazur. "Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Tax Credit Program." American Journal of Tax Policy 11, no. 2 (1994): 225-98.