Key Elements of the U.S. Tax System

HOW THE EARNED INCOME TAX CREDIT WORKS

The earned income tax credit (EITC) provides substantial support to low- and moderate-income working parents, but very little support to workers without qualifying children (often called childless workers). Workers receive a credit equal to a percentage of their earnings up to a maximum credit. Both the credit rate and the maximum credit vary by family size, with larger credits available to families with more children. After the credit reaches its maximum, it remains flat until earnings reach the phaseout point. Thereafter, it declines with each additional dollar of income until no credit is available (figure 1).

By design, the EITC only benefits working families. Families with children receive a much larger credit than workers without qualifying children. (A qualifying child must meet requirements based on relationship, age, residency, and tax filing status.) In 2020, the maximum credit for families with one child is $3,584, while the maximum credit for families with three or more children is $6,660.

In contrast to the substantial credit for workers with children, childless workers can receive a maximum credit of only $538. Moreover, the credit for childless workers phases out at much lower incomes. Also, childless workers must be at least 25 and not older than 64 to qualify for a subsidy—restrictions that do not apply to workers with children. As a result of these tighter rules, 97 percent of benefits from the credit go to families with children.

IMPACT OF THE EITC

In general, research shows that the EITC encourages single people and primary earners in married couples to work (Dickert, Houser, and Sholz 1995; Eissa and Liebman 1996; Meyer and Rosenbaum 2000, 2001). The credit, however, appears to have little effect on the number of hours they work once employed. Although the EITC phaseout could cause people to reduce their hours (because credits are lost for each additional dollar of eanings, which is effectively a surtax on earnings in the phaseout range), there is little empirical evidence of this happening (Meyer 2002).

The one group of people that may reduce hours of work in response to the EITC incentives is lower-earning spouses in a married couple (Eissa and Hoynes 2006). On balance, though, the increase in work resulting from the EITC dwarfs the decline in participation among second earners in married couples.

Recent analysis sheds some doubt on how large a work incentive the EITC has (Kleven 2020). Possibly, the strong economy and welfare reform played a larger role in increasing work for single moms during the 1990s when the majority of EITC studies find the credit increased work.

If the EITC were treated like earnings, it would have been the single most effective antipoverty program for working-age people, lifting about 5.6 million people out of poverty in 2018, including 3 million children (CBPP 2019).

The EITC is concentrated among the lowest earners, with almost all of the credit going to households in the bottom three quintiles of the income distribution (figure 2). (Each quintile contains 20 percent of the population, ranked by household income.) Very few households in the fourth quintile receive an EITC (fewer than 2 percent).

RECENT CHANGES

As a result of legislation enacted in 2001, the EITC phases out at higher income levels for married couples than for single individuals. That threshold was increased as part of the American Recovery and Reinvestment Act of 2009 (ARRA). The same act increased the maximum EITC for workers with at least three children. The American Taxpayer Relief Act of 2012 made the 2001 EITC changes permanent (a $3,000 higher (indexed) phaseout threshold for married couple than for singles) but extended the ARRA changes (a $5,000 higher (indexed) phaseout threshold for married couple than for singles, and higher credit maximum for workers with at least three children) through the end of 2017. The Protecting Americans from Tax Hikes Act of 2015 made these changes permanent. The Tax Cuts and Jobs Act, enacted in 2017, adopted a more conservative measure of inflation to be used in the federal income tax system beginning in 2018. As a result, the EITC will grow more slowly over time.

PROPOSALS FOR REFORM

Both Democrats and Republicans have proposed EITC amendments to provide a substantial credit for childless workers (Marr 2015). These proposals typically involve expanding the eligible age limits for the childless EITC—lowering the age of eligibility from 25 to 21 and increasing the age of eligibility from 64 to 67—increasing the maximum credit, and expanding the income range over which the credit is available. More recently, several Democratic policy makers have proposed much larger expansions to the credit, while maintaining the credit’s basic structure (Maag and Airi, forthcoming).

A more far-reaching approach to reform that would still expand benefits to childless workers would be to separate the credit into two pieces—one focused on work and one focused on children. There are many examples of this type of reform proposal, including the President’s Advisory Panel on Federal Tax Reform (2005), the Bipartisan Policy Center (2013), and Maag (2015b).

ERROR RATES AND THE EITC

The EITC likely delivers more than a quarter (28.5 percent) of all payments in error, according to a recent Internal Revenue Service (IRS) compliance study. The largest source of error was determining whether a child claimed for the EITC actually qualified (IRS 2014). The child must live with the parent (or other relative) claiming the EITC for more than half of the year to qualify. The IRS receives no administrative data that can verify where a child resided the majority of the year, making it difficult for the agency to monitor compliance. Attempts to use administrative data from other programs to verify child residence have not proven successful (Pergamit et al. 2014).

To reduce fraud, the Protecting Americans from Tax Hikes Act of 2015 requires the IRS to delay tax refunds for taxpayers who claim an EITC or additional child tax credit on their returns until at least February 15. Delaying refunds was paired with a requirement that third-party income documents related to wages and income be provided to the IRS by January 31 (in prior years, this information was due the last day of February for paper filing and March 31 for electronic filing, and employers were automatically granted a 30-day extension, if requested). As a result, information needed to verify wages often got to the IRS well after the first returns had been processed. Together, these measures allowed earlier systemic verification of EITC claims, which protected more revenue than in prior years (Treasury Inspector General for Tax Administration 2018).