Tax Policy Toward Low-Income Families

Key Points

  • In 2013, tax credits for low-income families cost $124 billion. Nearly 20 percent of all households that filed taxes benefited from the Earned Income Tax Credit (EITC) alone.
  • The majority of EITC benefits go to single parents and to households with annual income below $30,000. The EITC is more likely to increase the employment of single parents relative to other groups.
  • Expanding the EITC program to childless households and increasing the refundability of the Child Tax Credit (CTC) are predicted to improve work incentives while providing more benefits for the lowest income households.

Tax Policy Toward Low-Income Families

Editor’s Note: This article is part of a series of tax-related articles sponsored by the Penn Wharton Budget Model and the Robert D. Burch Center at Berkeley. All of the articles in this series are forthcoming in a book by Oxford University Press, co-edited by Alan Auerbach and Kent Smetters.

Tax Policy Toward Low-Income Families examines the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) in detail. It documents the type of households who receive these credits, examines if these credits are effective at alleviating poverty and inducing work and explores the administrative costs of these programs. Hilary Hoynes and Jesse Rothstein (2016) find that the EITC effectively targets low-income families while the CTC is less focused and reaches a broader part of the income distribution. The credits appear to be effective at increasing work, but only for some groups. Administrative costs are low. The authors then explore the potential economic impact of some reforms at providing redistribution while improving work incentives.

The EITC Tax Credit

Tax credits play an important role in federal support for low-income households. In 2013, at a cost of $68 billion, the EITC reached 28.8 million households, nearly 20 percent of all tax filers. For comparison, in the same year, far fewer (1.6 million) families received Temporary Assistance for Needy Families (TANF). EITC benefits, which can be as high as 45 percent of a family’s pre-tax income, are important to households’ bottom line. At $1,000 per child, the CTC benefit is smaller, but it reaches more families. As a result, the CTC program’s total cost ($56 billion) is almost the same as the costs of the EITC.

The EITC tax credit is fully refundable. Households whose tax liability is less than the benefit for which they are eligible will receive monetary refund. To be eligible for EITC, households must have earned income. The amount of the credit depends on filing status (single, married, joint, head of household), the number of qualifying children and income.

Qualification for the EITC depends on income, filing status and the number of children in the household. For instance, married couples with three or more children qualify with income up to $53,267, while for households with no children the maximum income is $14,820.

The EITC is also more generous for families with children. For example, in 2015, the maximum credit for a family with three children was $6,242, while the maximum credit for a family with no children was $504. The benefit size also varies by income. Figure 1 shows that the value of the EITC’s credit initially increases with income, then plateaus, and finally falls to zero as income increases.

Figure 1: Combined EITC and CTC Schedules for Heads of Households with 2 Children

Notes: Figures reflect a head-of-household filer with two children who qualify under dependent exemption, EITC and CTC rules but zero Child and Dependent Care Tax credit eligibility. The “CTC Forfeited” area reflects the family’s CTC eligibility that cannot be received due to the limit on the portion of the CTC that is refundable.

Source: Hoynes and Rothstein (2016), Figure 3, based on data from GPO (2011), Pomerleau (2014), Steuerle and Quakenbush (2015), and Tax Policy Center (2015b).

The CTC Tax Credit

In contrast to the EITC, the CTC is only partially refundable. The refundable portion of the CTC is limited to 15 percent of earned income above $3,000. Figure 1 shows that the value of the CTC’s credit first increases with income, then plateaus, and finally falls to zero as income increases.

However, the amount of income a household can earn and still qualify for the CTC is much higher than for EITC. The CTC’s income eligibility limits depend on the filing status and the number of children in the household. For instance, married couples with three or more children qualify with income up to $170,000. As a result, as shown in Figure 1, the CTC reaches a larger portion of the income distribution than the EITC. The refundable portion of the CTC, though, helps the same part of the income distribution as the EITC. However, some low income households fail to get the entire value of the CTC because the CTC is only partially refundable.

Goals of Tax Policy Toward Low Income Families

Hoynes and Rothstein (2016) argued that the EITC and CTC programs have three main goals. First, in the case of the EITC, it redistributes money to low- and moderate-income families; for the CTC, the goal is to help the broader middle class. Second, the programs aim to encourage work because benefits are based on income. The third goal is to have low administration costs when compared to other transfer programs that have more complex screening. The programs have varying degrees of success at meeting these three goals.

Is Tax Policy Effective at Alleviating Poverty?

The EITC and CTC are successful at transferring money to low-income families and alleviating poverty. According to the Census Bureau, in 2014, the poverty rate was 3.1 percentage points lower than it would have been without EITC and CTC. In that year, the programs lifted 5.2 million children, more than any other program, out of poverty. Estimates indicate that the majority of EITC benefits go to single parents and to households with income less than $30,000. Figure 2 shows that EITC is more likely to lift households with children out of poverty than households without children. CTC reaches households across the income distribution with those below $30,000 and above $100,000 each receiving 20 percent of the benefits.

Figure 2: Pre-EITC and Post-EITC Income and Poverty, 2015 Tax Year

Notes: Solid vertical lines indicate the locations of EITC kink points; see Hoynes and Rothstein (2016) Table 1 for exact values. Dashed vertical lines indicate the pre-tax income at which a family reaches the poverty line, with and without the EITC. In panel a, these are at pre-tax earnings of $11,770 without EITC or $11,518 with EITC; in panel b, they are at $15,930 and $15,565, respectively.

Source: Hoynes and Rothstein (2016), Figure 8, based on California Department of Health Care Services (2015), California State Legislature (2015), and Tax Policy Center (2015b).

Can Tax Policy Encourage Work?

EITC is designed to encourage work because to receive the credit a household must have earned income. However, in part due to the humped shape of EITC’s benefit schedule and the complexity of individual responses to work incentives, the incentive to work may vary by income, marital status and sex. EITC is effective at inducing low-income single mothers to work. For example, Figure 3 shows that after 1993, when EITC benefits for families with multiple children were expanded, employment for single women with multiple children rose from just over 60 percent to about 80 percent. There is little evidence that EITC has an impact on the labor supply of other groups or that EITC induces people to work longer hours.

Figure 3: Employment Rates of Unmarried Women Over Time, By Number of Children

Note: Sample consists of unmarried women aged 19-44.

Source: Hoynes and Rothstein (2016), Figure 13, based on analysis of the Current Population Survey Annual Social and Economic Supplement (U.S. Census Bureau 2015).

Is Tax Policy an Efficient Way to Distribute Benefits to Low-Income Households?

EITC and CTC are effective at distributing benefits to families who qualify and do so without a labor intensive screening process. About 80 percent of families with children who qualify for EITC actually claim those benefits. However, a lower take-up rate for families without children brings the overall take-up rate down to 75 percent.

On the other hand, some families receive more EITC benefits than they are legally eligible to receive. Households may misreport their income or the number of qualifying children to get higher benefits. During the phase in portion of the benefit schedule families who report more income can receive more benefits. Two-thirds of over-claims are a result of misreporting income, mostly from self-employment. Misreporting of children are responsible for 30 percent of tax returns that over-claim EITC benefits. EITC qualifying child rules can be confusing because they are different from the qualifying child rules for taking a dependent exemption on an individual income tax return. Moreover, in cases of separation, divorce or three-generation families, it can be difficult to determine who should claim a child.

Possible Reforms to EITC and CTC Policy

Hoynes and Rothstein (2016) also examine the potential impact of several reforms to the EITC and CTC programs, in particular, their impact on the program’s stated goals, including reducing poverty, providing stronger work incentives and administrative efficiency at distributing benefits.

Expanding EITC benefits for households with no children might allow EITC to reach more low-income households, improve take-up rates, reduce the incentive to misreport qualifying children, and encourage labor force participation. Hoynes and Rothstein (2016) examine the costs of setting EITC benefits for households with no children to the same level as for households with one child, after adjusting for the different needs of a households with a child. This expansion is projected to cost $18.3 billion, reach 127 percent more childless households, and increase benefits by more than five times for childless households.

The lowest income groups currently must forfeit part of the CTC credit because the refundable portion of CTC is limited to 15 percent of earned income above $3,000. Reducing the CTC refundability threshold to zero could increase CTC benefits for the lowest income groups. Hoynes and Rothstein (2016) find that this policy change is projected to cost $2.2 billion. Much of the benefit increase is predicted to go to households with income under $30,000.

Other possible reforms include a deduction that could improve EITC’s work incentives for secondary earners. Mailers with information about EITC might improve take-up rates. Simplifying the definition of qualifying children could help with misreporting. Research can be done to see if distributing EITC’s benefits throughout the year rather than in a lump sum at tax time could help improve the welfare of low-income families throughout the year. Finally, more study is needed to determine if employers of low-wage labor are able to capture part of the value of EITC by paying lower wages.

Conclusion

EITC and CTC cost about $124 billion a year. Evidence shows that the credits reduce child poverty, increase jobs among single mothers and seem to be administratively efficient. Various reforms to these credits might further reduce poverty among both households with children and childless households, induce more people to work, and improve take-up rates. But more empirical studies are required.

A discussion of this paper is provided by Diane Whitmore Schanzenbach.