Who's afraid of redistribution? An analysis of the earned income tax credit.

• Author: Bird-Pollan, Jennifer

1. INTRODUCTION

   In the 2008 Presidential campaign, the American public was reminded time and again of the differences in the economic policies of the nominees: John McCain would cut taxes, (2) and Barack Obama would raise them, although only on those earning over $250,000. (3) In the final days of the campaign, the McCain camp accused Obama of proposing "redistribution," and the Obama camp quickly denied that description. (4) So why do presidential candidates run so quickly from the r-word? McCain's senior policy advisor equated redistribution with socialism, (5) but redistribution, in the form of the federal income tax system, is a central tenet of American democracy. Indeed, the very notion of having a tax system at all--in which amounts are collected from certain members of society in order to benefit other members--fits a classic definition of redistribution.

   One central element of the American version of redistribution comes in the form of the Earned Income Tax Credit (the "EITC"). In his campaign platform, Barack Obama vowed to expand the EITC, making it available to more taxpayers than ever before. (6) Given the outcome of the 2008 election, and President Obama's seeming commitment to the tenets of redistribution (despite his disavowal of the word) and his express promise to expand the reach of the EITC, as well as the recent changes to the EITC introduced by the American Recovery and Reinvestment Act of 2009 (the "ARRA") (7), it seems a perfect time to look at the intent behind, and accomplishments of, the EITC as it currently stands, and the role it can (and will) play in the future of the U.S. federal income tax system.

   I begin this article with a review of the history of the EITC and an examination of the form it currently takes. I then turn to a review of some of the difficulties presented by the EITC, and some recurring criticisms it has faced since its inception. In the context of this discussion, I also introduce responses to those criticisms, both within the framework of the EITC as it is currently administered and in the form of possible adjustments that might serve to improve the system.

2. HISTORY OF THE EITC

   The EITC was instituted in response to the "Family Assistance Plan" ("FAP") proposed by President Richard Nixon in 1969, (8) which was itself an attempt to implement a version of a negative income tax in the U.S. income tax system. (9) Nixon intended the FAP to be "a new and drastically different approach to the way in which government cares for those in need." (10) The FAP was effectively a form of welfare, with the caveat that recipients would have to show that they were attempting to find work. (11) But even with this caveat, there was no requirement in the FAP that recipients be working or earning any income. (12) Under the plan, all families would be entitled to an annual income of $500 per person for the first two family members, with $300 for each additional family member. (13) In addition, the "work incentive" element of the plan allowed recipients to keep the first $720 of any earnings, plus half of any additional family income up to $4000, without losing FAP eligibility. (14) This proposal "would have established in law an unmistakably liberal principle: a federally guaranteed [minimum] income." (15) However, the political difficulty of these proposals proved insurmountable, and after passing the House, the FAP was defeated in the Senate. (16) Critics saw the plan as a work disincentive, in particular because the FAP's "guaranteed income" was joined with a high phase-out rate, so that each additional dollar of income earned by the FAP recipient resulted in a loss of 50 cents of FAP subsidy. (17)

   In response to Nixon's failed proposal, Senator Russell Long (D-LA) developed an alternative proposal incorporating a requirement that people who receive the credit work and earn income. Long, who was, at the time, chair of the Senate Finance Committee, led the campaign that resulted in the enactment of the EITC as part of the Tax Reduction Act of 1975. (18) The first EITC was only available to taxpayers with earned income and at least one child. (19) The maximum credit in 1975 was $400. (20) In 1986, the EITC was indexed for inflation and made a permanent (as these things go) part of the tax system. (21) In 1990, Congress made a larger credit available to families with two or more children, and President Clinton and the 1993 Congress significantly increased the EITC for all recipients. The 1993 changes also allowed childless taxpayers between the ages of 25 and 64 to claim a small EITC. (22) Finally, in 2001, Congress attempted to address the "marriage penalty" inherent in the EITC23 by raising the income ceiling for married taxpayers filing jointly. (24) Much of the recent history of the EITC has centered on an attempt to deal with fraud and general noncompliance with regard to claiming the credit. (25) I will explore these issues in detail later in the article. (26)

   The latest changes to the EITC were made by the ARRA, as part of the 2009 Stimulus Package. For tax years beginning after Decemer 31, 2008, credit amounts will increase and income ceilings, for purposes of determining EITC eligibility, will be raised. Perhaps most notably, the new law adds a new category of credit recipient: taxpayers with three or more children.

3. BACKGROUND INFORMATION

   The EITC is a powerful tool in the U.S. government's redistributive program. The largest program of its kind, the EITC is administered by the Internal Revenue Service (the "IRS") through the federal income tax system. In 2003, the EITC benefited 19.6 million families, providing $34 billion in tax credits (either in the form of an offset to taxes due, or in the form of a cash refund). (27) Part of what makes the EITC so unique is its construction as "a complex hybrid of an earnings subsidy, a traditional income-transfer program, and a tax credit program." (28)

   1. Mechanics of the EITC

      The current EITC is not available to individuals with no earned income. That is to say, the EITC is only available to taxpayers after they have earned their first dollar of income. (29) However, the phase-out scheme of the EITC means that not all taxpayers with earned income are eligible to receive the credit, either. In fact, both the phase-in and phase-out rates applicable to a given taxpayer depend on the number of children in the household. (30) In 2008, for example, for taxpayers claiming no children, the credit was eliminated at $12,880 ($15,880 for married taxpayers filing a joint return). For taxpayers with one qualifying child the credit would be eliminated at $33,995 ($36,995 for married taxpayers filing a joint return). For taxpayers with two or more qualifying children, the credit was eliminated at $38,646 ($41,646 for married taxpayers filing a joint return). (31) The phase-in rates vary equally depending on the number of children a taxpayer claims. These figures comprise Table 1. (32)

      As is illustrated by this table, the largest credit available through the EITC in 2008 was $4,824. This maximum credit amount was available to married taxpayers filing jointly with two or more qualifying children and an adjusted gross income ("AGI") of between $12,060 and $18,750, or single taxpayers with two or more qualifying children and an AGI of between $12,060 and $15,750. (33)

      To illustrate further, consider the following example. For the 2008 tax year, a single taxpayer with two children and $7,000 of earned income is entitled to a credit of $2,810. However, if that same taxpayer were to have $13,000 in earned income, she would be entitled to the maximum credit amount of $4,824. But then further, if this taxpayer's income were to increase to $25,000, the credit amount would drop back down to $2,869. If this taxpayer's earned income were to exceed $38,600, she would no longer be entitled to any tax credit under the EITC. This phasing-in and phasing back out of the credit amount (as demonstrated in the table below) is intended to focus the benefits of the credit on the neediest taxpayers.

      In order to receive the EITC, a taxpayer must first meet certain prerequisites and avoid potential disqualifications. First, recipients must file a tax return, which, in certain instances, they would not otherwise be required to do. (34) Also, only taxpayers with valid social security numbers are eligible to receive the EITC. (35) There are also certain things that can disqualify a taxpayer from receiving the EITC. For instance, if a taxpayer is within the qualifying amounts of earned income but also has above a certain amount of capital gains income or certain other kinds of investment income, that person will be ineligible for the EITC. (36) In addition, if a taxpayer is found to have fraudulently claimed the EITC in a past year or claimed more than she was entitled to, she may be prohibited from claiming the EITC in future tax years. (37) If an EITC claim contains an "error ... attributable to reckless or intentional disregard of the rules," then the taxpayer making the claim will be denied the credit for the next two years. (38)

      One central characteristic of the EITC is that amounts granted under the credit are fully refundable to the taxpayer. (39) Most credits available to taxpayers through the U.S. federal income tax system are only available to offset taxes owed. (40) Generally, therefore, if a taxpayer's credits exceed the amount of tax she owes, she essentially forfeits the difference. However, because the EITC is fully refundable, even if the taxpayer owes no tax, she will be eligible to receive as a refund the entire amount of the EITC to which she is entitled. (41) Because the credit only applies to very low income earners, who often owe little to nothing in tax, if the credit were not refundable, it is likely that most of the current recipients would not be able to use it at all. Because of the U.S. federal income tax system's standard deduction...