Cheating the Earned Income Tax Credit

Cheating the Earned Income Tax CreditC. Eugene Steuerle"Economic Perspective" column reprinted withpermission.Copyright 1997 TAX ANALYSTSThe nonpartisan Urban Institute publishes studies, reports,and books on timely topics worthy of public consideration.The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees,or its funders.In early 1995, taxpayers claimed $4.4 billion more in earned income tax credit (EITC) refunds on tax returnsthan they were eligible to receive. This revelation has put both the EITC and the IRS under fire, but bothdefenders and detractors of the credit often miss the broader question: how wage subsidies can best be fitinto the nation's transfer and tax systems.This nation now has a large number of programs to assist low-income individuals: foods stamps,supplemental security income, Medicaid, various housing programs, the new Temporary Assistance to NeedyFamilies (TANF), as well as the EITC. In truth, all of these programs have significant error rates. Mostincome-conditioned subsidy programs are administered by welfare offices that use monthly accountingsystems for the income of individuals. We know that annual accounting systems are difficult enough to runand that these monthly systems are full of errors. Studies that rely on actual contact with welfare families, forinstance, reveal that most have at least some source of outside, unreported income, and that the householdoften contains more adult members than is claimed for welfare purposes. Corruption and certainly unequaltreatment of individuals also occur in housing programs that use waiting lists for obtaining eligibility.Other parts of the tax system are prone to error and cheating. The IRS itself estimates that taxpayers in theaggregate underpay their income taxes by about 20 percent. In addition, there are many legal ways to avoidtax on income—perks on the job, avoidance of any realization of capital gains, and taking excessive amountsof deductions. These legal methods of tax avoidance also result in inequities among taxpayers.My point is to encourage neither an attack on all government programs nor a defense of the status quo. Thedifficulties in all government administrative systems simply reveal that EITC problems cannot easily be solvedin isolation. Some who attack the program often use the error rate as an excuse to pare the size of theprogram. But paring may do little or nothing to reduce the error rate of the EITC and, worse, may target theremaining resources in the nation's transfer system. Some who defend the program, on the other hand, wantto make light of this error rate and the revealed inability of the IRS to administer this particular program verywell. But simple maintenance of the status quo is not a viable defense for the long run, for it pretends thatwe don't really care how well the program works.In partial response to the high error rate, the Treasury Department announced a number of new initiatives.(For prior coverage, see Tax Notes, Apr. 28, 1997, p. 484.) Though the initiatives are worthwhile, they weredesigned quickly to try to mute new criticisms that would arise with the announcement that error ratesremained high. No one claimed that these initiatives—a combination mainly of stricter penalties and moreenforcement—were going to reduce the error rates dramatically. It was also unclear how an administrationcommitted to a smaller IRS was going to generate those greater resources. What other enforcement effortswould be reduced? One can't simultaneously increase resources for every IRS enforcement problem andreduce total enforcement resources.One alternative, of course, is simply to eliminate the EITC. Unless one knows what the larger transfer systemwould look like, however, this is an incomplete response. If the goal is merely to turn EITC responsibilitiesover to welfare agencies, there is no evidence that enforcement would be much better. Indeed, the originalreason for putting the EITC into the tax code was that it was to be based mainly on annual wages as reportedfor tax purposes. Because W-2 statements on wage payments are made by employers, wages as reported tothe IRS on an annual basis are much better monitored than, say, monthly wages as reported to the welfareagencies.If elimination is pure, and there is no transfer of responsibilities outside of the IRS, then our welfare systemeffectively moves backward in time. Perhaps the two most dramatic changes in the cash transfer system inthe last part of this century have been the adoption and expansion of the EITC and the attempt to put workDocument date: June 09, 1997Released online: June 09, 1997 responsibilities into the basic welfare system, as reflected in the displacement of Aid to Families withDependent Children with "Temporary" Assistance to Needy Families. While both efforts have been incompleteand imprecise, they are still viewed by many as superior to a pure welfare approach that emphasizes nothingb