The Future of the Earned Income Tax Credit (Part 1 of 3): Part One: Background

The Future of the Earned Income Tax Credit (Part 1 of 3)Part One: BackgroundC. Eugene Steuerle"Economic Perspective" column reprinted withpermission.Copyright 1995 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.Among the many provisions being considered for reform in the budget process this year is the earned incometax credit. In size and scope the EITC has become one of the most important elements of the combinedtax/transfer scheme applying to low-income individuals. Its growth in recent years has been relatively swift;indeed, it has been perhaps the fastest growing of all federal budget items that can trace its growth tolegislation over the past decade.Table 1 traces some of that growth. As can be seen, the credit was expanded substantially in the Tax ReformAct of 1986 and the budget agreements of 1990 and 1993. Interestingly, the Clinton administration likes topoint to the EITC expansion as one of its major accomplishments, while some critics like to blame thisadministration for any defects of the credit. Yet the largest expansions of the credit took place underPresidents Reagan and Bush—at least when measured in terms of total cost.Over the years, the EITC has been said to fulfill several purposes. One is simply to provide assistance tolow-income individuals. In this regard, it has achieved modest success as an antipoverty measure, as can beseen in Table 2, although it pales in comparison with social insurance programs such as Social Security OldAge, Survivors, and Disability Insurance.A second purpose was to provide an offset to Social Security taxes and, perhaps, other federal taxes. Formost families today, the combined employer and employee Social Security tax rate is more important thanthe income tax rate. It is not hard to understand why: the Social Security tax rate is 15.3 percent on allearnings, while the income tax rate on first dollars of earnings is zero and, for most individuals, does not riseabove 15 percent on the last dollars of earnings.The expansions of 1990 and 1993, however, could not be justified as offsets to the Social Security tax. Therate of credit was scheduled to rise as high as 25 percent under the 1990 agreement and as high as 40percent under the 1993 agreement. Since most individuals at low income levels do not pay income tax, theEITC pays out far more to many individuals than they pay in any form of federal tax.While the 1990 and 1993 reforms mainly increased the rate of credit, they made some other changes as well,such as an expanded credit for families with more than one child and a reformed definition of eligibility thatwas based more on the home in which a child resided and less on the amount of monetary support provided.These reforms did not change fundamentally the structure of the EITC system, the income levels at which amaximum credit would be reached, and the levels at which no credit would be made available.A final rationale for the credit was to provide work incentives. Here, however, the target was primarilyindividuals who were on or who might otherwise receive welfare—those who might earn modest amounts ofincome in the phase-in range of the credit. The connection to other types of transfers—in particular, Aid toFamilies With Dependent Children (AFDC)—is made fairly obvious by the restriction of the credit primarily tofamilies with children. This work incentive goal cannot really be separated from the antipoverty goal. That is,the EITC cannot be justified as work incentive alone, but only as an alternative to other mechanisms to try tomake transfers to low-income individuals.Although comparisons to AFDC have been made throughout the history of the credit, more recently it has alsobeen compared to increases in the minimum wage. Many economists believe that increasing the minimumwage reduces the jobs that would be made available to workers whose productivity is between the existingminimum wage and some new higher level that might be made available.Table 1Document date: June 19, 1995Released online: June 19, 1995 Amount of Earned Income Tax CreditTotal Amount ofCredit Year($billions) Pre-1986 1986 reforms 1990 reforms 1993 reforms197519801985199019951998$1.3$2.0$2.1$7.5$11.1$12.9--------$20.0$23.0--------$24.8$30.4------Source: Holtzblatt, McCubbin, & Gillette, National Tax Journal, Sept. 1994.Analyses of minimum wage workers, moreover, show that many of them are in middle-income families:teenagers, older workers with assets and pension income, and families where one earner already works atmuch higher wages. Accordingly, the EITC has also received much support as an alternative not only towelfare, but to minimum wage increases. In this regard, some health reform proposals, such as that ofPresident Bush in 1992, included a health credit modeled largely after the