Dave Williams and the Earned Income Tax Credit

Next week, my former student David Williams, who is now Director of Electronic Filing and Refundable Tax Credits at the IRS, will be speaking to my public finance class. Before joining the IRS, Dave worked as an aide to Senator Bill Bradley, who chaired the Senate Finance Committee during the 1990s. One of Dave's big projects with the Senate Finance Committee staff was working on the legislation to the Earned Income Tax Credit (EITC) as part of the welfare reform movement. The Washington Post ran a profile featuring Dave's work, David Williams: IRS Official Greatly Expanded Anti-Poverty Program.

Under the old AFDC welfare system, the odds were stacked heavily against a welfare recipient ever getting off of welfare. For every dollar of income she earned, under the old system, she would lose more than a dollar in benefits, once taxes were taken into account. The expansion of the EITC that went into effect as part of the mid-90s welfare reform was designed to make work pay, and it has led to a significant increase in people working their way out of the poverty trap.

For my public finance students, and anyone else who wants to learn more about the Earned Income Tax Credit, the Tax Policy Center provides an excellent introduction here. The EITC is now the biggest federal cash anti-poverty program in existence. Here is a graph drawn from that introduction, which illustrates the complex web of phase-in and phase-outs of the Earned Income Tax Credit.



As you can see, the EITC has both phase-in and phase-out ranges. When a taxpayer's income and number of qualifying children places him in the phase-in range, he actually faces a negative income tax rate. Effectively, the government is subsidizing earned income, providing matching money of up to 45 cents on the dollar for those taxpayers. Eventually, the subsidy levels off and reaches a plateau, where additional amounts of earned income do not change the amount of the subsidy for a while. After the plateau, the subsidy begins to decline during the phase-out region until it declines to zero. During the phase-out region, the taxpayer may face a very high marginal tax rate when you consider the regular income tax, the payroll tax, the phase-out implicit tax, and possibly state income taxes and phase-outs as well. (The new health care bill has subsidy phase-out provisions that may add to that effective marginal tax rate as well.)

In addition to the federal EITC shown above, many states offer EITCs that piggy-back on the federal EITC. For example, New Yorkers may qualify for a state EITC that is 30% of the federal credit.

The bottom line is that a low-income parent with two or three children working full-time at minimum wage may get a combined federal and state tax EITC refund which is equal to over 50% of her earned income for the year. The EITC could easily make the difference between the family living below the poverty level and above the poverty level.

There are lots of tradeoffs involved in designing the EITC--there is no perfect system, and it's a matter of trying to do the best one can with limited revenues. However, there's a lot of evidence that EITC has been successful in helping many previous welfare recipients start to work and develop human capital and ultimately become self-sufficient, moving into higher paid jobs where they may no longer need subsidies. A recent study, Stepping Stone or Dead End? The Effect of EITC on Earnings Growth, found that many EITC recipients have increased their earnings substantially over time. On the other hand, there are a number of concerns about the EITC, including the very severe marriage penalty for many EITC recipients.

Refundable credits are a "growth industry" these days as the government seems to be loading more and more policy programs onto the shoulders of the IRS. There is a strong and legitimate concern about the potential for fraud with refundable credits. There are particular concerns about systematic large-scale fraud by tax preparers who may fabricate returns with refundable credits, sometimes without the knowledge or consent of the taxpayer whose name is on the return. In some cases, this may involve identity theft, so the IRS has a lot to be worried about. On the one hand, it wants to make sure that all those who are legitimately entitled to refundable credits receive the proper amounts they are due under the law. On the other hand, the potential for abuse means that the IRS needs to take steps to ensure that fraudulent tax returns are detected and those who perpetrated them receive their due civil and criminal penalties. The IRS has a tough balancing act, as always.

It's not perfect, but overall, economists and political leaders on both the right and the left have embraced the EITC as a general success. The idea originally came from conservative economist Milton Friedman's proposal for a "negative income tax," but liberals have also hailed the concept as a successful one. There is strong empirical evidence that it has increased labor force participation rates among the poor and broken the cycle of welfare dependency for many families who had not worked in generations. We'll be talking more about this in class with David.