The Hidden Entitlements

3. Earned-income tax credit

The earned-income tax credit (EITC) is designed to supplement the wages of low- and moderate-income workers, primarily working families with children.It's available whether or not a family owes income taxes. That is, eligible workers can get a "tax refund" even if the credit exceeds what they otherwise owe in taxes.

As a result of changes adopted in 1993, in 1996 the EITC is equal to 40%of the first $8,890 in wages for families with two or more children--for a maximum of $3,556. It is 34% of the first $6,330 in wages for a family with one child (maximum $2,152). The credit is phased out between $11,610 and $28,490 in income for two-child-plus families and between $11,610 and$25,080 for one-child families. Low-income childless workers (ages 25 to 64) can get a small credit equal to 7.65% of up to $4,220 in wages ($323),phased out between $5,280 and $9,500. All these amounts are indexed for inflation.

First initiated as a small, ostensibly temporary program back in 1974, the EITC has become one of the federal government's largest programs to assist lower-income people. At $27 billion a year (fiscal 1997), its cost far exceeds what the federal government spends on Aid to Families with Dependent Children($17 billion) and equals the cost of both food stamps and Supplemental Security Income (each $27 billion in fiscal 1997).

Because it is available only to working families (and perhaps because itis styled as a tax expenditure), the EITC has historically been beloved by Democrats and Republicans alike--at least until 1995, when congressional Republicans proposed to reduce it. Clearly, it does a great deal of good for many working Americans.

Nevertheless, the EITC has been criticized. Some of the credit's intended beneficiaries fail to take advantage of it, due to ignorance on their part and perhaps insufficient zeal on the part of the IRS in handing out subsidies.Meanwhile, others who are not eligible for the EITC file fraudulent claims.In fact, by 1990, the level of EITC fraud was so high that Congress felt forced to change the EITC rules to sanction many of the previously illegal claims. That change, which allowed more than one worker per household to claim the credit, has led in turn to enormous "marriage penalties."Under current law, for example, a two-earner, two-child couple making $27,500(with a 60%/40% earnings split) can save an astonishing $3,700 a year in federal income taxes by avoiding marriage! Almost all that anti-marriage premium stems from the 1990 changes in the EITC eligibility rules.

When it comes to incentives and disincentives for working, the EITC is a mixed bag. On the positive and probably most important side, the credit substantially increases the rewards from working for many low-wage workers.But the necessary phase-out of the EITC means that workers in the phase-out range face the highest marginal tax rates on wages of any income group. The combination of the 15% federal income tax rate, the (effectively)14% payroll tax, state income taxes and the 21% EITC phase-out means that a two-child worker making between $11,610 and $28,490 keeps less than half of each additional dollar in wages earned. That's a higher marginal tax rate than even the very richest Americans face. Fortunately, however, there is little evidence that high marginal tax rates actually discourage work by people already in the work force.

Certainly, the problems discussed in the last two paragraphs are not exclusive to the EITC. Similar issues arise with direct welfare payments. But this discussion ought to illustrate that spending money through the tax code--even for the best of purposes--is not likely to be an improvement over spending it directly. On the contrary, asking the IRS--whose normal mission is to collect money from people--to run a program to give people money goes against the grain and has inherent administrative drawbacks.


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