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When the battle over overhauling the U.S. healthcare system comes to an end, tax reform will reemerge at the top of Congress’s agenda. December 31, 2010 marks the expiration date for most of the 2001 and 2003 tax cuts, and numerous levies will be under renewed scrutiny. As exhausted congressional aides turn from healthcare to taxes, they need to be mindful of a simple fact: the tax treatment of low-income individuals and families is extremely flawed.
The confusing and labyrinthine structure of low-income credits makes them less effective than they should be. The neediest recipients often fail to apply for credits, and the transaction costs associated with claiming benefits are high. For example, more than 70 percent of tax filers receiving the Earned Income Tax Credit (the EITC provides a refundable credit for low-income workers and their families) use a tax professional to navigate complex eligibility rules and extensive computation requirements. Further, the Internal Revenue Service has estimated that 25 percent of EITC payments go to taxpayers who are not eligible for the credit, while roughly 15 to 20 percent of those who are eligible fail to claim the credit.
A number of easy steps could be taken to simplify existing credits, beginning with streamlining eligibility requirements.
Despite the enormous complexity of low-income tax credits, public policy has increasingly relied on these programs to assist the poor. Consequently, the size and availability of low-income tax credits has expanded dramatically.
In addition, more and more middle-income families have begun to claim a share as well. In 2006, the government paid out more than $22 billion in credits to those with incomes between $50,000 and $100,000, while more than $5 billion was paid to taxpayers with incomes above $100,000.
Five primary credits provide income relief to working individuals and families: in addition to the EITC, the Child and Dependent Care Credit, Child Tax Credit, and American Opportunity Tax Credit are intended to encourage work and savings while also offsetting the cost of raising and educating children. The Making Work Pay credit, introduced in the stimulus package, also attempts to offset part of the payroll tax burden. Keeping track of which credit a family is eligible for is hard enough for tax professionals, much less for a qualifying worker.
The Internal Revenue Service has estimated that 25 percent of Earned Income Tax Credit payments go to taxpayers who are not eligible for the credit.
A number of easy steps could be taken to simplify existing credits, beginning with streamlining eligibility requirements. Under current rules, adjustments for family size and work incentives are needlessly complex. For example, age requirements differ among credits and some provisions employ different methods for measuring gross income.
A more complicated issue is determining the marginal tax rates that should apply at different income levels. A marginal tax rate measures the change in tax liability that occurs when an additional dollar of income is earned. Because higher marginal tax rates reduce incentives to work, it is desirable to keep them low for all taxpayers. Although tax credits enhance the progressivity of the tax system, they also increase marginal tax rates at some income levels, thus discouraging work. Therefore, policy makers face a trade-off between progressivity and work incentives.
If lawmakers seek to enact practical, bipartisan reforms of the tax code this year, an excellent place to start would be to follow the President’s Advisory Panel on Federal Tax Reform’s 2005 recommendations for simplifying and consolidating low-income credits.
Many tax credits phase in and out according to income. As income rises, the credit value falls and tax liability increases. The effective marginal rate reflects the official tax rate plus the rate at which the credit is being phased out. For example, if a $100 income increase causes a taxpayer to lose $5 of a credit, the effective marginal tax rate rises by 5 percent. The EITC, the largest anti-poverty tax program in the United States, is designed to encourage work among low-income earners by phasing in and out at high rates as earnings from work increase. Steep phaseouts over narrower income ranges can save the government significant revenue that would otherwise go to individuals with relatively high incomes, but they also impose higher marginal rates over the income range where the credit phases out.
In 2005, the President’s Advisory Panel on Federal Tax Reform created a sensible proposal for reforming low-income tax credits. The panel extensively examined low-income tax credits, seeking ways to improve their fairness and simplicity and to enhance work incentives. Many issues relating to eligibility requirements and phaseouts were resolved by consolidating existing family, child, and work-related tax benefits into two credits—the Family Credit and Work Credit. If lawmakers seek to enact practical, bipartisan reforms of the tax code this year, an excellent place to start would be to follow the tax panel’s recommendations for simplifying and consolidating low-income credits.
Amy Roden is the program manager in economic policy studies and a Jacobs Associate at the American Enterprise Institute.
Image by Darren Wamboldt/Bergman Group.
The tax treatment of low-income individuals and families is extremely flawed. We can do better.
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