A Closer Look at the CTC Lookback

Last week, the Ways and Means Committee passed a bipartisan bill that would expand the Child Tax Credit (CTC), temporarily restore three business tax provisions, and scale back the Employee Retention Credit among some other smaller changes. One CTC provision in the bill would add an earned income “lookback.” Under this provision, tax filers would use either last year’s or current year’s earned income to calculate the refundable portion of the CTC. There has been concern that this could greatly reduce work incentives of the CTC. The provision deserves a closer look.

Under current law, one way the CTC increases work incentives is by increasing the “return to work.” Since the refundable portion of the CTC is only available to households that report earned income, it increases the value of market employment relative to leisure and home production. Thus, the CTC makes it more likely parents enter the labor force.

The lookback provision alters this incentive by allowing households to use prior-year earned income to calculate the refundable portion of the CTC. However, the impact this provision would have on work incentives is somewhat complex. The impact will depend on the situation of a household and will create both increases and decreases in work incentives relative to current law across the population.

For a working parent that has past earnings, the lookback has two opposite effects on work.

First, the lookback creates a work incentive because work in the current year generates earned income that can be used the following year to generate a credit. The incentive effect will depend on how much this parent values the future potential benefit. They may view this as a type of insurance for a potential drop in earnings. This would also be valuable to a parent that did not plan to work the following year.

Second, the lookback reduces work incentives for this parent because they could use last year’s earned income to generate a credit instead of working in the current year. For tax filers with earnings in the phase in, the size of the disincentive depends on how the tax filer’s income changes year-over-year. If current year’s income is expected to be greater than previous year’s income (as is typically the case), there is still a work incentive for current year work, albeit smaller than under current law.

For parents with no prior-year earned income, the lookback will increase incentives to work. This is because entering the labor force for the first time would provide two benefits: a CTC for current year earnings and generating earned income that could be used the following year.

There is also an increased incentive for working parents who are expecting their first child. Under current law, working the year before your child is born does not provide you with a CTC. However, under the lookback, working the year before your child is born generates earned income that can be used the following year for a credit.

In contrast, working parents whose child is going to turn 17 face a work disincentive relative to current law. Working in the current year will no longer generate a future benefit. Regardless of work, a parent cannot receive a credit for a 17-year-old child.

Overall, the work incentives of the lookback provision are mixed. It would increase work for some and reduce it for others, but that should be expected. The goal of the proposal is to provide households with some flexibility. That said, the current proposal is temporary and whatever its impact on work incentives in the long term, they are unlikely to materialize in the short run. Regardless, this policy would not create a permanent incentive to leave the workforce. Lastly, the effect of the lookback on work should also be considered in the context of the entire credit expansion, which includes other features that would both increase and decrease work incentives.