Reduce Tax Rates on Low-Income Families by Extending Tax Phase-Outs

By :: June 29th, 2012

An ominous announcement for a House Ways & Means Committee joint hearing on “how welfare and tax benefits can discourage work” seemed a set-up to attack programs like the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) for their apparent disincentive to work. But that’s not what happened.  Rather than eliminate or downsize the programs, witnesses at the June 27 hearing suggested another possibility: Extend the credits so they phase out more slowly.

At issue are the high marginal tax rates that low- and moderate-income families face as their income rises and they lose the benefit of both transfer payments and tax credits (a problem I’ve discussed here).  The Urban Institute’s Net Income Change Calculator let’s you create your own examples of these phenomena.

At the extreme, a Connecticut mom of two children who participates in every tax and transfer for which she is eligible could double her earnings from $17,000 to $34,000 in 2008 but her post-tax and transfer income would increase by only about $2,000. Chairman Davis’s opening remarks might have led you to believe the problem was a too-generous tax and transfer system. But there is an alternate explanation:  Our system  phases out benefits  too quickly.

As noted by my colleague Gene Steuerle, it’s the classic liberal-conservative compromise. Liberals want to distribute benefits to the needy and conservatives want the programs to be limited. The end result is the need to phase programs out quickly – and when multiple programs phase-out at the same time, beneficiaries end up paying very high marginal tax rates. If the programs are universal, as is often the case in Europe, the problem goes away. You can make-up the lost revenue by putting these somewhat hidden rates directly in the tax code.

But beyond that, before supposing we ought to limit programs, we ought to understand the full effect of the programs. Time and again, research shows that the EITC encourages people to work. Its incentive effect outweighs any disincentive that might exist at higher earnings levels, as noted in Jared Bernstein’s testimony.

I agree with others that we need a simpler tax system. But we don’t need to eliminate programs like the EITC. We need to reform them so they work even better.