Elaine Maag is a Senior Research Associate at the Tax Policy Center. Her studies focus on how tax policy affects low-income families and state taxes.
Government redistributes income through tax and spending programs. Nearly everyone pays some tax – be it federal or state income taxes, payroll taxes, or sales taxes. The tax system also affects people by delivering a host of benefits through tax expenditures (subsidies like the mortgage interest deduction or the child tax credit). And broad spending programs such as national defense and Social Security affect nearly everyone over the course of their lifetime.
Yet, we know surprisingly little about the combined effect of taxes and spending on our well-being. Two new studies—one by the Congressional Budget Office (CBO) and another by the Tax Foundation—have begun to close this knowledge gap by analyzing spending and taxes together. Tuesday, I participated in a TPC panel discussion that highlighted these papers (you can hear the program and see the slides and papers here). Two things are clear: First, what CBO and the Tax Foundation are trying to do is very hard. It requires analysts to make assumptions about how taxes and spending affect people. Second, there’s a lot of redistribution—for example, from the nonelderly to the elderly and from higher-income people to lower-income people. (I focus on the CBO report here but the Tax Foundation’s analysis reaches similar conclusions.)
In 2006 (the year the CBO report focuses on), the federal government spent roughly $2.7 trillion and collected $2.4 trillion in taxes and other revenues.
The CBO study focuses on three groups – the elderly, the nonelderly with children, and the nonelderly without children. Given the size of Social Security and Medicare, it’s no surprise that CBO found that in 2006 the elderly received more in benefits than they paid in taxes. But, as my Urban Institute colleague Melissa Favreault pointed out, it isn’t that simple. What if you look at this picture not as a one-year snapshot but over a lifetime? Today’s elderly paid taxes when they were younger—in many cases, more than they will receive in benefits. And the story gets even more complicated because some nonelderly people benefit indirectly from Social Security and Medicare. Retirees’ children benefit because they do not have to provide as much support for their elderly parents as they would without the programs.
Younger households present other issues. CBO found that government spent more on low-income households in 2006 than on high-income households. But people’s incomes change during their lives as they move from low-income to higher-income or vice versa. An annual estimate may not reflect how a person will fare over a lifetime.
Other kinds of government spending create different challenges, especially programs such as defense. Unlike transfers that go to individuals, defense is a public good—we all benefit in some way. But how should we value those benefits for individuals? Do we all benefit equally? Do rich people benefit more? There’s no clear answer.
Ultimately, this sort of analysis could also provide information on how pre- tax-and-transfer income differs from after-tax-and-transfer income – information likely to be in high demand in any serious budget negotiations. We know from the CBO report the net effect of taxes and transfers on broad swaths of the population, but not on individual families or households within income classes. This can mask big winners and losers within income groups.
Notwithstanding these reservations, the CBO and Tax Foundation reports help us start to think about taxes and transfers together – and give a more accurate view of government than we get by focusing on only one side of the budget.
At an AEI panel discussion earlier this week, Senator Mike Lee (R-Utah) unveiled the Family Fairness and Opportunity Tax Reform Act. The centerpiece is an additional $2,500 tax credit for all children under age 17. The plan retains the $1,000 child tax credit under current law. Unlike the current credit, the new credit would not phase out at higher income levels.
Lee’s idea is straightforward—cut taxes for families with children and raise them for households with high itemized deductions.
He’d eliminate the standard deduction and personal exemption (except for dependents under 17) and replace them with a nonrefundable $2,000 per person credit. He’d also repeal the Alternative Minimum Tax and end the taxes associated with the 2010 Affordable Care Act (ACA).
He would also eliminate all but two itemized deductions, including those for state and local taxes. He’d keep the mortgage interest deduction (capped at $300,000 of debt) and the deduction for charitable giving—and make those available to all taxpayers.
The plan would have just two rates, 15 percent on the first $87,850 for single people (twice that for couples) and 35 percent—higher than the 25 percent top rate in other GOP plans. (The plan would eliminate most marriage penalties for higher-income households and provide marriage bonuses for many. High-income households with one earner and many children would get a huge tax cut.)
While Lee says he’d like to aim for even lower rates, his current design seems to recognize that you can’t slash tax rates for all without losing billions (or even trillions) of dollars in tax revenue. However, the 35 percent rate is significantly lower than the 39.6 percent top rate—plus surtaxes associated with the ACA—that applies to top incomes under current law. We don’t know yet whether the plan is revenue neutral because important details haven’t been specified.
Lee would remove many households from the federal income tax rolls. But he sees no special reason why the key feature of his plan—the added $2,500 per-child tax credit—needs to be a tax credit. He’d be willing to use a direct spending program instead (something my colleague Austin Nichols might think was a better idea).
If the new child credit were instead a transfer payment, the plan wouldn’t increase the number of people who don’t pay federal income tax, but it would still provide substantial assistance to families with children, albeit with higher administrative costs. By acknowledging that such a child credit is effectively spending, Lee challenges critics to assess the merits of the plan.
We ought to be talking about whom the federal government should assist and how much aid they ought to get, without turning policy inside out by making every benefit program a tax preference when direct spending might make more sense. I agree with Senator Lee. Spending programs and tax policy can often accomplish the same thing. We should evaluate benefits for families with children and see what form of subsidy makes the most sense. Maybe in the process we could stop obsessing about who does—and does not—pay federal income tax.
Every year at tax time I am reminded of two tax benefits that subsidize my children’s child care – the employer-provided child care exclusion and the Child and Dependent Care Tax Credit (CDCTC). Families with sufficient expenses can benefit from both provisions. Congress could simplify these child care benefits by harmonizing the maximum allowable expenses for both benefits, or eliminating one of the benefits altogether.
Here’s how the child care exclusion and CDCTC work. The exclusion allows me to set aside up to $5,000 from my salary to pay for child care expenses (regardless of the number of children I have) and exclude that from taxable income. However, I can only take the exclusion if my employer offers this benefit.
The credit applies to as much as $3,000 of child care expenses per child, to a maximum of $6,000. Unlike the Child Tax Credit (CTC) – which is refundable, the CDCTC is nonrefundable. It only benefits families with child care expenses who owe federal income taxes. The actual amount of the CDCTC depends on my adjusted gross income (AGI), and ranges from 35 percent of expenses for parents with AGI up to $15,000 down to 20 percent for those with AGI over $43,000.
Higher income parents tend to benefit more from the exclusion while middle-income parents are the primary beneficiaries of the credit. Because the credit only goes to families who owe taxes, very low-income families benefit more from the exclusion (because they don’t owe payroll taxes on the excluded income). However, relatively few of these workers have access to the exclusion because their employers are less likely to let them put aside pre-tax child care dollars.
I can receive benefits from both provisions. However, I must count different expenses for both s and when I calculate my child care credit, I must subtract the expenses already excluded from my income from my maximum allowable child care credit expenses. In my case, I exclude the maximum $5,000 of child care expenses from my taxable wages and claim the credit on $1,000 of expenses.
Sound confusing? It is. But it doesn’t have to be. Congress could set the same maximum allowable expenses for both benefits and limit parents to using only one. Congress could simplify more by eliminating the exclusion that provided $1.5 billion in tax benefits in FY2012 and keep the credit that provided $3.4 billion in tax benefits in FY2012. People currently using the exclusion would likely shift to the credit. .
On one hand, the exclusion makes sense if one considers child care a cost of earning income. But in practice, the credit is more popular, the plans allowing the exclusion are offered to less than one-third of employees, and eliminating the exclusion would simplify child care tax benefits for both parents and employee benefits’ offices. My own tax liability would increase.
Making expense limits uniform or getting rid of at least one provision It would be a good way to declutter the tax code, even if we can’t get broad tax reform.
Tax-based aid for higher education quadrupled between 2000 and 2010 and will continue to be a large part of the financial aid story – at least through 2017 when the American Opportunity Tax Credit is scheduled to expire. As part of a series of reports on federal financial aid, the Center for Law and Social Policy is urging a full review of who receives tax benefits for education, how those benefits compare with the better-known Pell grants, and whether Congress should reform higher education benefits. It proposes some important ideas for better targeting those subsidies to students who need them the most.
Since the enactment of the Hope and Lifetime Learning Credits in 1997, education tax benefits have grown from less than $1 billion to over $34 billion in FY2012. Most of that growth comes from the AOTC, which replaced the Hope credit in 2009 (figure 1).
In 2012, the $34.2 billion in tax-based aid represented nearly half of all non-loan federal assistance and rivaled the $35.6 billion in Pell grants. But unlike Pell grants that assist low-income students, tax subsidies often benefit students who are already likely to attend college. The Tax Policy Center estimates that in 2013, a quarter of the aid from the AOTC and half of the aid from the tuition and fees deduction will go to students in families with incomes between $100,000 and $200,000 (figure 2). According to the National Center for Education Statistics, in 2010 barely half of students from low-income families enrolled in two- or four-year colleges immediately after completing high school. In contrast, two-thirds of kids from middle-income families and 82 percent of kids from households making $100,000 or more went straight to college.
In addition, under current rules, tax aid often comes too late to be useful for low-income students. Unlike Pell grants which provide benefits at enrollment, tax benefits typically come when a person files their tax return – something that can happen more than a year after a student needs to pay tuition.
Experts have long noted the need to reform tax-based aid, and the CLASP report offers up some solutions. CLASP suggests three ways to better target tax subsidies to those students most in need and least likely to attend college. They focus on increasing the value of the AOTC for low-income families, simplifying the tax-based aid system by eliminating credits and deductions for those likely to go to college absent the tax benefits, and piloting real-time payment of the AOTC.
The CLASP proposal would improve both the efficiency and effectiveness of the tax incentives. However, even with these reforms, tax benefits may never help poor students as well as direct assistance like Pell grants.
In the realm of needless complexity, the work and family tax credits for low-income households rank near the top. The problem is especially challenging for immigrant families whose children’s legal status and residency determine eligibility for these credits.
A few weeks ago, the National Taxpayer Advocate in her Annual Report to Congress joined many others in calling for separating the work and family incentives in the tax code. This approach could make tax filing simpler and more efficient for low-income families.
Currently, the three largest child related provisions – the dependent exemption, the Child Tax Credit (CTC), and the Earned Income Tax Credit (EITC) – have three sets of rules governing eligibility. These inconsistencies in the law create confusion and prevent people from claiming deductions or credits for which they are eligible. Here are a few examples of how the rules differ:
- Children who are U.S. citizens or nationals qualify for all three benefits, if they live in the United States.
- Other children who reside in the U.S., Canada, or Mexico may be eligible for the dependency exemption.
- The CTC requires that the child reside in the U.S.
- The child must reside in the U.S. and have a Social Security number to be eligible for the EITC.
- Depending on whom you ask, a child may or may not need a Social Security number to get the Additional Child Tax Credit (ACTC)—the refundable portion of the CTC. The Treasury Inspector General for Tax Administration claims that children must meet the stricter EITC qualifications to get the ACTC. But the IRS maintains this interpretation is incorrect and says children need only reside in the U.S. as they would for the non-refundable portion of the CTC. Legislation to change the criteria for the ACTC to explicitly require SSNs did not pass in the last Congress.
The National Taxpayer Advocate’s recommendation to separate the dependent exemption, CTC, and EITC into a worker credit and a family credit follows that of many others (and this is not the first time the National Taxpayer Advocate has made the recommendation). In 2011, I suggested we separate work and family credits to clarify and strengthen incentives in the tax code. Similarly, the Bipartisan Policy Center, the George W. Bush Tax Reform Panel, and advocates for low-wage workers without children living at home all support separate work and child incentives in the tax code. The worker credit would not be affected by the presence of children so whatever rules were adopted for the child credit (and the current ones applying to the dependent exemption make sense to me) would be the only rules parents would need to know. I support refundability of both credits for simplicity.
This is a good idea for a whole host of reasons. Immigration reform is only one. Many policy analysts agree on the solution, but Congress has yet to seriously consider the notion. Maybe the Taxpayer Advocate’s recent report and the newly energized immigration debate will encourage lawmakers to finally separate work and child credits. It is about time.
As tax filing season approaches, the IRS is reminding low-income families about the Earned Income Tax Credit (EITC). The EITC provides a wage subsidy for low- and moderate-income families and is an important income support for many.
In 2012, a family with two children could receive an income boost of 40 cents for every dollar earned, until they reached the maximum credit of $5,236 (which happens once earnings reach $13,090). The credit begins to phase down when income exceeds $17,090 ($22,300 if married) and disappears entirely for families with two children when income hits $41,952 ($47,162 if married). A smaller credit is available for smaller families and a larger credit is available for families with at least three children (see chart), but that larger credit is scheduled to expire after 2017.
The Tax Policy Center estimates that almost 36 percent of all EITC benefits for 2012 will go to families in the lowest fifth of all incomes, and an additional 51 percent will go to families in the second income quintile. Almost no benefits flow to families in the top 40 percent of the income distribution. Because incomes at the bottom end of the distribution are highly volatile, EITC receipt status is often temporary with families typically receiving the credit for only one or two years.
Research consistently finds that the EITC encourages work, especially among single moms. One study found that the EITC lifted over 6 million people out of poverty in 2009. The credit also improves infant health. In 2012, 24 states and the District of Columbia have an EITC which supplements the federal EITC by as much as 45 percent.
It is not known how many people are eligible for the EITC and fail to claim it, though widely accepted estimates based on the 1990 tax year suggest between 16 and 20 percent of eligible families fail to claim the credit. Given the value of the credit, it is important to remind low-income families that it is a big reason why they should file a tax return. Kudos to the IRS for today’s EITC Awareness Day, which serves as an important reminder.
The 2001-10 tax cuts placed substantial emphasis on “pro-family” tax reform. The more prominent features favoring families with children included a doubling of the Child Tax Credit (CTC) to $1,000 per child and making it broadly refundable, increasing the Earned Income Tax Credit (EITC) for families with at least 3 children, increasing the point at which the EITC starts to phase out for married couples, increasing the credit rate of the Child and Dependent Care Tax Credit (CDCTC) for some families, and increasing the expenses eligible for a CDCTC for all families.
If left in place, in 2013 families with children would see over $43 billion in benefits from these provisions. But absent Congressional action, these expanded benefits will disappear over the cliff. Should the EITC, CTC, and CDCTC revert to their pre-2001 form, the Tax Policy Center estimates nearly three-quarters of all families with children will see their taxes rise or net rebates decline by an average of almost $1,200, compared with what they would pay if the provisions were extended. Keep in mind those changes would be in addition to the broad tax hikes that would affect nearly all working families such as the expiration of the payroll tax cut and any increase in marginal tax rates for all families with income above the tax entry thresholds.
Most low income and middle income families with children will see their taxes rise (almost 72 percent of families in the lowest 20 percent of incomes and 89 percent of families in the second income quintile), in many cases by a substantial share of their income. Among families whose taxes go up, the average increase will exceed $1,400 for families in the lowest quintile and $1,600 for families in the second quintile (see chart). Most of this increase comes from the reduction in the CTC to pre-2001 levels. Although the child credit phases out and the EIC is unavailable at higher incomes, even families in the top quintile are not immune to tax increases stemming from these three provisions. Just over one-third of families with children in the highest income quintile will see their taxes rise in 2013 by an average of about $600.
If Congress and President Obama can reach a deal (either before or after January 1), it’s likely to include an extension of the doubled CTC, higher income cut-offs for married couples claiming the EITC, and the increases to the CDCTC. This would preserve these benefits for most families. But the fate of other provisions, such as the reduced refundability thresholds for the CTC and the increased EITC for families with at least 3 children, are much less clear. For instance, neither is included in the House Republican Budget Plan. Those provisions deliver the lion’s share of benefits to those in the lowest income households.
Today, we still don’t know how the ongoing budget debate will end. But the debate thus far leaves the most vulnerable families quite close to the edge.
If a tax cut is scheduled to expire, but the focus of the debate is elsewhere, will people notice? Will the average family be surprised when their taxes rise by $1,000 or more next year, even if most of the rest of the 2001-2003 tax cuts are extended for all but the wealthiest Americans? That’s precisely what could happen to a family earning $50,000 when the current law reducing payroll taxes by 2 percent expires at the end of the year. This same thing was scheduled to happen at the end of 2011, but politicians assured us then this was a bad idea. This year, they don’t appear as concerned.
According to my colleagues at the Tax Policy Center, the expiration of the payroll tax cut would increase taxes by $115 billion in 2013. This provision affects more households than any other, yet President Obama and others have been strangely silent – arguing instead about the fate of the 2001-2003 tax cuts.
As I noted last month on TaxVox, focusing only on the 2001-2003 tax cuts ignores important changes to the Child Tax Credit for very low-income families that will expire at the end of 2012. But the payroll tax cut affects nearly every worker. No doubt, the 2010 version was expensive and poorly targeted. But it had its roots in a better-designed predecessor – the Making Work Pay (MWP) tax credit– that might offer a palatable step down from current policy, without sending those who remain vulnerable over the cliff.
To refresh your memory, in 2009 and 2010, the MWP provided a credit of 6.2 percent of earnings, up to $400 for singles ($800 for married couples). MWP started to phase out once earnings reached $75,000 ($150,000 for couples), with no credit available once earnings reached $95,000 ($190,000 for couples).
But MWP was temporary and the Obama Administration made no effort to extend it. Instead, in 2010, Congress replaced MWP with a payroll tax cut that had no income limit. Ultimately, MWP dollars were better targeted towards people who were likely to spend them – and cost about half as much as the current payroll tax cut. Restoring MWP would at least reduce the number of people who will be shocked to see their first paycheck in January.
Now, all Obama has to do is find a new name for this old but useful credit. Perhaps TaxVox readers can help. Send us your ideas. We can’t compete with Powerball but will pick a winning name on December 6.
The Child Tax Credit (CTC), a key piece of the safety net for low- and moderate-income families, is in jeopardy as the nation hurtles towards the fiscal cliff. Not only could the 2001 expansion of the credit die, but so could provisions in the 2009 stimulus that made the credit much more available to low-income families.
My biggest fear is that Congress will cut a year-end deal that extends the 2001 expansion but lets the important 2009 changes die.
To explain what’s happening, here is a bit of history: Prior to 2001, the credit was $500 per child. Families whose credit exceeded the income tax they owed could get the balance as a refundable credit only if they had at least three children and paid enough payroll tax. The credit phased out for single parents with income over $75,000 and married couples with income over $110,000.
The 2001 act doubled the credit to $1,000 per child and broadened its refundability. Families could receive 15 cents of their credit for each dollar of earnings over $10,000. (The threshold was indexed for inflation and would be about $13,000 in 2013.) Stimulus legislation in 2008 and 2009 reduced the threshold to $8,500 and then to $3,000. The more generous refundability level enacted in 2009 is critically important for low-income families.
Of the $38.3 billion in total child credits that TPC estimates families will claim this year, $29.5 billion comes from the 2001 tax law and another $8.8 billion from the 2009 stimulus. Most of the 2001 increase will go to families in the middle income quintile and higher (see chart). Families with the lowest incomes will get less than 3 percent of the 2001 increase. In contrast, fully 60 percent of the benefits from the 2009 changes will go to families in the lowest income quintile.
As we near the fiscal cliff, Congress should keep in mind the entire package of CTC changes, noting that the 2009 ARRA changes matter most for very low-income families.
The Earned Income Tax Credit (EITC) provides a significant income boost to low-income single-parent families, but can severely penalize those families if the parent marries. A new plan from Brooklyn College economist Robert Cherry could sharply reduce that problem while sharply increasing benefits for families with young children – particularly those with married parents.
Analysts consistently find that the EITC encourages work and reduces poverty. Recent evidence shows that EITC receipt is correlated with improved health outcomes for infants. But the credit is not all roses. A major problem is the marriage penalty embedded within the structure of the EITC. Taken to the extreme, if a single mom of three children earns $17,090, her EITC totals almost $6,000. If she marries a partner who earns more than $5,210, her EITC falls by just over 21 cents for every dollar his earnings exceed that threshold. If he earns $32,970 or more, she loses her EITC entirely.
Many analysts, including myself, have offered ideas for reducing or eliminating marriage penalties in the EITC, essentially by developing an individual worker credit and a child credit, rather than combining the two.
Cherry’s New Mothers Tax Relief (NMTR) proposal is more modest and would focus on marriage penalties that the EITC imposes on single parents. The proposal would be limited to parents with at least one pre-school aged child. While the NMTR does not increase the maximum EITC benefit, it does increase the income range over which the maximum benefit applies. For single-parent families, the NMTR (solid gray line in graphic) would start to phase out at a slightly higher income level than the current EITC ($18,000 rather than $16,690) and the phaseout rate would decline from the current 15.98 percent to 12 percent. Ultimately, this means that single-parent families would continue to receive a credit until earnings reached almost $44,000, rather than just over $36,000.
Benefits would rise much more for married couples. The proposal would increase the phaseout threshold for couples from not quite $22,000 to $40,000 and would reduce the phaseout rate from 15.98 percent to 6 percent to mitigate any remaining marriage penalties. Cherry contends that this would allow low-income parents to decide about marriage based on factors other than economic incentives in the tax code. At the extreme, the plan would allow a married couple to keep their entire EITC. For parents with 1 child, this is almost $3,100 – when under current law they would lose their EITC entirely.
Besides mitigating marriage penalties, the NMTR would also substantially increase the EITC for many parents with a young child – getting needed funds to lower middle class married families. If the proposal were limited to families with a child under age 3, Cherry estimates an annual cost of $8.5 billion. If the proposal were limited to families with a child under age 6, the annual cost of the proposal would be $15 billion. For reference, TPC estimates the total cost of the EITC in 2011 to be $57.5 billion.
This plan doesn’t go as far as others in separating out work and child incentives – and focuses on a very narrow population (families with a pre-school aged child), but it certainly provides for another way to improve the EITC for vulnerable low-income families by increasing benefits and reducing marriage penalties. The plan serves as a reminder that while the EITC continues to provide essential support to low-income families, there’s still room for improvement.