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.
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.
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.
State taxes and transfers can be an important form of assistance for low-income families. But the amount of government help varies widely among the states. And, importantly, so does what happens to those benefits when such a family increases its wages.
To help understand how those tax and spending programs work, the Urban Institute has created a new interactive Net Income Change Calculator (NICC). The calculator allows users to enter information about family and work characteristics, child care expenses, rent, and program participation. The calculator then provides estimates for taxes and transfers at five income levels so users can see how taxes and transfers change as income rises.
It includes state and federal income taxes, the employee share of payroll taxes, and a wide range of subsidy programs, including Temporary Assistance for Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP, formerly Food Stamps), the Supplemental Nutrition Program for Women, Infants, and Children (WIC) as well as subsidies for Housing and Child Care. All rules represent 2008 law.
The calculator shows how different these benefits are, depending on where a low-income family lives. For example, in 2008, a single parent with two children aged 0 and 3 with poverty level wages could have received transfer benefits ranging anywhere between $4,000 in several states and $9,200 (Connecticut) if she participated in TANF, SNAP, and WIC.
In addition, she could have received about $6,700 in federal tax credits and either owed state income taxes or received additional tax credits. For example, in Alabama her state tax bill would be over $300 while in Connecticut she would owe no states taxes. She would also have owed almost $1,300 in the employee side of payroll taxes. We assume her childcare costs, before subsidies, would increase to about $250 per month – some of which could be offset by childcare subsidies. Together, taxes and transfers could have changed this mom’s income from $17,000 in wages to between $27,500 and $32,000 in income and benefits, depending on where she lived.
What happens if that mom gets a job?
A single parent in Connecticut with two young children could have received over $18,000 in transfer benefits if she had no earnings and no income, assuming her pre-subsidy rent was $600 per month. But suppose her earnings increased to $17,000 (poverty level) – spread evenly throughout the year – increases in childcare costs (assumed to be $250 per month before subsidies) and payroll taxes would have reduced her earnings by almost $2,000. Income tax credits and transfer benefits would have then added $16,500 – for a total net income of almost $33,000. If her income increased to twice poverty, she’d have to pay almost $5,600 in subsidized child care costs, state income taxes and payroll taxes. She’d receive about $6,400 in tax and transfer benefits – for a net income of $35,000. Thus, doubling her wages from $17,000 to $34,000 resulted in a net change in income of only about $2,000.
In contrast, the same family in Alabama could have received almost $17,000 in transfer benefits if the parent had no earnings. If her earnings increased to poverty-level, she would have spent over $2,500 on childcare, state income taxes, and payroll taxes, while transfer benefits and tax credits would have decreased to under $15,000. In total, the family’s net income would rise from almost $17,000 to $29,000. If her wages doubled, the combination of declining transfers, increased taxes, and higher childcare costs would have resulted in a total net income of $33,000 – an increase of about $4,000.
The NICC provides a powerful tool to understand both how states differ with respect to taxes and transfers, and to understand how a family’s income changes as a parent increases her earnings. Try it out.