March 8, 2006
A HAND UP
HOW STATE EARNED INCOME TAX CREDITS HELP
WORKING FAMILIES ESCAPE POVERTY IN 2006
By
Ami Nagle and Nicholas Johnson
Executive Summary
An Earned Income Tax Credit is a tax reduction
and a wage supplement for low- and moderate-income working families. The
federal government administers an EITC through the income tax. So do many
states. States that enact EITCs can reduce child poverty, increase effective
wages, and cut taxes for families struggling to make ends meet.
Rising Number of States Offer EITCs
As of January 2006, nineteen states (counting the
District of Columbia as a state) have passed Earned Income Tax Credits. Most
recently, Delaware and Virginia enacted new EITCs, Illinois and Oregon changed
their state EITC from non-refundable to refundable, and several states,
including the District of Columbia, expanded existing EITCs. In addition, three
local governments – Montgomery County, Maryland, New York City, and San
Francisco – offer local EITCs.
State Earned Income
Tax Credits Based on the Federal Credit
Refundable Credits
Colorado
District of Columbia
Illinois
Indiana
Kansas
Maryland
Massachusetts
New Jersey
New York
Oklahoma
Oregon
Rhode Island
Vermont
Wisconsin
Non-refundable Credits
Delaware
Iowa
Maine
Virginia
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State EITCs have received broad support. EITCs
have been enacted in states led by Republicans, in states led by Democrats, and
in states with bipartisan leadership. The credits are supported by business
groups as well as by social service advocates.
Why Consider an EITC?
Several developments explain the popularity of
state EITCs.
- Continued child poverty and economic
hardship. In 2004, some 7.7 million children in working families remained
poor. And many families with incomes modestly above the official poverty line
– roughly $19,800 for a family of four – also face significant difficulty in
meeting the costs of food, housing, transportation, clothing, and other
necessities. Sluggish wage growth for low-earning families means that many
families are likely to continue to struggle. State EITCs can help reduce
poverty and hardship among families with children.
- Welfare reform and low wages. Over the last
several years, several million welfare recipients have left welfare and
entered the workforce; many other families have accepted the challenge of
making ends meet on low-paying jobs without seeking public assistance. Many
such families, however, cannot make ends meet on their earnings alone. A
full-time job at the federal minimum wage of $5.15 per hour often is not
sufficient to lift a family out of poverty. In part this is because the
federal minimum wage has not been adjusted for inflation in many years. Even
state minimum wages that are higher than the federal may fall short of
providing a sufficient income on which to live. State EITCs support families
who enter and remain in the workforce.
- Tax changes. Rising revenues in many states
are leading policymakers to consider enacting tax cuts. Enacting a state EITC
is a way to ensure that low- and moderate-income families share in the
benefits of tax cuts. This is particularly important because most state tax
systems rely heavily on sales, excise, and property taxes, the burden of which
falls most heavily on low- and middle-income families. Moreover, nearly half
of the states impose an income tax on working-poor families, and most states
levy income tax on families with incomes only slightly above the poverty line.
A state EITC can help offset such taxes.
Why Model a State Credit on the Federal EITC?
The federal EITC was established in 1975 to
offset the effects of federal payroll taxes on low-income families. It has been
expanded several times since, providing additional assistance to welfare
recipients entering the workforce and other workers supporting their families on
low wages.
The effectiveness of the federal EITC both in
supporting work and in alleviating child poverty has been confirmed by a number
of recent studies.
The EITC now lifts more than 4 million
people — roughly half of them children — out of poverty each year; it is the
nation’s most effective antipoverty program for working families.
- Research shows that the credit has contributed
to a significant increase in labor force participation among single mothers.
- Interviews with EITC recipients show that many
use their EITC refunds to make the kinds of investments — paying off debt,
investing in education, securing decent housing — that enhance economic
security and promote economic opportunity.
Designing a State EITC
Eighteen state EITCs piggyback directly on the
federal EITC; those 18 states use federal eligibility rules and express the
state credit as a specified percentage of the federal credit. (The percentages
are shown in Table 4 on page 22.) The nineteenth state with an EITC,
Minnesota, also uses federal eligibility rules, and its credit parallels major
elements of the federal structure.
TABLE 1:
FEDERAL EARNED INCOME TAX CREDIT PARAMETERS |
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Phase-out Range |
Tax Year |
Credit Percentage |
Maximum Benefit |
Phase-out
Rate |
(Single/head of household) |
(Married filing jointly) |
Families with two or more children: |
2005 |
40%
of first $11,000 |
$4,400 |
21.06% |
$14,370 to $35,263 |
$16,370 to $37,263 |
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|
|
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2006 |
40%
of first $11,300 |
$4,520 |
21.06% |
$14,760 to $36,222 |
$16,760 to $38,222 |
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Families with one child: |
2005 |
34%
of first $7,830 |
$2,663 |
15.98% |
$14,370 to $31,030 |
$16,370 to $33,030 |
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|
|
|
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2006 |
34%
of first $8,050 |
$2,737 |
15.98% |
$14,760 to $31,888 |
$16,760 to $33,888 |
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Families with no children: |
2005 |
7.65%
of first $5,220 |
$399 |
7.65% |
$6,530 to $11,750 |
$8,530 to $13,750 |
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|
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2005 |
7.65%
of first $5,370 |
$411 |
7.65% |
$6,710 to $12,080 |
$8,710 to $14,080 |
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Source: Internal Revenue Service |
Fifteen of the 19 states with EITCs follow the
federal practice of making the credit “refundable.” This means a family
receives the full amount of its credit even if the credit amount is greater than
its income tax liability. The amount by which the credit exceeds annual income
taxes is paid as a refund. If a family has no income tax liability, the family
receives the entire EITC as a refund. All low-income working families with
children can participate in a refundable EITC. Refundable credits have passed
in Colorado, the District of Columbia, Illinois, Indiana, Kansas, Maryland,
Massachusetts, Minnesota, New Jersey, New York, Oklahoma, Oregon, Rhode Island,
Vermont, and Wisconsin.
The remaining four states — Delaware, Iowa,
Maine, and Virginia — offer credits that are non-refundable. Such a credit is
available only to the extent that it offsets a family’s income tax. A
non-refundable EITC can provide substantial tax relief to families with state
income tax liability, but it provides no benefits to working families that have
income too low to owe any income taxes. Thus a non-refundable credit assists
somewhat fewer working-poor families with children and is likely to be less
effective as a work incentive.
Financing a State Credit
The annual cost of refundable state EITCs in
recent years has ranged from about $17.3 million in Vermont to $591 million in
New York, less than 1 percent of state tax revenue in each state. The cost of a
state EITC depends principally on four factors: the number of families in a
given state that claim the federal credit, the percentage of the federal credit
at which the state credit is set, whether the credit is refundable or
non-refundable, and how many state residents that receive the federal credit
also learn about and claim the state credit. Because state EITCs are more
specifically targeted to low- and moderate-income working families than many
other major tax cuts, the cost may be relatively modest. A relatively
straightforward procedure for estimating the cost of a refundable credit in any
state is outlined on pages 27 to 30 of this report.
State EITCs are financed in whole or in part from
funds available in a state’s general fund — the same funding source typically
used for other types of tax cuts. When an EITC is used to offset the effects of
a regressive tax increase, such as a sales tax increase, a part of the proceeds
of the revenue increase may be set aside for the EITC. Current federal
regulations also offer the opportunity to finance a portion of the cost of a
refundable credit from a state’s share of the federal Temporary Assistance to
Needy Families block grant, but most states have very limited availability of
such funds, because the value of the TANF block grant has eroded over time and
because states face costly new work requirements under the most recent federal
budget law. No matter how it is financed, however, an EITC can complement a
state’s welfare program by assisting low-income working families with children.
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