March 16, 1998
A Refundable Earned Income Tax Credit Will
Assist Maryland's Working Poor Families
by Elizabeth C. McNichol
Maryland's income tax includes an earned income tax credit, which is a credit based on a percentage of wages earned that reduces taxes owed by low- and moderate-income working people. Maryland's EITC builds on the federal EITC and is equal to 50 percent of the value of the federal credit. Unlike the federal credit, however, Maryland's credit is not refundable. This means that it can only be used to offset a family's state and local income tax liability; any amount that exceeds the amount of income tax a family owes is forfeited. As a result, no families with income below the poverty level benefit from the state's current EITC because below-poverty families already are exempt from paying Maryland income tax.
The Maryland legislature currently is considering proposals to add a refundable portion to the state's non-refundable earned income tax credit. Under legislation submitted by Delegate Sheila Hixson in the House and Senator Barbara Hoffman in the Senate, a 15 percent refundable credit would be added. The 50 percent non-refundable credit also would be retained. All families that currently benefit from the state EITC would receive at least the same benefit available under current law but thousands of additional families with incomes below the poverty line also would be assisted.
Adding refundability to the EITC would bring Maryland's EITC to its full potential.
- A refundable credit would provide a wage supplement that would lift a substantial number of working poor families out of poverty. Data from the Census Bureau's Current Population Survey show that 32,000 poor Maryland families with children or half of all poor families with children in the state have one or two working parents. As the Maryland EITC currently is structured, these working families receive no benefit from the state's EITC.
- Refundability would complement welfare-to-work efforts in Maryland by giving an additional income boost to those newly entering the work force from public assistance rolls.
- Refundability would help mitigate the growing income inequality in Maryland by boosting the incomes of low-wage workers. Since the 1970s, the pre-tax incomes of Maryland's poorest families have declined by nine percent after adjusting for inflation while the incomes of the state's wealthiest families jumped by 37 percent.
- A refundable credit would provide tax relief to Maryland's poorest families those that received no benefit from the $500 million income tax cut enacted last year.
The benefits to working poor families in Maryland from a refundable EITC would be significant.
- A family of four with one full time, year round minimum wage earner would receive the maximum credit of $563 in 1998.
- A family of three with one child and a parent earning $5,400 in 1998 roughly half-time work at the minimum wage would receive a refund of $273.
The Federal Earned Income Tax Credit As Context
To understand why making the Maryland EITC refundable would serve important policy goals, it is useful first to look at the role played by the federal EITC. The federal EITC is a tax credit for low- and moderate-income working people that is designed to offset the sizable burden of the payroll tax on low-wage workers, supplement the earnings of low- and moderate-income families, and complement efforts to help families make the transition from welfare to work.
The federal EITC, which was expanded substantially in 1986, 1990 and 1993, has become a central element of a strategy to boost income from work and lessen poverty among families with children. This is often called the "make work pay" strategy. The goal of this strategy, which has been espoused by both liberals and conservatives, is to ensure that a family in which a parent works full-time year-round should not live in poverty.
For families with very low earnings, the value of the EITC increases as wages rise. In 1998, families with two or more children will receive 40 cents for each additional dollar earned until wages reach nearly $9,390, for a maximum benefit of $3,756. For families with one child, the EITC benefit equals 34 percent of earnings up to $6,680, for a maximum benefit of $2,271. This means that parents with very low incomes who are able to gain additional earnings get an additional boost in income from a larger EITC benefit. (See Figure 1.)
Families that have incomes above $6,680 for a family with one child or $9,390 for a family with two or more children but less than $12,250 in 1998 will be eligible for the maximum EITC benefit. The value of the EITC benefit is reduced gradually as incomes rise above $12,250. A family with two or more children will be eligible for some EITC benefit until its income exceeds $30,100, while the family with one child may receive some benefit until its income exceeds $26,500.
The structure of the federal EITC thus boosts the incomes of working poor families, including those making the transition from welfare to work. It also provides continuing assistance to working families with incomes modestly above the poverty line. Since many of these families still struggle to make ends meet and may be one or two paychecks away from needing to rely on assistance, the EITC helps parents support their families through work and remain off welfare.
As noted, the federal EITC is refundable, which means that a family receives a refund if its EITC benefit is greater than its tax liability. This ensures that families receive the full EITC benefit for which they are eligible. The fact that the EITC targets substantial benefits on families with earnings near the poverty line makes it effective in lifting working families with children out of poverty.
Recent research finds the federal EITC to be having substantial effects in reducing poverty. Data from the Census Bureau's most recent Current Population Survey show that in 1996, the EITC lifted out of poverty 4.6 million people in low-income working families who would have been poor without it. More than half of those whom the EITC lifted out of poverty 2.4 million of these 4.6 million people were children.(1)
The Census data also show that 14.5 percent of the children who would have been poor in the absence of any government benefits more than one in every seven such children were lifted out of poverty by the EITC.
It is important to note that poor working families owe no federal income tax, just as they owe no Maryland income tax, and thus they would not benefit from the federal EITC if it were not refundable.
Nine States Have Enacted State EITCs
The success of the federal EITC has led nine states to enact a state EITC. In 1997 alone, two states Massachusetts and Oregon enacted new EITCs and Minnesota greatly expanded its credit. The additional states with EITCs are Iowa, Maryland, New York, Rhode Island, Vermont, and Wisconsin. (See Figure 2.) Each of the nine state EITCs piggybacks on the federal EITC; the states use federal eligibility rules and express the state credit as a specified percentage of the federal credit.
There are two principal decisions to make when designing a state EITC: whether the credit will be refundable or non-refundable, and the percentage of the federal credit at which the state credit will be set. Five of the nine states with a state EITC Massachusetts, Vermont, Minnesota, Wisconsin and New York have made their credits refundable. The EITCs in these states range from 10 percent to 25 percent of the federal credit, with the exception of the Wisconsin EITC, which ranges from four percent of the federal credit for families with one child to 43 percent of the federal credit for families with three or more children.(2)
State Earned Income Tax Credits, 1998
States with Refundable EITC's Percentage of Federal Credit, 1998
4% - One child
14% - Two Children
43% - Three+ Children
States with Non-refundable EITCs
*As a result of cut in the basic rate for the state's income tax, the EITC will fall to 25 percent of the federal by 2002.
In most states with refundable EITCs, families at the poverty line have little or no tax liability before the refundable credit is applied as is the case in Maryland. The credits are refundable so poor families can benefit from them. Minnesota and Vermont use the federal tax threshold which exempts all poor families from federal tax. In New York, pre-EITC tax liability for a family of four at the poverty line was just $67 in 1996. In Massachusetts, a family of three with poverty-level income has no pre-EITC tax liability. The only other state with a refundable EITC is Wisconsin and poor families in Wisconsin do have a substantial pre-EITC tax liability. In Wisconsin, the state EITC both reduces or eliminates tax liability for poor families and provides a refund.
A Refundable EITC Would Continue Maryland's Tradition of Fairness
In Maryland, as in most states, major tax cuts generally are enacted during good economic times and major tax increases are enacted during economic downturns. In the past, Maryland families at all income levels have shared in the tax relief provided during good times and all have had to pitch in during the bad times. The experience during the current expansion is different, however.
During the economic boom that Maryland enjoyed during the late 1980's, a number of tax cuts were enacted. Most of these were income tax cuts, as economic growth and federal tax reform resulted in rapid increases in income tax revenues. The changes made to the state's income tax benefited taxpayers at all income levels. Upper-income taxpayers benefited from the exclusion of 40 percent of capital gains income from taxable income. Middle-income taxpayers saw tax relief from increases in the personal exemption and standard deduction. Poor families benefited from the enactment of the 50 percent non-refundable EITC and from the enactment of the poverty subtraction.
When the economy turned down in the early 1990s, Maryland taxes were raised in order to fill budget shortfalls. During that time, the impact of tax increases was also spread across families at all income levels. Upper income taxpayers received a tax increase when the 40 percent capital gains exclusion was eliminated and a temporary tax bracket of 6 percent for taxpayers with income over $100,000 was added to the income tax. At the same time, lower- and middle-income families were disproportionately affected by the expansion of the sales tax base and increases in excise taxes, including the tripling of the cigarette tax rate.
With the renewed economic growth of the mid- and late-1990s taxes are once again being cut in Maryland. By contrast to earlier periods, the tax cuts enacted so far have almost exclusively benefited families with incomes above the poverty line. In 1994, the higher top income tax rate expired giving upper-income taxpayers a $29.3 million tax break. All of the benefits of the $500 million personal income tax break enacted in 1997 will go to families with incomes above the poverty line, with the greatest benefits going to upper-income families. While poor families will see some small benefit from the repeal of the sales tax on some prepared foods, their share of the total sales tax reduction of $16 million is very small compared to the tax relief provided to middle- and upper-income taxpayers.
This year, Maryland lawmakers are considering additional tax cuts. Adding refundability to Maryland's EITC would be an effective way to target tax relief to Maryland's poor families. Along with the other benefits of a refundable EITC, this would allow poor families in Maryland a share of the benefits of the state's current good times.
The Maryland EITC Currently Plays a Limited Role
Although Maryland has a state earned income tax credit set at a relatively high percentage of the federal EITC, the state credit serves a much more narrow purpose than the refundable state credits. This is because the Maryland EITC is non-refundable, which means it can be used only to offset a family's income tax liability. Any amount by which a family's EITC benefit exceeds its tax liability is forfeited. Families that owe little or nothing in state income taxes receive little or no benefit from what would appear to be a substantial state credit.
In Maryland, families with incomes below the poverty line owe no state income taxes. The state's tax system includes a provision called the "poverty subtraction" that supersedes all other provisions of the income tax for families with income below the federal poverty guidelines. For example, the tax tables show a tax liability of $111 for a family of four with income of $12,000, but the poverty subtraction would eliminate the entire amount. Under this provision, a family that would otherwise owe income taxes but whose income falls below the federal poverty guideline faces no income tax liability. The amount of the federal poverty guideline varies by family size and is adjusted each year for changes in the cost of living.(3)
For families with incomes modestly above the poverty line that do incur state and local income tax liabilities, the Maryland EITC provides substantial tax relief. When the state EITC is considered, families of four in Maryland owe no state income tax in 1997 until their incomes exceeds $22,900. This is well above the poverty line of $16,050 for a family of four and one of the highest state income tax thresholds in the nation. Given that the income tax liability for near-poor Maryland families would be substantial without the state EITC a family of four with earnings of $20,000 would owe $507 in state income taxes alone without the EITC in 1998 it is clear that the state credit offers significant income tax relief to this group of families with incomes modestly above poverty.
Adding a refundable portion to Maryland's current EITC would extend the benefit of the EITC to families with below-poverty income. The value of the refundable credit would be equal to 15 percent of the federal EITC. Because families with below poverty income owe no income taxes in Maryland, all of this credit would be received as a cash refund. For example, a family of four with income of $10,700 the earnings from a full-time, year-round minimum wage job does not qualify for any credit under Maryland's current non-refundable EITC. Under a 15 percent refundable EITC this family would qualify for the maximum credit of $563, all of which would be received as a refund. The proposal also would give modest refunds to some near-poor families. For these families, the refundable EITC would serve partly to reduce tax liability and partly to provide a refund. (Table 1 compares federal and Maryland EITC benefits for additional families at various income levels.)
It is important to note that some previous proposals to make the Maryland EITC refundable would have also lowered the percentage at which the federal credit is set for all EITC-eligible families. While this would have provided a refund to working poor families, it would have resulted in a tax increase for moderate-income families that had taken full advantage of the 50 percent state credit. The proposals currently being considered avoid this problem by allowing families to continue using the 50 percent non-refundable EITC if they choose.
Earned Income Tax Credit Amounts for Tax Year 1998
Family of Four with 2 children Income Federal EITC Current Law: Proposed Law: Half Minimum Wage $ 5,356 $2,142 0 $321 Minimum wage 10,712 3,756 0 563 Poverty Level 16,449 2,876 0 431 150% Poverty Level 24,675 1,144 572 572
Family of Three with 2 children Income Federal EITC Current Law: Proposed Law: Half Minimum Wage $ 5,356 2,142 0 321 Minimum wage 10,712 3,756 0 563 Poverty Level 13,649 3,465 0 520 150% Poverty Level 20,475 2,028 596 596
Family of Three with 1 child Income Federal EITC Current Law: Proposed Law: Half Minimum Wage $ 5,356 1,821 0 273 Minimum wage 10,712 2,271 0 341 Poverty Level 13,649 2,050 0 308 150% Poverty Level 20,475 960 596 596
For example, a family of four earning $24,675 approximately 150 percent of the poverty line would owe $703 in Maryland income taxes before the EITC. Because the family's taxes exceed the amount of the current 50 percent EITC of $572, they would receive the full benefit of the current credit. By contrast, the proposed 15 percent EITC would equal only $172. In this case, the family could opt to use the current credit.
A Refundable EITC Would Help Working Poor Families in Maryland
In Maryland, as in all states, poverty affects a greater share of children than of any other age group. Despite Maryland's wealth and solid economic growth in recent years, one in seven children (15 percent) lived in poverty in the state. A child in Maryland is 70 percent more likely to be poor than an adult. This is cause for concern because there is strong evidence that poverty can limit a child's physical and cognitive development.
Contrary to popular perception, many poor children in Maryland live in families where one or more adults work. Earnings from work are the primary source of income for almost half of poor Maryland families with children. The high child poverty rate reflects in large part the fact that millions of working parents are not able to earn enough to lift their families out of poverty, including many parents who work full time all year.
The income boost provided to the working poor by a refundable state EITC would complement the goal of the federal EITC to help bring working families with children up to or above the poverty line. This is significant because full-time work does not guarantee that families will have incomes above the poverty line, even when the substantial level of the federal EITC and the 1996 legislation to raise the federal minimum wage are considered.
- In 1998, the first full year after the federal minimum wage reaches $5.15 an hour, a married couple with one child and a parent working full-time at the minimum wage will fall $922 below the poverty line, even after the EITC is taken into account.
- The "poverty gap" the difference between income including the EITC and the poverty line will be more than $3,100 for a family of four with two or three children. The poverty gap will be even larger for families of five or more.
A Refundable EITC Would Complement Maryland's "Poverty Subtraction"
In the past, when refundability of Maryland's EITC was considered, there have been suggestions that the "poverty subtraction" provision of the income tax should be eliminated at the same time. If the poverty subtraction were eliminated, the new refundable EITC would not be a wage supplement but rather would be for many taxpayers replacement income tax relief. The advantages of refundability would be muted or, in many cases, lost.
Maryland exempts low-income families from the income tax through both the poverty subtraction and the current non-refundable EITC. Under the poverty subtraction, a family that would otherwise owe income taxes but whose income falls below the federal poverty line faces no Maryland income tax liability. Maryland's personal exemptions and standard deductions shield some poor taxpayers from the income tax. However, the combination of personal exemptions and the standard deduction falls far short of the poverty line for families of all sizes. As a result, poor families would owe a significant amount of Maryland income taxes if there were no poverty subtraction. The current non-refundable EITC also provides income tax relief for low-income families in Maryland. Under current law, the credit serves to extend the tax relief of the poverty subtraction to near-poor and moderate-income families by offsetting some or all of their tax liability. If there were no poverty subtraction, all of the income tax liability of EITC-eligible families with incomes below the poverty line would also be offset by the current credit.
By contrast, as detailed in this paper, a refundable EITC would do much more than provide income tax relief. A refundable EITC would provide a wage supplement that would lift working poor families out of poverty, complement welfare-to-work efforts, and also would offset taxes other than the income tax.
Eligible poor families would receive the 15 percent EITC as a refund that boosts their income. This would occur because the poverty subtraction eliminates their income tax liability. If the poverty subtraction were eliminated at the same time that a refundable EITC were put in place, for many taxpayers a large portion of the credit would serve to offset income taxes rather than be received as a refund. For example, a two-parent family of four earning $16,400 would receive a refund of $433 under a 15 percent refundable EITC if the poverty subtraction remained in place. By contrast, without the poverty subtraction, $329 of that credit would be used to offset income taxes and only $104 would be received as a refund.
The elimination of the poverty subtraction would reduce the value of the refundable credit for all eligible families with incomes that exceed the combined value of Maryland's personal exemptions and standard deduction $8,600 in 1998 and $12,600 in 2002 for a family of four. (If the poverty subtraction were eliminated for all taxpayers and not just those receiving the EITC, the elimination would result in income tax liability for many poor taxpayers without children including poor elderly taxpayers.)
Retaining the poverty subtraction, on the other hand, would allow Maryland's EITC to serve the same purposes as the federal EITC and that of four of the five states with refundable credits where families with below-poverty income have little or no tax liability before the application of the refundable EITC.
It should be noted that these estimates of the "poverty gap" do not include the value of food stamps, which are nearly equivalent to cash, because most working poor families do not receive food stamp benefits. For example, just 35 percent of poor families with children with a full-time worker received food stamps in 1995. The low rate of food stamp participation partly reflects the fact that many working poor families do not meet the program's somewhat stringent asset limits, including a limit on the value of a family car. In addition, some eligible families do not apply for food stamps, in part because they face barriers to participation such as a limited number of food stamp offices and limited hours of operation at these offices.(4)
The above examples all reflect families in which a parent works 52 weeks at 40 hours per week, but this is not the reality for many low-wage working parents. Census Bureau data indicate that in 1995 nearly half of the working parents in poor families with children 2.1 million working poor parents were either employed part-time because they could not find full-time work or spent a portion of the year unemployed because they were temporarily laid off or no work was available. Parents that work less than full-time year-round can fall into poverty even if they receive the federal EITC and even if they earn above the minimum wage.
- For example, a mother of two children who works 30 hours per week earning $6.00 an hour would have cash income of $12,500 if she worked year-round, including the federal EITC. That is more than $600 below the poverty line for a family of three. If she were able to work only 40 weeks in the year, the family's cash income would fall $3,500 below poverty.(5)
These findings do not mean that the federal EITC expansions and federal minimum wage hike have made little progress toward "making work pay." Indeed, the combined income from work and the EITC will be sufficient to lift a single parent who has two children and works full-time year-round at the minimum wage out of poverty in 1998. Nevertheless, these figures indicate that a refundable state EITC can help other working families escape poverty.
The importance of making the Maryland EITC refundable is underscored further by data showing that thousands of working families in Maryland have below-poverty incomes, and by the fact that welfare reform is likely to increase the number of working poor families in the state.
- Data from the Census Bureau's Current Population Survey for the mid-1990s show that 32,000 poor Maryland families with children or half of all poor families with children in the state had one or two working parents.
- One-fourth of poor families with children in Maryland had a parent working full-time year-round.
It is likely that the number of working poor families in Maryland will increase in the near future as a result of state welfare reform. A large share of the parents in the families now receiving welfare will be expected to enter the labor force in the next few years. Yet it is likely that most of these families will remain below or near poverty. Findings from Maryland's current welfare-to-work program show that welfare recipients who found work in the last quarter of 1996 earned an average of $6.02 an hour. That wage is insufficient by itself to lift a family of three with a full-time year-round worker out of poverty.
The Earned Income Tax Credit Will Enhance Welfare-to-Work Efforts
Adding refundability to Maryland's EITC will enhance the state's welfare reform efforts. Maryland is among the many states that have adopted policies designed either to boost the incomes of welfare recipients who find work or to provide services to families that successfully make the transition from welfare to work. Maryland has adopted an "earnings disregard" under which families lose less than one dollar of welfare benefits for every dollar of earnings, thereby helping ease the transition from welfare to work. Despite the earnings disregard, families lose all cash assistance benefits at incomes well below the poverty line.
Research Findings on the Effectiveness of the EITC
Several recent academic studies indicate that the EITC has positive effects in inducing more single parents to go to work, reducing welfare receipt, and moderating the growing income gaps between rich and poor Americans.
Harvard economist Jeffrey Liebman, who has conducted a series of studies on the EITC, has noted that workforce participation among single women with children has risen dramatically since the mid-1980s.a In 1984, some 72.7 percent of single women with children worked during the year. In 1996, some 82.1 percent did. The increase has been most pronounced among women with less than high school education. During this same period there was no increase in work effort among single women without children.
A number of researchers have found that the large expansions of the EITC since the mid-1980s which have resulted in substantial increases in income for parents who work have been a major factor behind this trend. Studies by Liebman and University of California economist Nada Eissa find a sizable EITC effect in inducing more single women with children to work.b In addition, a new study by Northwestern University economists Bruce Meyer and Dan Rosenbaum finds that "a large share of the increase in employment of single mothers in recent years can be attributed to the EITC." They find that the EITC expansions explain more than half of the increase in employment among single mothers over the 1984-1996 period.c
These findings are consistent with an earlier study by Stacy Dickert, Scott Hauser, and John Karl Scholz of the University of Wisconsin, which projected that the EITC expansions in the 1993 budget law would generate a reduction in welfare receipt. The Dickert, Hauser, and Scholz study estimated that the 1993 EITC expansions would induce approximately 500,000 families to move from welfare to the workforce.d
Finally, Liebman also has found that the EITC moderates the gap between rich and poor. During the past 20 years, the share of national income received by the poorest fifth of households with children has declined, while the share of income received by the top fifth has risen sharply. Liebman found that the EITC offsets between one-fourth and one-third of the decline that occurred during this period in the share of income the poorest fifth of households with children receive.
a) Jeffrey B. Liebman, "The Impact of the Earned Income Tax Credit in Incentives and Income Distribution," October 1997.
b) Nada Eissa and Jeffrey B. Liebman, "Labor Supply Response to the Earned Income Tax Credit," Quarterly Journal of Economics, May 1996, 112(2), pp. 605-637
c) Bruce D. Meyer and Dan T. Rosenbaum, "Welfare, The Earned Income Tax Credit, and the Labor Supply of Single Mothers," November 1997.
d) Stacy Dickert, Scott Hauser, and John Karl Scholz, "The Earned Income Tax Credit and Transfer Programs: A Study of Labor Market and Program Participation," in James M. Poterba, ed., Tax Policy and the Economy, Vol. 9., MIT Press, 1995.
Adding a refundable portion to Maryland's EITC would improve these efforts by providing additional support to families that have left welfare but continue to have modest incomes. This additional support can help families meet expenses of working such as transportation, clothing, or child care. Recent academic research indicates that the EITC has positive effects in inducing more single parents to go to work and reducing welfare receipt. More information on these findings are provided in the box on page 13.
A Refundable EITC Could Reduce Pre-Tax Income Inequality in Maryland
Since the late 1970s, income inequality has increased significantly in Maryland. From the late 1970s to the mid-1990s, the average incomes of the lowest-income families fell 9 percent after adjustment for inflation. Over the same time period, the average real incomes of the middle fifth grew, but only by 8 percent. The average real incomes of the richest fifth of families jumped by 37 percent. The resulting gap between the incomes of the top fifth of the population and the bottom fifth is wide the highest income 20 percent of families in Maryland had income more than 11 times the incomes of the lowest-income families in the mid-1990s.
Many factors have contributed to the increase in income inequality. Foremost among them are fundamental changes in the U.S. economy that have favored highly-skilled, highly-paid workers over low- and middle-income workers. These factors include the decline of many domestic manufacturing industries, the growth of low-paying service sector jobs and technological innovations that have increased the demand for skilled workers and diminished the demand for lower-skilled workers. The decline in unionization has also contributed to the increase in income inequality. In addition, investment income has increased substantially over the past two decades, with the benefits accruing mainly to the top 20 percent of families.
Government policies at both the federal and state levels have had an impact on the distribution of income. While government policies may not be able to reverse the economic forces that have led to increased income inequality, it is possible for labor policies and government programs providing assistance to low- and middle-income people to impact the distribution of income. Tax policies also can mitigate the effects on families of the pre-tax income distribution.
Making the Maryland EITC refundable is one direct way that Maryland can use tax policy to raise income from work for its poorest residents. By supplementing the income of the state's working poor, Maryland can push against the trend of rising income inequality.
The income provided by a refundable state EITC could bring a substantial number of working families with children in Maryland up to or above the poverty line. Recent research on the effect of poverty on children has shown that, when all other factors are controlled for, poverty can have a substantial effect on child and adolescent well-being. In recent years, 15 percent of children in Maryland have lived in families with incomes below the poverty line. Children who grow up in families with incomes below the poverty line have poorer health, higher rates of learning disabilities and developmental delays, and poorer school achievement. When children growing up in poverty become adults, they are far more likely to be unemployed than children who were not poor. Lifting children out of poverty could have long-term positive effects on the state's economy and future budgetary expenditures.
Refundability Will Provide Tax Relief to Poor Working Families
Poor working families in Maryland do not pay state or local income tax, but they do pay substantial amounts of state and local taxes. Like many states, Maryland's state and local tax system relies heavily on sales taxes, excise taxes on gasoline, alcohol and cigarettes, and property taxes. These taxes are regressive, meaning that they consume a larger share of the income of low-income families than of higher income families. A report from the Washington, DC-based Citizens for Tax Justice finds that sales, excise, and property taxes consumed 7.8 percent of the income of the poorest 20 percent of Maryland families in 1995, compared with 2.2 percent of the income of the wealthiest one percent of Maryland families. This regressivity is partially offset by Maryland's relatively heavy reliance on the income tax. Nevertheless, even when the income tax is considered, the overall state and local tax system in Maryland is regressive.
Since the current Maryland EITC can only be claimed against the income taxes a family owes, it does not help offset the significant burden of sales, excise, and property taxes on low-income Maryland families and does not significantly lessen the regressivity of the state and local tax system. By contrast, the federal EITC provides tax relief to low-income families that owe nothing in income tax but pay substantial amounts in regressive federal payroll taxes. In addition, refundable state EITCs in other states have been used to reduce the burden of regressive taxes. In Minnesota, for example, the state EITC was established in part to offset the regressive impact of a sales tax increase.
Extending Tax-Cut Benefits to Working Poor Families
Making Maryland's EITC refundable would target tax relief on households that received no benefit from last year's income tax cut. Maryland cut its income tax 10 percent last year by lowering the top income tax rate and by increasing personal exemptions. These changes will be phased in over five years. By tax year 2002, when the tax changes are fully phased in, all income tax payers with incomes above the poverty line will receive a tax reduction. Families with income below the poverty line will receive no benefit from the tax cut because they owe no Maryland income tax. (Figure 3 shows the size of the reduction for sample families of four.)
By contrast, the vast majority of added benefits from a refundable EITC set at 15 percent of the federal credit would go to families with below-poverty income. The value of the proposed credit relative to the current-law EITC declines rapidly for families just above the poverty line ($16,450 in 1998 for a family of four and $13,650 for a family of three.) Two-parent families of four with incomes of above $18,250 just 11 percent above the poverty line would receive no additional benefit from a 15 percent refundable EITC.
Earned Income Tax Credits and Error Rates
One concern sometimes voiced in debates over state EITC proposals is that the error rate in the federal EITC is relatively high. An IRS study released in April 1997 estimated that 20.7 percent of EITC benefits were paid in error, in part because some families made mistakes when claiming the EITC and in part due to fraud.(6)
While this concern should not be dismissed, it is important to note that the EITC error rate is lower than that of many other elements of the federal income tax. In fact, the EITC error rate is lower than the error rate for all credits taken together, and it is much lower than the error rate resulting from under-reporting of income from self-employment or sole proprietorships.
Discussions of the EITC error rate also should take these important points into account.
- While some EITC errors stem from fraud, many EITC errors reflect understandable mistakes. They result from the complex living arrangements of low-income families especially divorced and separated families that create difficulties when trying to understand who in a family can claim the EITC. In most cases where such errors occur, someone in the family would have been eligible for the EITC, although perhaps at a smaller amount.
- In situations where an EITC was claimed by the wrong member of a family, the IRS study counted the entire EITC benefit as an error, rather than counting the amount by which the payment exceeded the EITC that could have been claimed appropriately by another family member. For this reason, the 20.7 percent error rate identified in the study is an overstatement.
- The error rate of the EITC should be balanced against the advantages of administering the program through the tax code. While means-tested benefit programs often have administrative costs as high as 15 percent, EITC administrative expenses are only one percent of total program costs. Operating the EITC through the tax code also makes it easy for families to claim the credit and limits the stigma sometimes attached to receiving means-tested benefits such as welfare cash assistance.
- New federal legislation addressing compliance issues, combined with additional resources available to the IRS, are likely to reduce EITC error rates in future years in ways that will affect both federal and state credits. States that wish to do so also may take steps in administering their tax systems to further reduce state EITC errors.
In particular, some policymakers have argued that a major cause of EITC errors is the refundable nature of the EITC. The IRS study indicates, however, that this argument is incorrect. The study found the EITC overclaim rate to be significantly lower among families that did not earn enough to have a pre-EITC income tax liability the families that would receive a cash refund than among families that did owe income tax before the EITC was taken into account. In fact, the overclaim rate for families with no pre-EITC tax liability was only about one-third the rate for families whose EITC served to offset income tax liability.
These issues are discussed in more detail in a separate Center paper titled State Earned Income Tax Credits and Error Rates dated February 18, 1998.
1. Unpublished Census data from the March 1997 Current Population Survey.
2. Some policymakers have raised a concern that adding a refundable portion to Maryland's EITC could result in increased fraud. There is no evidence, however, that refundability would increase errors or fraud. To the contrary, a recent IRS study of the federal EITC found that the error and fraud rate was one-third lower for families receiving their EITC as a refund than for families for whom the EITC solely offset tax liability. See Appendix A for further discussion of EITC error rates.
3. For 1998, the federal poverty guideline equals $13,650 for a family of three and $16,450 for a family of four.
4. Families of four or smaller with a full-time worker at the minimum wage that receive both the EITC and food stamps will have above-poverty income line in 1998. After 1998, however, only families of three or fewer people with a full-time year-round worker will be guaranteed to have above poverty incomes, even when both the EITC and food stamp benefits are counted. These calculations are based on the minimum wage under current law $5.15 an hour.
5. This example does not include cash assistance a family may receive either while working or unemployed. In Maryland, such a family would be ineligible for cash assistance while working. If it is assumed the family would receive cash assistance for the period of unemployment a period of roughly three months Maryland's welfare benefits would provide an additional $1,131 in cash income, leaving the family well below poverty for the year.
6. Internal Revenue Service, "Study of EITC Filers for Tax Year 1994," April 1997. The study reported that 25.8 percent of Earned Income Tax Credit benefits claimed on tax returns in 1995 were in error. Because the IRS catches some erroneous claims before payment is made, the actual overpayment rate was estimated to be somewhat lower 20.7 percent.