A Hand Up: How State Earned Income Tax Credits Help Working Families Escape Poverty in 2006

PDF of this report (42pp.)

By Ami Nagle and Nicholas Johnson

March 8, 2006

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

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

 

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
2006 40% of first $11,300 $4,520 21.06% $14,760 to $36,222 $16,760 to $38,222
Families with one child:
2005 34% of first $7,830 $2,663 15.98% $14,370 to $31,030 $16,370 to $33,030
2006 34% of first $8,050 $2,737 15.98% $14,760 to $31,888 $16,760 to $33,888
Families with no children:
2005 7.65% of first $5,220 $399 7.65% $6,530 to $11,750 $8,530 to $13,750
2005 7.65% of first $5,370 $411 7.65% $6,710 to $12,080 $8,710 to $14,080
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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