Reducing Overpayments in the Earned Income Tax Credit
April 30, 2013
A recent report from the Treasury Department’s Inspector General raised the issue of overpayments in the Earned Income Tax Credit (EITC). The EITC, a tax credit for low- and moderate-income working families that has been shown to increase work, lower welfare receipt, and reduce poverty, has a significant error rate that needs to be reduced. But, in addressing EITC errors, policymakers should understand three facts:
- EITC errors occur primarily because of the complexity of the rules surrounding the credit. Most of them thus reflect unintentional errors, not fraud.
- Internal Revenue Service (IRS) studies of EITC overpayments suffer from significant methodological problems that likely cause them to overstate the actual EITC overpayment rate, as analysis by the IRS National Taxpayer Advocate has shown.
- The IRS has launched initiatives since 2008 (the year used in the most recent IRS report) to reduce EITC errors, and Congress can — and should — take several steps to help the IRS make further progress in lowering overpayments.
Complexity of EITC Rules Accounts for Most EITC Errors
The EITC is one of the most complex elements of the tax code that individual taxpayers face. The IRS instructions for the credit are nearly double the 13 pages of instructions for the Alternative Minimum Tax, which is widely viewed as difficult, and also include a 62-page IRS reference publication. The EITC’s complexity results in significant part from efforts by Congress to target the credit to families in need and thereby minimize its budgetary cost.
EITC overpayments often result from the interaction between the complexity of the EITC rules and the complexity of families’ lives. For example, where parents are divorced or separated, only the parent who has custody of the child for more than half of the year can claim the EITC. Sometimes, however, a non-custodial parent may erroneously claim the EITC related to that child, especially if he pays child support and thus has a perception of being eligible for the credit. For example, a non-custodial parent who pays child support may be entitled, under the terms of a divorce agreement, to claim the child for the personal exemption and the Child Tax Credit; he may understandably — but incorrectly — assume that he can claim the child for the EITC as well.
In addition, U.S. families can be complicated, with working grandparents, or aunts and uncles, living with working parents and their children. More than one working adult in such families may potentially qualify to claim the children for the EITC. Neither they nor their tax preparers may fully understand the complex rules that determine who is entitled to claim the EITC in such circumstances. Duplicate claims for the same child can result, requiring the IRS to sort out who is the proper claimant and who filed in error.
IRS studies have acknowledged that the complexity of EITC rules contributes to the error rates, and analysis of IRS data by Treasury experts as well as studies by outside researchers indicate that a minority of EITC overpayments result from intentional action by tax filers.
Actual Overpayment Rate Is Likely Lower Than IRS Estimate
The Inspector General report cites a recent IRS estimate that in tax year 2008, about 21 percent to 25 percent of EITC payments represented overpayments. Like other studies of EITC errors in recent years, it was based on random IRS audits of a sample of EITC claimants; if, in the course of the audit, a claimant was unable to document his or her claim to the examiner’s satisfaction, the claim was considered an overpayment.
However, evidence suggests that this approach significantly overstates the error rate. Most EITC recipients can’t afford to hire lawyers or accountants to help them navigate an IRS audit, and many have trouble documenting their claim to the examiner’s satisfaction. Nina Olson, the IRS’ National Taxpayer Advocate, has reported that in over 40 percent of the cases where the IRS examiners classified an EITC claim as invalid but the filer later received assistance from the Taxpayer Advocate Service in appealing the ruling, the ruling was reversed.
Most of the EITC claimants in the recent IRS study — and most filers whom the IRS audits in general — didn’t have this assistance. Olsen has testified that because the IRS studies used to estimate EITC error rates do not provide for an adequate process of this nature, their overpayment estimates are likely exaggerated.
Two other cautions apply to the IRS estimate. First, its overpayment rate does not include related underpayments. For example, if a non-custodial father claims an EITC mistakenly (because the child lives with the mother), the father’s EITC counts as an overpayment, but the amount that the mother was eligible to claim but did not isn’t taken into account. In such cases the actual loss to the Treasury is the net amount — specifically, the EITC that the father received minus the EITC that the mother qualified for but did not receive — rather than the gross amount that the Treasury study counts.
Second, the IRS study does not reflect the impact of several new enforcement measures that the IRS has implemented since 2008 (see below).
It is also worth noting that the EITC’s “refundability” (the fact that recipients whose credit exceeds their federal income tax liability receive the difference in the form of a refund) is not the source of overpayments. If it were, one would expect overpayments to be more common for EITCs claimed as refunds than for EITCs that simply lower the recipient’s income tax liability. In reality, however, a sophisticated analysis by a senior Treasury economist found that the overpayment rate was one-third lowerfor EITCs claimed as refunds. The National Taxpayer Advocate has independently reached a similar conclusion.
While it is important to reduce EITC overpayments, the noncompliance rate is consistently lower for the EITC than for a number of other parts of the tax code. A recent IRS study found that 51 percent of rent and royalty income, 57 percent of small business income, and 72 percent of farm income went unreported. The IRS estimated that such misreporting of business income cost $109 billion in 2001, or ten to fifteen times the size of estimated EITC overpayments that year.
IRS Is Working to Reduce Overpayments — and Congress Can Help It Do More
As noted, one reason that the IRS report may overstate the current level of EITC overpayments is that the IRS has taken various steps since 2008 to reduce EITC errors:
The IRS has launched a major new initiative to reduce EITC errors by requiring commercial tax preparers to register as tax preparers with the IRS and pass a competency exam. Commercial preparers file roughly two-thirds of all EITC returns, and the IRS believes most EITC errors occur on commercially prepared returns; unscrupulous preparers may see an opportunity for larger fees if they can inflate a filer’s tax refund, while untrained preparers can easily make errors in preparing EITC claims. Yet until now, commercial preparers have not had to fulfill any IRS competency requirements or even to register with the IRS.
Unfortunately, a U.S. District Court ruled in January that the IRS lacked the legal authority to regulate preparers in this manner. The IRS has appealed the ruling, even as it continues an accelerated effort to identify preparers with high rates of erroneous EITC claims and to take corrective actions against them.
- To improve its ability to identify questionable EITC claims, the IRS has developed a powerful database to help it identify cases in which an EITC claimant may be incorrectly claiming a child. It now uses this system to identify nearly 500,000 questionable EITC claims each year that it examines before making payment. Many of these claims are denied or reduced as a consequence.
- The Treasury Department has launched an EITC pilot project to examine whether matching EITC claims to state databases of verified eligibility information for other low-income programs, such as SNAP (food stamps) and TANF, can identify inaccurate EITC claims before payment.
What Congress Can — and Should — Do
There are three steps, all thoroughly bipartisan, that Congress can and should take to shrink overpayments further.
First, if the IRS is unsuccessful in appealing the court ruling regarding commercial preparers, Congress should give the IRS the necessary authority to regulate these preparers so that the IRS can undertake this initiative, which is a cornerstone of IRS tax compliance efforts.
Second, Congress should adopt a series of simplification measures, most of which George W. Bush’s Treasury Department proposed in the mid-2000s after the introduction of simplified EITC rules led to a 13 percent drop in overpayments. Congress never acted on these proposals, which were included in several Bush budgets. Several have strong merit, including two areas where honest taxpayers unintentionally commit errors: simplifying the rule governing how parents who are separated can claim the EITC, and allowing filers who live with a qualifying child but don’t claim the child for the EITC to claim the much smaller EITC for workers not raising a child.
Third, Congress should provide the IRS with the necessary resources to intensify its efforts to use other databases to identify questionable EITC claims. The IRS’ efforts to date, and their impact on the overpayment rate, have been hampered by the limitations of the IRS computer systems and by the lack of sufficient IRS staff to follow up on all questionable cases. (As Treasury Secretary Jack Lew recently told Congress, the IRS has 8,000 fewer full-time employees than two years ago and has had to undertake fewer enforcement actions as a result. ) These shortcomings — which would worsen if the sequestration budget cuts continue — hinder IRS compliance efforts generally, not just with regard to the EITC.
Added funding for the IRS to modernize its information technology systems and to have sufficient staff to follow up on more of the questionable claims would far more than pay for itself by reducing errors in the EITC and other parts of the tax code.
 Treasury Inspector General for Tax Administration, “The Internal Revenue Service Was Not in Compliance with All Requirements of the Improver Payments Elimination and Recovery Act for Fiscal Year 2012,” February 25, 2013, http://www.treasury.gov/tigta/auditreports/2013reports/201340024_oa_highlights.pdf.
 For a summary of the research on the impact of the EITC, see Chuck Marr, Jimmy Charite, and Chye-Ching Huang, “Earned Income Tax Credit Promotes Work, Encourages Children’s Success at School, Research Finds,” Center on Budget and Policy Priority, revised April 9, 2013, http://www.cbpp.org/cms/index.cfm?fa=view&id=3793.
 See Janet Holtzblatt and Janet McCubbin, “Issues Affecting Low-Income Filers,” in Henry Aaron and Joel Slemrod, The Crisis in Tax Administration, Brookings Institution Press, November 2002; and Jeffrey Liebman, “Noncompliance and the EITC: Taxpayer Error or Taxpayer Fraud,” Harvard University, November 1995.
 Janet McCubbin, “EITC Noncompliance: The Determinants of the Misreporting of Children,” National Tax Journal, Vol. 53, No. 4 Part 2 (December 2000), pp. 1135-1164.
 Taxpayer Advocate Service, Internal Revenue Service, “The National Taxpayer Advocate’s Report to Congress, FY 2009,” December 31, 2009, Vol. II, p. 81.
 These figures, which are for 2001 tax returns, represent the estimated impact of business underreporting in the personal income tax; they do not include underreporting or other sources of error in the corporate income tax. Internal Revenue Service, “Individual Income Tax Underreporting Gap Estimates, Tax Year 2001,” February 2006.
 Meg Shreve and William Hoffman, “Lew and IRS Commissioner on Sequestration Impact on IRS,” Tax Analysts, April 26, 2013.