Reducing Overpayments in the Earned Income Tax Credit

PDF of this report (9pp.)

By Robert Greenstein, John Wancheck, and Chuck Marr

Revised April 7, 2014

Both the debate over the minimum wage and the recent 50th anniversary of President Johnson’s War on Poverty have focused more attention on the Earned Income Tax Credit (EITC) for low- and moderate-income workers, which has been shown to increase work, reduce poverty, and lower welfare receipt.[1]  In addition, some leading experts from across the political spectrum, as well as President Obama, have recommended expanding the EITC for adults not raising children, who currently are eligible for only a very small credit.[2]   These developments have brought renewed attention to the EITC’s error rate.[3]  As policymakers consider whether to improve the EITC for childless workers, they can also take additional steps to reduce the error rate, taking account of these basic facts: 

  • EITC errors occur primarily because of the complexity of the rules surrounding the credit.  Most of them thus reflect unintentional errors, not fraud.  What the Internal Revenue Service (IRS) refers to as the EITC’s “improper payment rate” is not a “fraud” rate and shouldn’t be characterized as such.
  • IRS studies of EITC overpayments suffer from methodological problems that likely cause them to overstate the actual EITC overpayment rate, as analysis by the IRS National Taxpayer Advocate has shown.
  • As the Treasury Department’s Inspector General for Tax Administration has noted, EITC administrative costs are very low, at less than 1 percent of the benefits provided.  The Inspector General has commented that “this is quite different from other non-tax benefits in which administrative costs related to determining eligibility can range as high as 20% of program expenditures.”[4]  Testimony from the IRS National Taxpayer Advocate, Nina Olson, suggests that if EITC payments had been delivered by another agency that spent 20 percent of program expenditures verifying eligibility, little or no net savings would accrue.[5]

The IRS has launched initiatives since 2009 to reduce EITC errors.  Since the current estimate of the EITC error rate is based on IRS analysis of data from tax year 2009, the error rate could be modestly lower now.  More important, Congress can help the IRS make progress in lowering EITC overpayments further.  Congress should:

  • Give the IRS the needed authority to reduce EITC errors by commercial preparers.  Commercial preparers file roughly two-thirds of all EITC returns,[6] and the IRS believes most EITC errors occur on commercially prepared returns.  In 2010, the IRS launched a major initiative to require preparers who lack professional credentials to pass a competency examination in order to be certified to prepare tax returns.  A small number of paid preparers challenged this initiative in the courts, arguing that the IRS lacks the necessary statutory authority to implement it.   (Many other preparers have supported the IRS initiative.) 

    A few weeks ago, the U.S. Court of Appeals for the District of Columbia upheld a lower court’s decision in favor of the preparers who brought the suit.  Congress should quickly provide the IRS with the needed authority.  Without that authority, the IRS cannot move forward with key aspects of its plan to reduce EITC overpayments resulting from preparer errors.
  • Provide adequate IRS funding.  IRS funding is at its lowest level in real terms since 2000, despite a 10-percent increase in tax returns over this period.  Cuts in the IRS budget can actually raise budget deficits by making it harder for the IRS to enforce compliance with the EITC rules and other areas of the tax code.  Treasury Secretary Jack Lew has noted, “for every dollar we spend on our enforcement initiatives, we expect to collect six dollars in revenue.” [7]     
  • Enact EITC simplifications that the Bush Administration proposed.  For example, simplifying the rule governing how parents who are separated can claim the EITC would likely reduce errors.  This and other simplification provisions are included in bills that various Senators and House members have introduced. 

It is important to note that much of the complexity of EITC rules that leads to errors stems from EITC claims involving children, due to the intricacy of the rules regarding who can claim the child for EITC purposes in divorce, separated, and three-generation families.  IRS Commissioner John Koskinen recently observed that the errors related to who can claim a child do not affect the EITC for childless workers.  Koskinen pointed out that the IRS could expand the childless workers’ EITC “in a very straightforward way” because that credit is free of errors related to “where [children] live, whether you’re separated or divorced, [and] who actually has the right to claim them.”[8]  Moreover, a forthcoming IRS study of EITC errors over 2006-2008 finds that errors involving the rules for claiming the EITC for childless workers are the least costly of overclaims, according to recent testimony from Nina Olson.[9]

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 39-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.  In fact, the Treasury Department estimates that fully 70 percent of EITC improper payments stem from issues related to complex residency and relationship requirements and filing status issues that arise when married couples file — often following a separation — as singles or heads of households, and from other issues related to who can claim a child in non-traditional family arrangements.[10] 

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, 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 a given child 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, and errors can result.

IRS studies have acknowledged that the complexity of EITC rules contributes heavily to the error rates.  Analysis of IRS data by Treasury experts, as well as studies by outside researchers, indicate that most EITC overpayments do notresult from intentional action by tax filers.[11] 

Actual Overpayment Rate Is Likely Lower Than IRS Estimate

The IRS estimates an EITC improper payment rate of about 22 percent to 26 percent for fiscal year 2013.[12]  Like other recent IRS estimates of EITC errors, this estimate is derived from a study based on IRS audits of a sample of tax returns for tax-year 2009; 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.  

Evidence suggests that this approach 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 has reported that in over 40 percentof the cases where the IRS examiners classified an EITC claim as invalid but the filer later received assistance from the Taxpayer Advocate Service (a component of the IRS that the National Taxpayer Advocate oversees) 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.  Olson 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 overstated.

Olson also has pointed out that when confronted with this process, “low-income taxpayers have considerable difficulty documenting relationship and residence because of a lack of clarity from the IRS as well as their present circumstances.”  She has criticized the IRS for “inconsistency as to what documents the IRS will accept (a document is accepted in one office, but not in another) and inflexibility in accepting proof (failure to accept other types of documents where the taxpayer cannot provide standard documentation).”[13]

Two other cautions apply to the IRS estimate.  First, its improper payment rate does not include significant areas of likely underpayments.[14]  For example, if a non-custodial father claims an EITC mistakenly, the father’s EITC counts as an overpayment, but the amount that the mother was eligible to claim but didn’t is not 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 IRS study counts.

Second, the IRS study does not fully reflect the impact of several new enforcement measures that the IRS has implemented since 2009 (see below).

It is also worth noting that the EITC’s “refundability” (the fact that tax filers whose credit exceeds their federal income tax liability receive the difference in the form of a refund) is not the driver 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 filer’s income tax liability.  A sophisticated analysis by a senior Treasury economist found, however, that the overpayment rate was lower for EITCs claimed as refunds.[15]  The National Taxpayer Advocate has independently reached a similar conclusion.[16]

It is important to reduce EITC overpayments.  But it should also be noted that the noncompliance rate is lower for the EITC than for a number of other parts of the tax code.  A recent IRS study found that 56 percent of business income that was supposed to show up on individual tax returns went unreported in 2006.  The underreporting of business income accounted for fully 52 percent of the total underreporting within the individual income tax.[17]  As the Taxpayer Advocate has highlighted, EITC overclaims accounted for just 6 percent of this amount.[18]

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 2009 to reduce EITC errors.  Unfortunately, the IRS has been blocked from taking other planned steps by a court ruling that it lacks the needed legislative authority.  Congress can address this problem by providing that authority, as the President’s 2015 budget calls for.

In 2010, the IRS launched a major new initiative to combat EITC errors by paid return preparers.  Commercial preparers file a large majority 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 hundreds of thousands of paid preparers had no previous obligation to meet any IRS competency standard.  

Nina Olson has noted that “unenrolled preparers — those who are neither attorneys, certified public accountants, nor enrolled agents — account for more than three-fourths of EITC returns that are prepared by a paid preparer.”  She points out that unenrolled preparers not affiliated with a national tax preparation firm “are most prone to error,” with 49 percent of the EITC returns they prepare containing errors that average 33 percent of the amount claimed.[19]

Under the IRS initiative:

  • All return preparers were required to obtain a new Preparer Tax Identification Number (PTIN) to use when submitting returns to the IRS, and the IRS assembled a registry of preparers with a PTIN.  This registry became fully operational for the 2012 tax filing season and helps the IRS track returns submitted by individual preparers. 
  • The IRS established a tax law competency examination system at the start of 2013 with the goal of requiring preparers without other professional credentials to pass the test in order to be certified to file returns in the 2014 filing season.  As Nina Olson recently testified, IRS data show that most EITC claims are filed by return preparers who aren’t affiliated with a national tax preparation chain (the chains may have internal training programs and the ability to review returns before submission) and that 49 percent of the returns from these unaffiliated preparers contained an over-claim.[20]
  • The IRS planned to require preparers to complete IRS-approved continuing education courses in tax law to maintain their certification in the PTIN system.

In 2013, some individual tax preparers challenged this initiative in the courts, arguing that the IRS lacks the necessary statutory authority.  The D.C. Court of Appeals recently denied the IRS’s appeal of a lower court decision in the preparers’ favor.  As a result, while the IRS may continue to require preparers to obtain a PTIN to use in signing tax returns, it cannot move forward with its plan to have preparers pass a competency examination, and preparers will not have to complete any continuing education courses.  Congress should quickly provide statutory authority so the IRS can act to fully implement its strategy to lower EITC errors resulting from preparer mistakes.  (See the text box for Nina Olson’s plea to Congress to provide the IRS with this authority.)

Despite the setback in the courts, the IRS continues to require preparers to register and obtain PTINs.  In 2013, the IRS also identified 7,000 preparers with high error rates in the EITC claims they filed.  It carried out a range of “real time” interventions with these preparers before and during the 2013 filing season, including educational visits by IRS agents.  Overall, this strategy averted an estimated $590 million in erroneous claims, according to the IRS.[21]

In addition, the Treasury Department has launched an EITC pilot project to examine whether matching EITC claims to state databases of eligibility information that has been verified for other low-income programs, such as SNAP (food stamps) and TANF, can identify inaccurate EITC claims before the claims are paid.

IRS National Taxpayer Advocate Nina Olson Calls on Congress to Act

In recent congressional testimony, Olson explained the need for Congress to accord IRS the authority to carry out its initiative to reduce EITC overpayments made by commercial preparers.*

“Simply stated, unenrolled preparers are the make-and-break point for all EITC compliance strategies.  Preparers account for the majority of EITC claims submitted to the IRS, and unenrolled preparers account for three-quarters of preparer EITC returns.  Unenrolled preparers have the highest error rate of all types of preparers.  If a single unenrolled preparer plays fast and loose with EITC eligibility rules, tens if not hundreds of taxpayers’ returns could be in error.

“The recently strengthened regulations and increased EITC due diligence penalty under IRC § 6695(g), coupled with a robust preparer compliance initiative and vigorous preparer prosecutions, should shift some preparer compliance behavior.  But so long as anyone can purchase off-the-shelf software and hang out a shingle declaring him or herself a return preparer, without any demonstration of competency or any set of ethical rules to adhere to, we will not bring about significant change in EITC compliance.

“The low income population is vulnerable to unskilled and unethical preparers.  The size of the refund is attractive to payday lenders and others interested only in what fees they can charge, not to mention criminal opportunists.  Preparers in this category have no professional responsibility to the tax system.  Yet, as numerous studies have shown, they operate in the areas and communities where low income persons reside.138

“The single most useful step Congress can take to improve EITC compliance and reduce the Improper Payments is to enact a regulatory regime that requires unenrolled preparers who prepare returns for a fee to demonstrate minimum levels of competency by passing an initial test and then taking annual continuing education courses (including ethics).139  The IRS cannot audit this EITC noncompliance out of existence — audits occur after the noncompliance has occurred and, in many instances, after the dollars have already gone out the door.  Preparer regulation is prophylactic and efficient.

“More specifically, I believe Congress should explicitly authorize the IRS to require unenrolled return preparers to take a competency test and fulfill annual continuing education requirements as a condition of preparing tax returns for compensation.”  

*Testimony of Nina Olson, op. cit., pp. 46-47.

138 For a chilling inventory of studies showing the predatory practices and abuses in this area, see Brief of Amici Curiae, National Consumer Law Center and National Community Tax Coalition in Support of Defendants-Appellants, Loving v. Internal Revenue Service, No. 13-5061 (D.C. Cir. 2014.)

139 Support for preparer regulation as a means both to protect consumers and to improve return accuracy has been broad and bipartisan.  The Senate Finance Committee has twice approved legislation to authorize preparer regulation — once under former Chairman Grassley (during Republican control) and once under former Chairman Baucus (during Democratic control).  On the House side, the Ways and Means Committee has not considered preparer regulation, but its Oversight Subcommittee held a hearing in 2005 at which numerous preparer groups testified in support of such regulation.  In 2010, the IRS began to implement preparer regulation on its own, but the Court of Appeals for the District of Columbia recently invalidated the regulation as exceeding the agency’s authority in the absence of authorizing legislation.  See Loving v. IRS, 2014 U.S. App. LEXIS 2512 (D.C. Cir. 2014).  Authorizing legislation would allow the IRS to resume the program that was already underway.

What Else Congress Can — and Should — Do

In addition to providing statutory authority for the IRS to implement its full preparer initiative, Congress should take certain steps to shrink EITC overpayments.

First and foremost, Congress should reverse its recent course and provide the IRS with sufficient budget resources to administer the tax code.  Adjusted for inflation, IRS funding in 2014 is 14 percent below the 2010 level (see graph) and at its lowest level since 2000.  Yet the number of tax returns filed has grown by more than 10 percent over roughly the same period.  IRS Commissioner Koskinen recently testified that 40 percent of calls to the IRS are going unanswered and its workforce has been reduced by 10 percent since 2010.[22]  Underfunding enforcement is penny-wise and pound foolish.  As noted, Treasury Secretary Lew has said the IRS receives six dollars in tax revenue for every dollar it spends on enforcement.[23] 

These budget constraints directly affect administration of the EITC.  For example, the IRS would like to expand the above-mentioned effort that averted an estimated $590 million in improper EITC claims in 2013, by identifying suspect tax preparers.  Like other activities, such initiatives require adequate funding.

Inadequate funding also threatens to stymie IRS plans to overhaul the tax return filing process so that the IRS can match crucial income information (W-2s, 1099s) provided by employers and other institutions with the information provided by individual filers and then follow up on the matching results in a timely fashion.  The IRS conducts matching now with various databases and identifies a significant number of questionable EITC returns prior to making payment.  But it has the staff capacity only to follow up on a portion of those cases within the time frame required by law for paying tax refunds, and must go ahead and make payment in the remaining cases.  The IRS could lower EITC errors if it had more staff to follow up on more of these EITC claims. 

In addition, the IRS could substantially lower errors due to income misreporting if it had more sophisticated information technology so that it could match information on W-2s to information on tax returns before making payments, something that its systems currently don’t permit.  The President’s 2015 budget takes a step in this direction by proposing to move up the deadline for employers and other institutions to submit W-2s and 1099s to January 31 (the current deadline is the end of February, or the end of March for electronically filed returns). 

Expanding the IRS’s capacity to avert improper payments will require increased investments in IRS staffing and computer systems — not steadily deepening cuts in the IRS budget.  And, the growing pressure on IRS to devote more resources to combat identity theft only tightens the squeeze on scarce IRS resources. 

Second, Congress should adopt a series of EITC simplification measures that President George W. Bush’s Treasury Department proposed in the mid-2000s, after the enactment of a first round of EITC simplifications in 2001 led to a 13 percent drop in overpayments.  Congress never acted on the Bush proposals from the mid-2000s, which were included in several Bush budgets.  Two of those proposals in particular have strong merit.  They address areas where honest taxpayers can unintentionally commit errors:  a proposal to simplify the complicated rules governing how parents who are separated can claim the EITC, and a proposal to allow filers who live with a qualifying child but do not claim the child for the EITC to claim the much smaller EITC for workers not raising a child.  (Current rules consider such filers to have a qualifying child even if they don’t claim the child, and regard a claim for the much smaller EITC for childless workers to be an error and an overpayment.)  Both of these meritorious Bush Treasury proposals are included in legislation introduced last year in the Senate and the House.[24]

End notes:

[1] Council on Economic Advisers, “The War on Poverty 50 Years Later: A Progress Report,” January 2014.  Table 2 on page 27 highlights that the EITC and its sibling Child Tax Credit lift more Americans out of poverty than any other program except Social Security.

[2] Chuck Marr, “Commentary: One Anti-Poverty Initiative Both Sides Can Agree On,” Center on Budget and Policy Priorities, January 24, 2014, http://www.cbpp.org/cms/?fa=view&id=4079.

[3] Department of the Treasury, Agency Financial Report (AFR), fiscal year 2013, p. 210.

[4] Treasury Inspector General for Tax Administration, Ref. No. 2011-40-1023.

[5] Testimony of Nina Olson, IRS National Taxpayer Advocate, before House Appropriations Subcommittee on Financial Services and General Government, February 26, 2014, p. 31.

[6] Testimony of John A. Koskinen, IRS Commissioner, before House Ways and Means Subcommittee on Oversight, February 5, 2014.

[7] Testimony by Treasury Secretary Jack Lew before the Senate Appropriations Committee on the Treasury Department’s fiscal year 2014 budget request, May 8, 2013, http://www.c-span.org/video/?312625-1/DepartmentFiscalYe.

[8] William Hoffman, “Koskinen Kicks Off Filing Season With Spotlight on EITC,” Tax Analysts, February 3, 2014. 

[9] Testimony of Nina Olson, op. cit., pp. 34-35.

[10] Department of the Treasury, p. 207.  The remaining 30 percent of EITC improper payments stem from verification of wage and self-employment income.  (EITC recipients are as likely to be self-employed as other taxpayers.)  Income verification issues regarding self-employment are a concern in the tax code as a whole, not unique to the EITC.

[11] 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.

[12] Treasury 2013 AFR, p. 210.  The 2014 estimate is based on a sample of tax returns studied for tax year 2009 as part of the IRS’s National Research Program

[13] Testimony of Nina Olson, op. cit., p. 37-38; see also National Taxpayer Advocate 2005 Annual Report to Congress, pp. 106-7.

[14] Ibid., p. 206.  The improper payment rate includes only underpayments defined as “the amount of EITC disallowed by the IRS in processing that should have been allowed.” 

[15] 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.

[16] Taxpayer Advocate Service, Internal Revenue Service, “The National Taxpayer Advocate’s Report to Congress, FY 2009,” December 31, 2009, Vol. II, p. 81.

[17] These figures, which are for 2006 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, “Tax Gap for Tax Year 2006: Overview,” January 6, 2012, http://www.irs.gov/pub/newsroom/overview_tax_gap_2006.pdf.

[18] Testimony of Nina Olson, IRS National Taxpayer Advocate, before House Appropriations Subcommittee on Financial Services and General Government, February 26, 2014, p. 32.

[19] Testimony of Nina Olson, op. cit., pp. 39-41.

[20] Ibid., p. 41.

[21] Koskinen testimony, p. 20

[22] Ibid, pp. 4 and 10

[23] Testimony by Treasury Secretary Jack Lew before the Senate Appropriations Committee on the Treasury Department’s fiscal year 2014 budget request, May 8, 2013, http://www.c-span.org/video/?312625-1/DepartmentFiscalYe.

[24] Working Families Tax Relief Act of 2013 (S. 836, introduced by Senators Sherrod Brown, Richard Durbin, and 28 co-sponsors) and the Earned Income Tax Credit Improvement and Simplification Act of 2013 (H.R. 2116, introduced by Rep. Richard Neal and 19 co-sponsors).

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