Reducing Overpayments in the Earned Income Tax Credit
December 1, 2015
The Earned Income Tax Credit (EITC) for low- and moderate-income workers has been shown to increase work, reduce poverty, lower welfare receipt, and improve children’s educational attachment. Hilary Hoynes, a University of California economist who is one of the leading researchers on the EITC, has written that the EITC “may ultimately be judged one of the most successful labor market innovations in U.S. history.” Concerns are often raised, however, about the EITC’s error rate, which the IRS estimates at about 22 percent to 26 percent. This is clearly too high, and policymakers should take steps to reduce it. In doing so, policymakers should take account of some basic facts:
- The EITC’s "improper payment rate" is not a "fraud" rate and shouldn’t be characterized as such.EITC errors occur primarily because of the complexity of the rules surrounding the credit. Most of them 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 somewhat the actual EITC overpayment rate, as analysis by the IRS National Taxpayer Advocate has concluded.
- 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. “[T]his is quite different from other non-tax benefits in which administrative costs related to determining eligibility can range as high as 20 percent of program expenditures,” the Inspector General has noted. Testimony from the IRS National Taxpayer Advocate, Nina Olson, suggests that if the IRS spent the equivalent of 20 percent of EITC expenditures verifying eligibility, little or no net savings would accrue even if the extra spending eliminated EITC errors altogether.
The IRS has launched initiatives since 2010 to reduce EITC errors. Since the current estimate of the EITC error rate is based on IRS analysis of data from tax year 2010, the error rate could be modestly lower now. More important, Congress can help the IRS make progress in lowering EITC overpayments. Congress can:
Give the IRS the needed authority to reduce EITC errors by commercial preparers. Commercial preparers file close to 60 percent of all EITC returns, and the IRS has found that the majority of 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 in 2013, arguing that the IRS lacks the necessary statutory authority to implement it. (Many other preparers have supported the IRS initiative.)
In 2014, the cannot move forward with key aspects of its plan to reduce EITC overpayments resulting from preparer errors.
Provide adequate IRS funding. Congress has cut IRS funding by 18 percent since 2010, adjusted for inflation. These cuts have occurred even as the IRS’s responsibilities have grown due to its role in implementing new laws (such as health reform), a significant increase in the number of tax returns filed, and growing threats such as tax-related identity theft. Cuts in the IRS budget can raise budget deficits by making it harder for the IRS to enforce compliance with the EITC rules and other areas of the tax code. Indeed, the IRS now identifies a number of questionable EITC returns through data-matching with various databases, but can follow up on only a portion of the questionable claims that it identifies because it lacks the resources to follow up on the others. It must pay those claims instead.
Enact EITC error-reduction proposals that the Treasury Department has developed (which are included in the President’s budget), as well as EITC simplifications that the Bush Administration proposed. The President’s budget issued in February includes a number of error-reduction proposals. Simplifying the rule governing how parents who are separated can claim the EITC, as the Bush Treasury proposed, might also reduce errors. These 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 a child for EITC purposes in divorce, separated, and three-generation families. Errors related to who can claim a child do not affect the EITC for childless workers, IRS Commissioner John Koskinen has pointed out. (Koskinen explained 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.”) IRS research on EITC errors over 2006-2008 finds that errors involving the rules for claiming the EITC for childless workers are the least costly of overclaims.
Complexity of EITC Rules Accounts for Many 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 twice as long as the 13 pages of instructions for the Alternative Minimum Tax, which is widely viewed as difficult. 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. The Treasury Department estimates that 70 percent of EITC improper payments stem from issues related to the EITC’s residency and relationship requirements, which are complex; filing status issues, which can arise when married couples file (often following a separation) as singles or heads of households; and other issues related to who can claim a child in non-traditional family arrangements.
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 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’ living arrangements 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, in too many cases, their tax preparers may fully understand the complex rules that determine who is entitled to claim the EITC in such circumstances. Mistakes can result.
IRS studies note that the complexity of EITC rules contributes to the error rate. Analysis of IRS data by Treasury experts and studies by outside researchers suggest that most EITC overpayments do not result from intentional action by tax filers.
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 2015. This estimate is derived from a study based on IRS audits of a sample of tax returns for tax year 2011. 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 cannot 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. The IRS National Taxpayer Advocate, Nina Olson, has reported that in over 40 percent of the cases where 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.
Many of the EITC claimants in the recent IRS study (and most filers whom the IRS audits) did not have this assistance. Olson has testified that because the IRS studies used to estimate EITC error rates do not provide for a process of this nature, their overpayment estimates are likely overstated.
Olson also has noted 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 may be accepted in one office, but not in another) and inflexibility in accepting proof (i.e., a failure to accept other types of documents where the taxpayer cannot provide standard documentation).”
Two other cautions apply to the IRS estimate. First, its improper payment rate does not include significant areas of likely underpayments. 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. (Tracking down the amount that the other parent was eligible to receive in such circumstances was beyond the scope of the IRS study, so the study wasn’t able to produce a net loss calculation.)
Second, the IRS study does not fully reflect the impact of several new enforcement measures that the IRS has implemented since 2010 (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. The National Taxpayer Advocate independently reached a similar conclusion.
It is vital to reduce EITC overpayments. It should also be noted, however, that the noncompliance rate is lower for the EITC than various other parts of the tax code. An IRS study found that 56 percent of business income that was supposed to be reported on individual tax returns went unreported in 2006, costing $122 billion in uncollected revenues. That was about ten times the estimated EITC overpayments that year.
Congress Needs to Help the IRS Reduce Overpayments
The IRS has taken various steps since 2010 to reduce EITC errors. Unfortunately, it 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 2016 budget calls for.
In 2010, the IRS launched a major initiative to combat EITC errors by paid return preparers. Commercial preparers file a majority of all EITC returns, and the majority of EITC overpayments 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 have no obligation to meet any IRS competency standard.
The IRS reported in a study released in 2014 that “unenrolled preparers” — those who are neither attorneys, certified public accountants, nor enrolled agents — account for more than three-fourths of EITC returns prepared by a paid preparer, and 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. (National firms may have internal training programs and the ability to review returns before submission.)
In testimony, IRS Commissioner Koskinen pointed out, “Currently, about 60 percent of tax return preparers operate without any type of oversight or education requirements.” In contrast, volunteers in the IRS-sponsored VITA and TCE free assistance programs — which have the lowest error rates, at about 11 percent, according to Treasury’s EITC compliance study — undergo rigorous certification training and must pass a competency examination before they are allowed to prepare and file returns.
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 (including all unenrolled return preparers, whether or not affiliated with a national chain) to pass the test in order to be certified to file returns in the 2014 filing season.
- 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, a few individual tax preparers challenged this initiative in the courts, arguing that the IRS lacks the necessary statutory authority. In 2014, the D.C. Court of Appeals 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 do not have to complete any continuing education courses. Congress should provide statutory authority so the IRS can act to fully implement its strategy to lower EITC errors resulting from preparer mistakes. (See 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 2015, the IRS also identified 21,000 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 2015 filing season, including educational visits by IRS agents. This strategy averted an estimated $465 million in erroneous claims, according to the IRS. IRS also issued 225 penalties to preparers for failing to meet the basic EITC due diligence requirement in 2015; this represented an improvement in compliance over 2014, when 800 preparers failed to comply with this requirement and faced a penalty. (Return preparers are required to complete a detailed checklist of taxpayer answers to eligibility questions in the course of preparing a claim for the EITC and must now include a copy of the completed checklist when filing the tax return.)
What 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.
Congress should provide the IRS with sufficient resources to administer the tax code. Adjusted for inflation, IRS funding for enforcement in 2015 is 20 percent below the 2010 level (see Figure 1), and, in turn, the number of IRS staff devoted to enforcement has also fallen 18 percent over this period. Yet the number of tax returns filed has grown significantly over the same period.
Underfunding enforcement is penny wise and pound foolish. The Treasury Department estimates that each additional dollar invested in IRS tax enforcement activities yields $6 or more in increased revenue. Greater enforcement funding also produces further, indirect revenue savings by deterring tax evasion; Treasury estimates those indirect savings to be at least three times the direct revenue impact.
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 $465 million in improper EITC claims in 2015 by identifying suspect tax preparers. But like other activities, such initiatives require adequate funding.
Inadequate funding also threatens 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 in a timely fashion. The IRS conducts matching 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 it 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.
Expanding the IRS’s capacity to avert improper payments will also require increased investments in IRS staffing and computer systems, rather than steadily deepening cuts in the IRS budget. And the growing pressure on the IRS to devote more resources to combat identity theft only tightens the squeeze on scarce IRS resources.
Congress has thus far taken few steps to enable the IRS to better attack EITC overpayments. It should consider measures the Treasury has proposed to lower tax-credit errors, which are reflected in the President’s fiscal year 2016 budget. These measures include:
- Requiring third parties such as employers to send the IRS “information returns,” such as W-2s and 1099s, earlier in the year to improve the IRS’ ability to detect erroneous or fraudulent refund claims;
- Giving the IRS the statutory authority to improve accuracy on the part of paid tax-return preparers, as discussed above;
- Providing Treasury with “correctable error” authority to enable the IRS to automatically correct erroneous claims detected through reliable data sources at the time that a tax return is filed and before a refund claim is paid; safeguards would be required to assure that claims are not automatically rejected based on data sources that could be out of date or are not accurate in virtually all cases;
- Requiring paid return preparers to follow due diligence requirements in determining eligibility for the Child Tax Credit, as they already must do for the EITC;
- Increasing penalties for the use of stolen identities in making fraudulent claims; and
- Increasing IRS access to the New Hires Database, which contains data from Form W-4 for newly hired employees, quarterly wage data for all employees from state workforce and federal agency databases, and unemployment insurance data from state workforce agencies for all individuals who have applied for or received unemployment benefits.
In addition, Congress can consider a series of EITC simplification measures that President George W. Bush’s Treasury Department proposed in the mid-2000s, after enactment of a first round of EITC simplifications in 2001 led to a 13 percent drop in overpayments. Congress never acted on these proposals, which were in several Bush budgets. Two in particular merit consideration. 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 don’t 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 in legislation that has been introduced in the Senate and the House.
IRS National Taxpayer Advocate Nina Olson Calls on Congress to Act
In congressional testimony in February 2014, Olson explained why Congress should accord IRS the authority to carry out its initiative to reduce EITC overpayments 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 Charles Grassley (during Republican control) and once under former Chairman Max 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 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 underway.
 Council of 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.
 Hilary Hoynes, “A Revolution in Poverty Policy: The Earned Income Tax Credit and the Well-Being of American Families,” Pathways, Summer 2014, pp. 23-27, http://web.stanford.edu/group/scspi/_media/pdf/pathways/summer_2014/Pathways_Summer_2014_Hoynes.pdf.
 Internal Revenue Service Report to the Treasury Inspector General for Tax Administration, in TIGTA Ref. No. 2011-40-1023, Appendix IV, p. 6.
 Testimony of Nina Olson, IRS National Taxpayer Advocate, before House Appropriations Subcommittee on Financial Services and General Government, February 26, 2014, p. 31.
 Testimony of John A. Koskinen, IRS Commissioner, before House Oversight and Government Reform Committee, Subcommittee on Government Operations, July 9, 2014.
 William Hoffman, “Koskinen Kicks Off Filing Season With Spotlight on EITC,” Tax Analysts, February 3, 2014.
 Internal Revenue Service, “Compliance Estimates for the Earned Income Tax Credit Claimed on 2006-2008 Returns,” http://www.irs.gov/pub/irs-soi/EITCComplianceStudyTY2006-2008.pdf.
 Department of the Treasury, Agency Financial Report (AFR), fiscal year 2014, p. 198; http://www.treasury.gov/about/budget-performance/annual-performance-plan/Documents/508%20FY%2014%20AFR%20FINAL.pdf. The remaining 30 percent of improper EITC payments primarily relate to the reporting of wage, self-employment, and other income. (EITC recipients are as likely to be self-employed as other taxpayers.) Errors related to the reporting of income are a significant problem in the tax code as a whole and are not unique to the EITC.
 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.
 The corresponding dollar range is $14.2 to $17.0 billion. Treasury 2015 AFR, p. 196. The FY 2015 estimate is based on a sample of tax returns studied for tax year 2011 as part of the IRS’s National Research Program.
 Testimony of Nina Olson, op. cit., pp. 37-38; see also National Taxpayer Advocate 2005 Annual Report to Congress, pp. 106-7.
Ibid., p. 197. The improper payment rate includes only underpayments defined as “the amount of EITC disallowed by the IRS in processing that should have been allowed.”
 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 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.
 Internal Revenue Service, “Compliance Estimates for the Earned Income Tax Credit Claimed on 2006-2008 Returns,” http://www.irs.gov/pub/irs-soi/EITCComplianceStudyTY2006-2008.pdf.
 Treasury 2015 AFR, p. 201.
 See Chuck Marr, Joel Friedman, and Brandon DeBot, “IRS Funding Cuts Continue to Compromise Taxpayer Service and Weaken Enforcement,” Center on Budget and Policy Priorities, updated September 30, 2015, http://www.cbpp.org/research/federal-tax/irs-funding-cuts-continue-to-compromise-taxpayer-service-and-weaken-enforcement?fa=view&id=4156.
 “The Budget of the United States Government, Fiscal Year 2016, The Department of the Treasury,” p. 1035, http://www.whitehouse.gov/sites/default/files/omb/budget/fy2016/assets/tre.pdf.
 Working Families Tax Relief Act of 2015 (S. 1012, introduced by Senators Sherrod Brown, Richard Durbin, and 43 co-sponsors) and the Earned Income Tax Credit Improvement and Simplification Act of 2015 (H.R. 902, introduced by Rep. Richard Neal and 54 co-sponsors).