The Future of the Earned Income Tax Credit (Part 2 of 3): Part Two: Distortions and Compliance Problems

The Future of the Earned Income Tax Credit (Part 2 of 3)Part Two: Distortions and Compliance ProblemsC. Eugene Steuerle"Economic Perspective" column reprinted withpermission.Copyright 1995 TAX ANALYSTSThe nonpartisan Urban Institute publishes studies, reports,and books on timely topics worthy of public consideration.The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees,or its funders.While the earned income tax credit has received strong bipartisan support in recent years, it has also growninto one of the largest budget items applying to low-income individuals. After almost a decade of legislativeexpansion through agreements in 1986, 1990, and 1993, it is not surprising that the credit would begin toreceive more in-depth examination and criticism. For example, some cutback, particularly in expansionsalready scheduled for 1996, is being considered as part of the budget agreement this year. The principalsources of concern relate to the credit's impact on work effort and the extent of noncompliance. My ownconclusions on these two issues are as follows: (1) All transfers and taxes distort some choices, and the EITCis no exception. The EITC can be best assessed against alternatives that attempt to help low-incomehouseholds and workers, not as a stand-alone provision. (2) As currently designed, the EITC cannot be fullyenforced by the IRS and, to deter abuse, must either be supplemented by further restrictions or berestructured.Almost all elements of the nation's tax and transfer system can be argued to create some distortions. Afterall, they affect the rates of return from work, saving, and other activity, and they increase the incomes ofsome families and reduce the incomes of others. These distortions almost inevitably raise the cost ofgovernment policy: if that policy is effective in achieving desirable goals, however, then the benefits mayoutweigh the costs.For the EITC, a closely related issue is whether it is a net work incentive for the population as a whole. Whenlooking mainly at the EITC population, including those individuals who might move into the workforce becauseof the EITC, the evidence is mixed. J. Karl Scholz of the University of Wisconsin, and Alberto Martini, mycolleague at the Urban Institute, have some evidence that for this population the net effect on work may bepositive. A major reason is that the cutbacks in work by those in the phase-out ranges of the credit may besmaller in size than the increases in work by those in the phase-in ranges, in particular, those who move fromunemployed to employed status.There are a number of reasons why these results are controversial. The method of accounting, for instance,can affect how the conclusions are stated. It may be possible to increase hours of work, but to decreasenational product. Thus, if those who move into the labor force work 100 more hours at $5 an hour, but thosewho are already working cut back 80 hours at $10 an hour, then hours worked goes up (and so might levelsof employment), but the total value of production is reduced.There are further complications. Reductions in hours of work often take place among those families who havemore than one worker. If we were able to reduce dependence on welfare at a cost of some spouses spendingmore time with their children, we might not be bothered so much by any net reduction in product. Anothercomplication is that some of the increase in work involves a movement from the informal sectors of theeconomy to the formal sectors, which means that the gain in total product is even less than the gain inmeasured product. At the same time, work in the formal sector probably increases respect for the law andhelps some individuals develop a greater ability to deal with work requirements of the modern society.Even if we could take all these factors into account, the calculations can be misleading. All transfers arebacked up by taxes—first, by direct taxes to support the system, and, second, by indirect taxes when benefitsare phased out as the income of beneficiaries increases. The types of calculations reported above tend tocount only the effects of the transfers and the indirect taxes, but to ignore the direct taxes. On net across allof society, the financing of transfer systems will tend to increase the potential taxes or losses from additionalwork to a greater extent than the transfer will increase the potential gains to some individuals from additionalwork.Document date: June 26, 1995Released online: June 26, 1995 We could go on, but whether the EITC is a net work incentive is probably the wrong question. If we as asociety are committed to providing some minimum levels of well-being to individuals, then it is much lessclear that providing, say, $3,000 of EITC benefits to someone who earns a modest amount of income is anyless of a work disincentive than providing $3,000 of pure welfare benefits to someone who doesn't work atall. The effect of the EITC o