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vantaged workers. Remnants of the latter approach are found in the cur-
rent, modest Work Opportunity and Welfare-to-Work tax credits that are
part of the federal income tax.
4
A problem with earnings or employment
subsidies is that they do nothing for adults (and the children that live with
them) who are unable or unwilling to work. Consequently, they must be
matched with programs that help provide food, housing, health care, and
other basic needs to those not in the labor market.
The EITC was established amid the political debate over the NIT that
occurred in the 1960s and 1970s. The NIT held great promise to the early
designers of the war on poverty since it would solve the difficult integration
issues that arise with categorical antipoverty programs—the need for bu-
reaucracies to administer and enforce eligibility and benefit rules and the
need to mitigate potentially high marginal tax rates that recipients face as
earnings increase. Partly for these reasons, in 1966 an NIT was the cap-
stone of the Office of Economic Opportunity’s (the federal agency in
charge of conducting the war on poverty) plan to eradicate poverty. Presi-
dent Johnson, however, opposed the NIT and a leading alternative pro-
posal at the time, a guaranteed annual income, on the grounds that both
proposals undermined work effort. Without the support of the president,
an NIT was not adopted. Nevertheless, in the late 1960s and early 1970s,
the government launched the first widespread social experiments, the Gary
(Indiana), New Jersey, Iowa, and Seattle-Denver Income Maintenance Ex-
periments, to examine the effects of an NIT.
In 1969 President Nixon introduced an NIT called the Family Assis-
tance Plan (FAP) that would have replaced the AFDC program. Although
it enjoyed widespread initial support, the FAP was subsequently attacked
by liberals as being insufficiently generous and by conservatives as being
overly expensive and having insufficiently stringent work requirements.
Russell Long, then chair of the Senate Finance Committee, opposed the
FAP and, as an alternative, designed a proposal targeted at those willing to
work. His 1972 proposal included a large public service jobs component
and a “work bonus” equal to 10 percent of wages subject to Social Secu-
rity taxation. The FAP was defeated in 1972, but Senator Long aggres-
sively pushed his work bonus scheme over the next three years. His efforts
were aided by the confluence of three events. First, from 1960 to 1970 the
payroll tax rate increased to 4.8 percent from 3.0 percent (on both employ-
ers and employees), and it increased further to 5.8 percent in 1973, which
focused attention on the rising tax burdens of low-income families. Sec-
ond, fostered in part by the income maintenance experiments, there con-
tinued to be a great deal of intellectual attention paid to the NIT and NIT
alternatives in think tanks, universities, and government agencies. Third, a
144 V. Joseph Hotz and John Karl Scholz
4. For further discussion of employment subsidies and a broader treatment of employment
strategies for low-wage labor markets, see Bishop and Haveman (1978) and Haveman (1996).
recession started in 1974. This prompted members of Congress in 1975 to
try to stimulate aggregate demand by refunding $8.1 billion in 1974 income
taxes and cutting 1975 income taxes by an additional $10 billion. With the
passage of a tax bill in 1975, Senator Long was able to enact a variant of his
work bonus, called the EITC, on a temporary, eighteen-month basis. The
provision added a 10 percent supplement to wages up to $4,000 ($12,387 in
1999 dollars) for taxpayers with children, and it phased out at a 10 percent
rate over the $4,000 to $8,000 income range.
Senator Long undoubtedly understood that once a provision is in the tax
code, it is likely to remain. Indeed, the EITC remained in the tax code each
subsequent year until it was made permanent in 1978. Legislation in 1978
also added a flat range to the EITC’s phase-in and phaseout ranges, as
shown in figure 3.1.
5
An “advance payment” option was also added to the
credit in 1978, so that workers would be able, if they desired, to receive the
credit incrementally throughout the year.
Spending on the safety net slowed in the late 1970s and shrank in the
1980s. Between 1978 and the Tax Reform Act of 1986 (TRA86), the fact
that the tax credit (and tax code) was not indexed for inflation caused a
substantial erosion of the EITC’s real value. The TRA86, as part of its
provisions to eliminate income taxes on families with incomes below the
The Earned Income Tax Credit 145
Fig. 3.1 The Earned Income Tax Credit for a family with two or more children in
1979 and 2001
Notes: 1 ϭ subsidy rate; 2 ϭ maximum benefit for two or more children; 3 ϭ benefit reduc-
tion (implicit tax) rate.
5. The phase-in rate for the credit was 10 percent on earnings up to $5,000, for a maximum
credit of $500. The maximum credit was available for taxpayers with earnings between $5,000
and $6,000. The phaseout rate for the credit was 12.5 percent on incomes between $6,000 and
$10,000.
poverty line, increased the EITC to the point where the maximum credit in
1987 equaled the real value of the credit in 1975. The TRA86 also indexed
the credit for inflation. During this period the EITC continued to be sup-
ported by liberals and conservatives, both of whom were sympathetic to
the idea of reducing tax burdens on low-income families and rewarding
work.
Through much of the 1980s and into the 1990s, deficits were a dominant
topic in Washington economic policy discussions. By 1990, annual deficit
forecasts exceeding $300 billion—“as far as the eye can see”—were com-
mon, so that year President Bush agreed to abandon his “no new taxes”
pledge and meet with Democratic leaders of Congress to fashion deficit-
reduction legislation. The tortuous negotiations led to the 1990 tax bill,
which phased out exemptions and itemized deductions on high-income
taxpayers and raised the highest marginal tax rate from 28 percent to 31
percent. Whereas distributional issues have always played a role in tax pol-
icy, they played an exceptionally important role in 1990, perhaps because
of the antipathy of Democratic congressional leaders toward the Republi-
can president and the sense of those leaders that policy in the 1980s disfa-
vored low-income families.
6
The EITC proved to be a straightforward way
to alter the distributional characteristics of various deficit-reduction pack-
ages, and distributional tables became an important factor behind the 1990
EITC expansion that was phased in over three years. In 1991, the credit for
the first time was also made larger for taxpayers with two or more children
than for taxpayers with one child.
Another major change to the EITC occurred as part of the 1993 budget
bill. In his first State of the Union Address, President Clinton said, “The
new direction I propose will make this solemn, simple commitment: By ex-
panding the refundable earned income tax credit, we will make history; we
will reward the work of millions of working poor Americans by realizing
the principle that if you work forty hours a week and you’ve got a child in
the house, you will no longer be in poverty.” This declaration completed the
evolution of the EITC from Senator Long’s modest “work bonus” to a ma-
jor antipoverty initiative. President Clinton set a target for the EITC: full-
time work at the minimum wage plus the EITC (and any food stamps a
family is eligible for) should be enough to raise the family’s net-of-payroll-
tax income above the poverty line. To achieve this goal, the EITC was again
increased, and increased sharply for families with two or more children.
7
146 V. Joseph Hotz and John Karl Scholz
6. Many of the newspaper articles about 1990 budget talks emphasized distributional is-
sues. See, for example, “GOP’s Tax Proposal Said to Favor Wealthy; Budget Talks Proceed-
ing at ‘Glacial’ Pace,” Washington Post, 14 September 1990, A12, and “Budget Negotiations
Recess Amid Confusion on Progress; Officials Disagree on Extent of Disagreement,” Wash-
ington Post, 18 September 1990, A1.
7. The specific goal was achieved only for families with fewer than three children, and only
after the minimum wage was increased in 1996 and 1997.
The 1993 budget bill (and EITC expansion) passed by one vote in the
Senate and received not a single supporting Republican vote. This too
marked a transformation in the EITC’s political history. For the first time,
the EITC became a policy linked exclusively to Democrats. In subsequent
years, there have been highly partisan battles over EITC-related issues.
3.2.1 EITC Rules
To receive the earned income credit, taxpayers file their regular tax re-
turn and fill out the six-line Schedule EIC that gathers information about
qualifying children. The EITC is refundable, meaning that it is paid out by
the Treasury regardless of whether the taxpayer has any federal income tax
liability. There are several basic tests for EITC eligibility. The taxpayer
must have both earned and adjusted gross income below a threshold that
varies by year and by family size. Most EITC payments go to taxpayers
with at least one “qualifying child.” A qualifying child needs to meet age,
relationship, and residence tests. The age test requires the child to be
younger than nineteen, younger than twenty-four if a full-time student, or
any age if totally disabled. The relationship test requires the claimant to be
the parent or the grandparent of the child or for the child to be a foster
child.
8
Under the residence test the qualifying child must live with the tax-
payer at least six months during the year.
9
Another rule limits the sum of
taxable and tax-exempt interest, dividends, net capital gains, rents, royal-
ties, and “passive” income to less than $2,350 (indexed for inflation).
In 2001, taxpayers with two or more children could receive a credit of 40
percent of income up to $10,020, for a maximum credit of $4,008. Taxpay-
ers (with two or more children) with earnings between $10,020 and $13,090
received the maximum credit. Their credit was reduced by 21.06 percent of
earnings between $13,090 and $32,121. The EITC schedule in 2001 for
families with two or more children is shown in figure 3.1. A small credit
available for childless taxpayers between the ages of twenty-four and sixty-
five with very low incomes was added in 1994. The credit rate for these tax-
payers is 7.65 percent, and the maximum credit in 2001 was $364. Table 3.1
shows the complete evolution of income eligibility thresholds, credit rates,
and phaseout (or implicit tax) rates.
Panel A of figure 3.2 shows total tax payments and marginal tax rates for
two-parent, two-child families in Illinois (a state with relatively high tax
The Earned Income Tax Credit 147
8. Until late 1999, a foster child was any child for whom the claimant cared for “as if the
child is their own.” The caring stipulation still holds, but now the child must also be placed in
the home by an authorized placement agency. Prior to the 2001 tax legislation, EITC-eligible
foster children also needed to live with the taxpayer for twelve, rather than six, months.
9. In 1990 (tax year 1991) the residency and AGI tiebreaker (to be discussed) tests replaced
a support test, since in principle it is easier to verify where a child lives than it is to verify
who supports a child. Under the support test the taxpayer had to pay for at least half the
child’s support, where items like transfer payments (e.g., AFDC and housing subsidies) and
child support were not considered support provided by the taxpayer.
Table 3.1 Earned Income Tax Credit Parameters, 1979–2001 (in nominal dollars)
Phase-in Phase-in Max Phaseout Phaseout
Ye ar Rate (%) Range ($) Credit ($) Rate (%) Range ($)
1975–78 10.0 0–4,000 400 10.00 4,000–8,000
1979–84 10.0 0–5,000 500 12.50 6,000–10,000
1985–86 11.0 0–5,000 550 12.22 6,500–11,000
1987 14.0 0–6,080 851 10.00 6,920–15,432
1988 14.0 0–6,240 874 10.00 9,850–18,576
1989 14.0 0–6,500 910 10.00 10,240–19,340
1990 14.0 0–6,810 953 10.00 10,730–20,264
1991
a
16.7
b
0–7,140 1,192 11.93 11,250–21,250
17.3
c
1,235 12.36 11,250–21,250
1992
a
17.6
b
0–7,520 1,324 12.57 11,840–22,370
18.4
c
1,384 13.14 11,840–22,370
1993
a
18.5
b
0–7,750 1,434 13.21 12,200–23,050
19.5
c
1,511 13.93 12,200–23,050
1994 23.6
b
0–7,750 2,038 15.98 11,000–23,755
30.0
c
0–8,245 2,528 17.68 11,000–25,296
7.65
d
0–4,000 306 7.65 5,000–9,000
1995 34.0
b
0–6,160 2,094 15.98 11,290–24,396
36.0
c
0–8,640 3,110 20.22 11,290–26,673
7.65
d
0–4,100 314 7.65 5,130–9,230
1996 34.0
b
0–6,330 2,152 15.98 11,610–25,078
40.0
c
0–8,890 3,556 21.06 11,610–28,495
7.65
d
0–4,220 323 7.65 5,280–9,500
1997 34.0
b
0–6,500 2,210 15.98 11,930–25,750
40.0
c
0–9,140 3,656 21.06 11,930–29,290
7.65
d
0–4,340 332 7.65 5,430–9,770
1998 34.0
b
0–6,680 2,271 15.98 12,260–26,473
40.0
c
0–9,390 3,756 21.06 12,260–30,095
7.65
d
0–4,460 341 7.65 5,570–10,030
1999 34.0
b
0–6,800 2,312 15.98 12,460–26,928
40.0
c
0–9,540 3,816 21.06 12,460–30,580
7.65
d
0–4,530 347 7.65 5,670–10,200
2000 34.0
b
0–6,920 2,353 15.98 12,690–27,413
40.0
c
0–9,720 3,888 21.06 12,690–31,152
7.65
d
0–4,610 353 7.65 5,770–10,380
2001 34.0
b
0–7,140 2,428 15.98 13,090–28,281
40.0
c
0–10,020 4,008 21.06 13,090–32,131
7.65
d
0–4,760 364 7.65 5,950–10,708
Source: U. S. House of Representatives, Committee on Ways and Means (1998, p. 867). 1998 through
2001 parameters come from Internal Revenue Service Publication 596.
a
Basic credit only. Does not include supplemental young child or health insurance credits.
b
Taxpayers with one qualifying child.
c
Taxpayers with more than one qualifying child.
d
Childless taxpayers.
The Earned Income Tax Credit 149
A
B
Fig. 3.2 A, Taxes and marginal rates, family of four, Illinois, 1998; B, Taxes and
marginal rates, family of four, Illinois, 1984 (in $ 1998)
Notes: Calculations only reflect the effects of the state and federal tax system and do not in-
clude the effects of transfer programs. See Feenberg and Coutts (1993) for details of the
NBER’s TAXSIM model used for these calculations.
rates on low-income families) in 1998.
10
We assume workers bear the full
burden of payroll taxes, so the employer and employee share of payroll
taxes is 14.2 percent.
11
The marginal tax rate line is initially at –25.8 per-
cent, reflecting the sum of the 14.2 percent effective payroll tax rate and
10. Nineteen states impose positive (but typically small) state income taxes on families of
four with incomes below the poverty line (Johnson 2001).
11. Employers and employees both contribute 7.65 percent of earnings as payroll taxes, but
the standard incidence assumption for payroll taxes implies that after-tax earnings would be
7.65 percent larger in the absence of payroll taxes, so the effective payroll tax rate is (0.153/
1.0765) or 14.2 percent.
the –40 percent EITC rate. The flat portion of the EITC occurs around
$10,000, where the Illinois household would face a 3 percent marginal
state tax rate. Effective rates are 38.3 percent over much of the phaseout
range, reflecting the sum of the 14.2 percent payroll tax, the 21.1 percent
EITC phaseout, and the 3 percent Illinois state income tax. Rates jump to
53.3 percent between $25,000 and $29,000 as this family enters the 15 per-
cent bracket of the federal income tax.
12
The corresponding average tax
burdens are shown in the bars. Two-parent, two-child Illinois families
would have negative combined income and payroll taxes up to roughly
$17,200.
13
Panel B of figure 3.2 shows the analogous situation for the same type of
family in 1984, before the 1986 tax reform, and the 1990 and 1993 EITC ex-
pansions, all of which reduced taxes on low-income families. The pattern
of marginal and average tax rates is strikingly different from what applied
in 1998. The payroll tax (7 percent on employers and employees) was al-
most as high as it is now, resulting in an effective rate of 13.1 percent. The
EITC was only 10 percent on incomes up to $7,844 (in 1998 dollars), so
even taxpayers with very low incomes faced positive marginal rates. The
EITC was phased out at a 12.5 percent rate beginning at $9,413 (again, in
1998 dollars). In addition, the 11 percent federal marginal tax bracket
started at around $9,413 of income. Thus, all but the lowest-income fami-
lies faced marginal tax rates of at least 28 percent, and some faced signifi-
cantly higher marginal rates.
In calendar year 2001, fourteen states and the District of Columbia had
EITCs as part of their state income tax systems.
14
The parameters of these
credits are summarized in table 3.2. Most are structured as percentages of
the federal credit and use the same eligibility definitions. In New York, for
example, the state EITC was 25 percent of the federal credit in 2001, rising
to 30 percent by 2003. Ten of the state EITCs (including D.C.) are refund-
able, and most make the credit available to workers without qualifying chil-
dren.
Two unusual features show up in state EITCs. Wisconsin’s state EITC
has a three-tiered schedule equaling 4 percent of the federal credit for tax-
payers with one child, 14 percent of the federal credit for taxpayers with
150 V. Joseph Hotz and John Karl Scholz
12. The EITC phaseout rate is lower for taxpayers with one child, but because they only re-
ceive one child credit and have one less personal exemption, one-child families in 2002 begin
to pay the federal 10 percent marginal income tax rate at an income of $22,850. Hence, EITC
recipients with one child and incomes between $22,850 and $29,201 have cumulative marginal
tax rates around 40 percent (including payroll taxes).
13. Low-income families would generally file returns because their incomes exceed filing
thresholds or to get back withheld taxes. With the $600 child credit along with exemptions of
$3,000 and the standard deduction of $7,850, a married couple with two children in 2002 will
not have a positive income tax liability until their earnings exceed $31,850, even without the
EITC.
14. This discussion is from Johnson (2001).
two children, and 43 percent of the federal credit for taxpayers with three
or more children. This schedule was developed with explicit reference to
the higher incomes needed to keep families with three or more children out
of poverty. The Minnesota schedule includes a second phase-in range to
combat the problem that increases in wages or hours for certain minimum-
wage workers made them no better off because of the loss of cash assis-
tance and food stamps and increases in taxes (see Johnson 2001, page 21,
for more details).
The state credits in combination with the federal credit can be substan-
tial. A family with three or more children earning $9,600 in Wisconsin, for
example, could receive a combined state and federal EITC of $5,457, or a
57 percent supplement to their earned income.
3.2.2 Interaction with Other Social Welfare Programs
The tax system operates independently of transfer programs, so there is
relatively little interaction between the EITC and other programs. In 1979
(as part of a technical corrections bill) Congress required both advance and
The Earned Income Tax Credit 151
Table 3.2 State Earned Income Tax Credits, Tax Year 2001
Percentage of Federal Credit
Refundable credits
Colorado (1999) 10
District of Columbia (2000) 25
Kansas (1998) 10
Maryland (1987)
a
16 (rising to 20 in 2003)
Massachusetts (1997) 15
Minnesota (1991) Averages 33%, varies by earnings
b
New Jersey (2000) 15 (20% by 2003), limited to families with
incomes below $20,000
New York (1994) 25 (30% by 2003)
Vermont (1988) 32
Wisconsin (1989) 4% one child; 14% 2 children; 43% 3 children
Nonrefundable credits
Illinois (2000) 5
Iowa (1990) 6.5
Maine (2000) 5
Oregon (1997) 5
Rhode Island (1975) 25.5
Source: Johnson (2001, particularly Table 4). Adoption years are from Dickert-Conlin and
Houser (2002), which in turn are from Johnson.
Note: State names are followed by year adopted (in parentheses).
a
A Maryland taxpayer may claim a refundable credit or a nonrefundable credit (equal to 50
percent of the federal credit), but not both.
b
Minnesota’s credit for families with children, unlike the other credits shown in the table, is
not expressly structured as a percentage of the federal credit. Depending on income levels, the
credit may range from 22 percent to 46 percent of the federal credit.
lump-sum EITC payments to be treated as earned income for AFDC, food
stamp, and Supplemental Security Income (SSI) recipients. The 1981 tax
legislation went even further in requiring welfare agencies to assume that
individuals eligible for both the EITC and AFDC received the EITC incre-
mentally through the year, thus likely lowering AFDC and food stamp ben-
efits. In 1984 this position was reversed and states were allowed to reduce
AFDC benefits only when they could verify that individuals actually re-
ceived the EITC. The 1990 tax legislation prohibited the counting of the
EITC as income or as a resource in the month received or in the following
month when determining eligibility for AFDC, Medicaid, food stamps,
SSI, and low-income housing benefits. Finally, the 1993 Mickey Leland
Hunger Act prohibited counting the EITC for the first twelve months after
receipt for food stamp eligibility and benefits. Beyond these time intervals,
the EITC could cause potential recipients to fail program asset tests.
Since the abolition of AFDC, it has not yet become clear how the EITC
will interact with state TANF programs. There are two major issues. First,
states now have the authority to count the EITC as income when deter-
mining eligibility for their welfare programs. Second, many TANF pro-
grams contain employer subsidies and other job-related activities, which
may or may not trigger tax obligations and potential EITC payments. The
1997 budget bill made clear that the EITC could not be claimed on income
resulting from “community service” and “work experience” jobs funded
under TANF. Other situations will be judged by their “facts and circum-
stances” under the general welfare doctrine.
15
The law is not yet well devel-
oped in this area.
3.2.3 Quality Control and Noncompliance
Relative to alternative delivery mechanisms, the EITC is inexpensive to
administer. Most EITC recipients would be required to file a tax return
even in the absence of the credit, so the marginal cost of obtaining the
EITC is simply the small cost of filling out Schedule EIC. The cost to the
IRS is also quite small. The IRS has a budget of roughly $8 billion to serve
some 120 million individual taxpayers and 15 million corporations. The in-
cremental cost of administering the EITC is surely a very small fraction of
this total. The costs of administering two other major income-support pro-
grams for low-income families are much higher. Administrative costs in fis-
cal year (FY) 1995 were $3.7 billion for food stamps and $3.5 billion for
AFDC, although a significant portion of those costs also paid for client
services.
A system based largely on self-assessment (like the U.S. income tax) will
152 V. Joseph Hotz and John Karl Scholz
15. A loose description of the general welfare doctrine is that if payments are made for the
general welfare, meaning that payments are public support for a disadvantaged family, they
are not taxable and do not trigger the EITC. If payments are more job-related, they are less
likely to be viewed as payments made to support the general welfare and more like compen-
sation for services rendered. In this case they would be taxable and trigger the EITC.
have lower administrative costs than a more bureaucratic approach, but it
will also have higher noncompliance. The most recent study of EITC non-
compliance examined returns filed in 2000 (for tax year 1999) and found
that of the $31.3 billion claimed in EITC, between $8.5 and $9.9 billion, or
27.0 to 31.7 percent of the total, exceeded the amount to which taxpayers
were eligible (IRS 2002a).
Of the errors the IRS was able to classify, roughly half involve qualify-
ing-child errors.
16
About half of these arose because the child claimed was
not the taxpayer’s qualifying child. Of these errors, the most common prob-
lem was that EITC-qualifying children failed to live for at least six months
(see footnote 8 for the rules applying to foster children) with the taxpayer
who was claiming the child. Reasons for mistakes of this type can run the
gamut from innocent taxpayers running afoul of complex IRS rules to
fraud. Consider, for example, a divorced couple whose divorce agreement
gives the dependency exemption to the noncustodial parent, who in turn is
regularly paying child support. Since the noncustodial parent receives the
dependency exemption, that parent could easily assume that he or she
could also claim the child to receive the EITC if he or she is otherwise qual-
ified. But in this case the claim would be inappropriate, since the child does
not live with the claimant for more than six months. In the category of clear
noncompliance, consider the situation described in the ethnographic study
of Romich and Weisner (2000). They write that “one woman relies on her
mother to baby-sit her younger daughter every weekend. The grandmother
also buys school clothes for the child. In return for this care, the grand-
mother ‘gets hers back at the end of the year’ by (illegally) filing the child
as her dependent and receiving an EITC” (p. 1256).
Two other sources of qualifying-child errors arise with the adjusted gross
income (AGI) tiebreaker and relationship rules. The AGI tiebreaker rule
stipulated that if two people could legitimately claim the same EITC-
qualifying child (such as a mother and grandmother in the same house),
the one with the greater income was supposed to. Something like a
tiebreaker rule is necessary to establish legitimacy in cases where more
than one taxpayer claims the credit based on the same child. But it led to
outcomes where, for example, a parent who lived and cared for a child
could not claim the child because the child’s grandparent also lived in the
house and had a higher income. The AGI tiebreaker rule was simplified be-
ginning in 2002 and now applies only if two taxpayers actually claim the
same EITC-qualifying child. This change should significantly reduce er-
rors related to the AGI tiebreaker rules, which accounted for 17.2 percent
of all errors in 1999. The relationship test is violated when the person
claiming the EITC-qualifying child is not the child’s parent (including the
parent of an adopted child, stepchild, or foster child) or grandparent.
The Earned Income Tax Credit 153
16. Also see McCubbin (2000), Scholz (1997), U.S. General Accounting Office (1998), and
Holtzblatt (1991) for discussions of earlier EITC compliance studies.