Earned Income Tax Credit – A Solution to Poverty?

by Tom Yamachika, President, Tax Foundation Hawaii

The federal Earned Income Tax Credit (“EITC”), enacted in 1975, has been called the most effective federal program for poverty relief. According to a report by the Hawaii Appleseed Center for Law and Economic Justice, it lifts more families out of poverty than any other federal policy, and as a result, is linked to positive social outcomes such as improved education, increased participation in the work force leading to improved earnings and financial security, and better health (particularly for infants). In Hawaii 110,000 returns claimed an aggregate credit of $239 million in 2013, or $2,175 per return.

Many of the challenges associated with this credit come from its complexity. IRS Publication 596, which is the official information given to taxpayers for use in claiming the EITC, is 37 pages long. It’s no surprise that not everyone eligible for the credit claims it. The IRS has estimated that 81% of Hawaii households claimed the credit in 2010, slightly more than the national average of 79%.

Another challenge associated with complexity is credits paid to people who aren’t entitled to them. A recent report from the Treasury Inspector General for Tax Administration states that the estimated amount of “improper payments” of the EITC in fiscal year 2013 was between 22% and 26%, with a negative impact to the Treasury of between $13.3 and $15.6 billion. Improper payments don’t necessarily mean tax fraud; honest taxpayers can and often do misunderstand complicated programs like this one, and research by a Harvard professor has concluded that both taxpayer error (55%) and taxpayer dishonesty (45%) contribute significantly to the total of improper payments. The Treasury report also contains error rate estimates for the past ten years, and the 2013 numbers seem to be typical; in that time, the Treasury and the IRS haven’t been able reduce the error rate – or even move it on a downward trajectory.

That being said, should we adopt a similar EITC program in Hawaii? The Hawaii Appleseed Center, for one, says we should. They point out that the EITC reaches more people than the social services programs do. Specifically, in 2006 about 80% of eligible people claimed the EITC, compared with about 40% for Temporary Assistance for Needy Families or Aid to Families with Dependent Children. With regard to the EITC complexity issue, they say that the Hawaii credit would be easy to apply for and administer: “Since it simply piggybacks on the federal EITC, calculating the state credit is simple. A taxpayer takes a set percentage of whatever was claimed for the federal EITC. We propose that the percentage be 20 percent. Thus, if the federal EITC for a family were $2,500, the Hawai‘i EITC would amount to $500 — $2,500 x 20% = 500.”

Piggybacking on the federal credit would, of course, also piggyback on its error rate. Can we, as a state, stomach the possibility of having 22% to 26% of credit payments go to the wrong people? And once the dollars have gone out the door, it’s tough to get them back: if the $2,500 federal EITC in the above example was paid out in error, the IRS might find it worthwhile to go after the $2,500. If it does, the Department of Taxation probably would get a copy of the audit adjustment and then could chase the $500 that the taxpayer presumably claimed at the same time, assuming the taxpayer still had it. If the IRS doesn’t, would it be cost effective for Hawaii to chase the $500?

When lawmakers again ponder the program, probably this session, they’ll need to ask themselves: does the social good of the program for the 80% of families outweigh either missing the 20% of families who didn’t claim the credit or paying the 22% to 26% of ineligible taxpayers who claimed it improperly?

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