When you hear that something is refundable, you probably think that means that someone gets a refund on something he or she paid. But the IRS and even economists who study tax policy don’t mean that at all. By “refundable,” they mean that someone gets a payment even if he or she paid nothing in the first place.
That issue comes up when one examines the Earned Income Tax Credit (EITC.) As Cato Institute economist Chris Edwards points out, of the $71 billion of the EITC given to 27 million people in 2021, $69 billion, or almost all, was “refundable.” That is, it was given to people who paid no income tax. The EITC is almost wholly a welfare-spending program, not a tax-cutting program.
These are the opening two paragraphs of David R. Henderson, “Tighten the Earned Income Tax Credit,” November 30, 2022, my short TaxBytes column for the Institute for Policy Innovation.
Another excerpt:
Moreover, the program is rife with fraud. Interestingly, Hilary Hoynes, an economics professor at the University of California, Berkeley, wrote an article in 2014 calling for an expansion of the EITC without ever mentioning fraud. Around that same time, Professor Hoynes gave a talk at the Naval Postgraduate School, where I was an economics professor. In her talk, she defended the EITC and didn’t mention fraud then either. However, in Q&A, she readily admitted that many recipients of EITC funds got them fraudulently. What would you expect from a program that one can benefit from simply by filing a false tax return and receiving a check from the U.S. Treasury? Not all of the mistakes are fraudulent. But the Government Accountability Office estimated that the error and fraud rate between 2016 and 2020 averaged 24 percent.
Did I do a complete analysis? No. I can’t do that in the allotted 450 words.
Read the whole thing.
READER COMMENTS
Jon Murphy
Dec 1 2022 at 5:46pm
Quite frankly, I’m always amazed at what you can do in 450 words
David Henderson
Dec 1 2022 at 6:00pm
Thank you, Jon.
Garrett
Dec 1 2022 at 6:46pm
Reminds me of Bryan Caplan’s recent post on Alex Epstein, credibility, and big blatant omitted facts.
Scott Sumner
Dec 1 2022 at 7:09pm
I don’t understand why they don’t use the payroll tax system to reduce fraud. Require paperwork from both the employee and employer. There would still be some fraud, but surely it would be much more difficult to cheat if the employee had to get his employer to go along with the fraud.
Are people claiming EITC despite reporting a different income from what’s shown on their payroll tax? (Given the primitive nature of the federal government’s computer system, maybe I should not be surprised.)
Mark A Swanstrom
Dec 1 2022 at 8:12pm
In my experience, the fraud was in the number of children claimed. I’m not sure employer verification would help except possibly for the number of dependents listed on W-4.
vince
Dec 1 2022 at 9:15pm
Many (most?) who get the EIC are independent contractors rather than employees. And if they’re paid in cash, they can report what they want, and even optimize the refund. Of course, a tax return is signed under penalties of perjury.
Scott Sumner
Dec 1 2022 at 9:23pm
Thanks. Is the fraud typically that they are earning more than they claim, or less? (In either case, the eligibility for the EITC can be lower than for an intermediate income.)
vince
Dec 1 2022 at 11:23pm
Both. There’s maximum refund based on income before it starts declining. If income is too high, either don’t report cash income, or overstate deductions. If income is too low, understate deductions, or even report extra income. The IRS even had to issue a ruling that a taxpayer HAD to take all of his deductions.
Jim Glass
Dec 1 2022 at 10:11pm
I don’t understand why they don’t use the payroll tax system to reduce fraud.
Requirements to claim the EIC include information about family and potential other employment and income, etc., not available to the employer running payroll. Must be provided on a 1040.
There would still be some fraud, but surely it would be much more difficult to cheat
Remember who’s claiming the EIC. Mostly young, all poor, people who are illiterate about taxes (though I’ve known many quite well off middle-agers who fit that description), many not so good even with English.
Most of the ‘excess claims’ are not actual fraud. They are people who don’t understand the rules and papers and give themselves the benefit of the doubt about what’s right. (Just like millions of very well off people do all over their returns every year.) Most people are basically, sorta, kinda, honest. Even among the poor.
Of course there’s plenty of fraud too. There are fraud mills where people who do know the rules file false maxed out EIC claims en masse, taking $$$ up front, from people who just hand them their returns, who may know what’s going on or not. When you create a program where people can get money just by asking, this is going to happen.
Jim Glass
Dec 1 2022 at 10:41pm
Mostly young, all poor, people who are illiterate about taxes …many not so good even with English… people who don’t understand the rules…
The rules, so simple and clear.
Mark A Swanstrom
Dec 1 2022 at 8:08pm
I spent one season working at a rapid refund place and couldn’t believe the number of ‘foster’ children people claimed. The marginal refund per child falls, so the people with several children let other people claim their child to get higher refunds. They also all paid extra to get the next day refund instead of waiting two weeks despite my effort to explain that they were effectively paying APRs of 100% or more.
Jim Glass
Dec 1 2022 at 9:39pm
It’s not like any of this is new – or even, not really old.
Back circa 1993 I interviewed then IRS Commissioner Peggy Richardson for an article I wrote for publication. She started off in a very exasperated mood…
The article I was writing had nothing to do with the EIC. She was just really peeved and venting. It all was that big a problem way back then — and the EIC goes back to 1975.
The EIC is one really politically stable program. Both parties have had full control of the government multiple times during its run and both have supported it. If you really want to change it, you have to figure out the politics of that stability.
Part of it is that on the merits it is genuinely better and more efficient than most other anti-poverty programs — something to ponder. Much better the EIC than a minimum wage hike. If one wants something better, one has to present an alternative.
As to: “Tighten the Earned Income Tax Credit”, I have no idea what that means. Audit more EICers? Already, IRS Audits Poorest Families at Five Times the Rate for Everyone Else (Though most are ‘letter audits’ about paperwork, not face-to-face.)
Or something else nobody has ever thought of?
BC
Dec 2 2022 at 6:50am
At the end of David’s linked IPI article — he does say to read the whole thing — David does explain what “tightening the EITC” means: “reducing the EITC expenditure by reducing benefit levels and narrowing eligibility.”
He also links to a Cato article by Chris Edwards that describes an alternative to EITC: pursue reforms to increase worker productivity and boost market wages by adopting policies favorable to capital investment and innovation. The suggested policies are to “minimize tax rates on business income, provide favorable rules for venture capital and angel investment, and reduce regulatory barriers to competition and new investment”. One can question how effective such policies would be in boosting market wages, but Edwards does present an alternative to other anti-poverty programs. Hopefully, we all agree that anti-poverty programs are not limited to government spending programs. In fact, if we could reduce poverty by raising market wages, I would hope that everyone would find such policies preferable to welfare spending.
David Henderson
Dec 2 2022 at 1:02pm
Thanks, BC.
nobody.really
Dec 2 2022 at 5:15pm
What does “alternative” mean?
If Edwards knew that we were keeping the EITC, would he’d abandon support for these reforms? If not, then I don’t regard these reforms as an “alternative” to the EITC; they just happen to be (arguably) good public policies with a side-order of Whataboutism.
He’s a different concept of “alternative”: If we’re really concerned about tax cheats, why not boost the IRS enforcement budget to the point where the marginal investment meets the marginal return? Maybe even order the Commissioner to optimize net tax receipts. Whether than would mean pursuing EITC tax cheats (maybe low cost/low return?) or Donald Trumps (maybe high cost/high return?), I’d leave to the experts.
Vivian Darkbloom
Dec 2 2022 at 10:53am
The comments by Commissioner Richardson remind me of the on-going battle over voter fraud. On the one hand, you’ve got folks who want to make it easier to vote/claim the EITC for fear that eligible people will be excluded. On the other hand, you’ve got folks concerned that the easier it is to vote/claim the EITC , the more fraud you will have. Both sides are right, to some extent.
The latest in this on-going tug of war is “American Rescue Plan Act of 2021” which significantly expanded the EITC making it more lucrative to commit fraud and simultaneously more difficult to verify that people claiming it actually qualify. And, if we believe the rhetoric around the “Inflation Reduction Act of 202” none of those 87,000 new IRS employees will be targeting fraudulent EITC claims.
David Henderson
Dec 2 2022 at 1:01pm
Interesting story about your 1993 interview. Thank you.
You write:
Actually, I don’t agree that one “has to,” but I do agree that doing so is a good idea. Unfortunately, with my word limit, I couldn’t. But I would advocate radical deregulation of the labor market, including ending virtually all (and probably literally all) occupational licensure.
Thomas Lee Hutcheson
Dec 1 2022 at 10:24pm
“not a tax-cutting program”
And why can’t taxes be cut to less than zero?
My reform would be to make it more like a wage subsidy. It is a superior way to transfer income compared to the minimum wage both becasue it does not cause unemployment and the incidence of the tax that funds it is broader than the implicit tax on owners amd customers of firms paying minimum wages.
Stéphane Couvreur
Dec 1 2022 at 10:29pm
I am surprised by this part of your criticism:
I thought the EITC resembled the well-known proposal by Milton Friedman of a negative income tax, which he supported in order to avoid high effective marginal rates for low-income earners – the so-called “poverty trap” which reduces incentives to earn more.
Stéphane
Jim Glass
Dec 1 2022 at 11:15pm
Yes. The EIC was a sort of political step child to Friedman’s negative income tax (NIT). It’s creators deemed it so in spirit. There are very big differences of course. Friedman’s NIT itself too required very steep marginal effective tax rates unless the full “negative income” amount was implausibly high, so that’s not it.
The big difference is the EIC being employment based — one has to work to get one’s “welfare” (good), and it reduces the cost of hiring to the employer (good), incentives which expand employment and get people who formerly would have been sitting at home collecting welfare checks into the workforce.
The EIC has had so much bipartisan support and grown so much over the decades because it has been a big success compared to the alternative “hand-out” model welfare programs of the ’60s and ’70s which preceded it, and which it has largely replaced. They destroyed employment incentives, while the EIC creates them. And you want problems with waste, political manipulation, fraud, corruption? Check out their histories.
So let’s be fair to the EIC. It’s easy to criticize anything if one doesn’t look at the alternatives.
The EIC was such a visible and clear improvement over its alternatives that its been copied by countries around the globe. So if you don’t like bureaucratic tax system waste, OK, but give the EIC credit for what it has accomplished.
vince
Dec 1 2022 at 11:34pm
Or get rid of all the income transfer programs and just do one universal basic income. David Henderson wrote an article recently about it. The amount of transfer to lower income households is staggering, especially when one adds the ACA insurance subsidies.
https://www.econlib.org/myths-of-economic-inequality/
David Henderson
Dec 2 2022 at 1:03pm
Actually, Vince, a UBI is WAY more expensive. I wrote an extensive piece on it a few years ago. If you’re interested, I’ll post the link.
vince
Dec 2 2022 at 7:02pm
A Cato report estimated welfare at about $1 trillion, back in 2012. Using rough numbers, today there are about 120 million households. The poverty level for a couple is about $17,000. That’s $2 trillion for UBI, and some of that could be recovered through progressive tax rates.
I saw your article, Henderson’s Case Against a UBI. It discussed the costs more than the benefit, the main one being incentives to work. For many in poverty, the cliff effect discourages them from working–it’s just not worth it without a high-paying job. I’ve worked with people who refused extra hours because it would disqualify their aid. They’re trapped in poverty. UBI could even eliminate the need for minimum wage laws.
Stéphane Couvreur
Dec 2 2022 at 4:17am
But don’t the NIT and the EIC lower the effective marginal tax rate compared with what it would be under the current progressive income tax without the EIC? David Henderson’s seems to say that the EIC increases the marginal tax rate. I don’t see how…
David Henderson
Dec 2 2022 at 9:28am
The EITC lowers the marginal tax rate in the initial range of income and raises it in the income range of the phaseout.
Stéphane Couvreur
Dec 2 2022 at 12:50pm
Thanks
Scott Sumner
Dec 2 2022 at 1:50am
Jim and Vance, Thanks for that info.
Johnson85
Dec 2 2022 at 5:17pm
I’m sympathetic to the arguments against the EITC, but the problem is that simply reducing the welfare state does not appear to be a winning political position. And the EITC seems to be one of the least damaging welfare programs, so it has historically I think been a politically manageable way to stop more damaging and wasteful welfare programs from expanding.
Some people need to keep arguing from a position of principles, but we also need something politically practical that at least moves the needle in the right direction. I don’t know what that would be right now. At the very least, it seems like maybe we could tie EITC, SNAP, and Section 8 vouchers together as far as income and benefits go. Seems crazy to me that our welfare programs are so disjointed. Don’t think that would do a ton but would at least reduce the implicit marginal tax rate and maybe result in a more equitable distribution of benefits.
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