In the annual State of the State address delivered in January 2014, Illinois Gov. Pat Quinn announced that he would push for a doubling of the Earned Income Tax Credit, or EITC, over the next five years. Currently, the state EITC is worth 10 percent of the federal EITC and would climb to 20 percent under Quinn’s plan. The governor bills this change to the EITC as a benefit to working families in Illinois.
Unfortunately, expanding the EITC does not necessarily provide the tax relief that struggling working- and middle-class families need. Rather, expanding this tax credit often discourages most people eligible for the tax credit from earning more money and advancing their careers.
Instead of expanding the EITC, Illinois would be better off using funds to help all taxpayers; lawmakers could lower the personal income tax rate or implement a real increase in the personal exemption, beyond simply adjusting for inflation. Households with incomes of less than $50,000 claim more than half of all exemptions, so a higher personal exemption would especially benefit lower- and middle-income families.
To understand why this is the case, this analysis will examine what economists call the “marginal” tax impact of the EITC. Put simply: After reaching a certain level of annual pay, it is less advantageous for an individual to increase his income because every additional dollar earned will come with a higher price tag in the form of lower EITC benefits. As such, this study calculates the “effective marginal tax rate,” or EMTR, that people will face under the EITC. Keep in mind that the Illinois EITC is an add-on to the federal EITC, so the analysis first begins there.
Table 1 shows the tax parameters in order for a married couple to qualify for the federal EITC in 2013 based on the number of children in the household. There are three distinct phases of the EITC based on the person’s income: the phase-in, the plateau and the phase-out. If you make less than $51,567 as a married couple, you can potentially earn the EITC.
During the phase-in period, a household accrues EITC benefits for every dollar earned by working. If the EITC amount exceeds the couple’s federal income tax liability, the taxpayer will receive a check from the government in the amount of the EITC (technically called “refundable”). For example, a married couple with three children can qualify for a credit of up to $6,044 when their income reaches $13,400. As a result, in the phase-in they are facing a -45.1 percent EMTR—every $1 earned increases the EITC benefit by $0.45.
During the plateau period, between $13,400 and $22,900 for this married couple, they would still continue to qualify for the maximum EITC of $6,044. As a result, in the plateau the couple faces a 0 percent EMTR since the value of the EITC does not change.
During the phase-out period, this married couple would begin losing EITC benefits worth $0.21 for every dollar earned. The phase-out begins at $22,900 in income and ends when they earn more than $51,567. As a result, in the phase-out they are facing a 21.1 percent EMTR.
Overall, the federal EITC only encourages work effort for this family of five during the phase-in stage, where the EMTR is -45.1 percent. The taxpayer is, at best, indifferent during the plateau stage, where the EMTR is 0 percent, and is actually penalized during the phase-out stage with an EMTR of 21.1 percent. Since the income range of the phase-out is twice as large as the income range of the phase-in, the federal EITC is spreading more work disincentives than incentives.
The state EITC, since it is an add-on to the federal EITC, only serves to exacerbate the work disincentives. The current state EITC is worth 10 percent of the federal EITC, which, for the same married couple with three children, creates an EMTR during the phase-out of 23.2 percent (vs. 21.1 percent under the federal EITC alone). At the proposed state EITC worth 20 percent of the federal EITC, the EMTR during the phase-out will increase to 25.3 percent. Expanding the state EITC will only serve to further discourage work.
Compounding the work disincentive related to the phase-out of the EITC are other federal, state and local taxes, and other government welfare programs.
These other factors increase the EMTR faced by people in the EITC’s phase-out range. In addition to the income tax itself, other taxes such as the payroll, sales and excise taxes add to the tax burden on each additional dollar earned while, at the same time, the money received from government welfare programs begins to phase out. In fact, a recent, more comprehensive estimate by University of Chicago economist Casey Mulligan found that the EMTR will climb to more than 50 percent once ObamaCare is added into the equation.
Additionally, the EMTR varies significantly based on the number of children in the household. A married couple with no children faces a work penalty of 8.5 percent, but with one child the penalty nearly doubles to 17.6 percent. The EMTR for two or three children is even higher at 23.2 percent. Ironically, the EITC actually penalizes larger families with a higher work penalty.
Finally, the Illinois state tax code has other tax credits similar to the EITC, such as the property tax credit and the K-12 Education Expense Credit, which also create effective tax rates that are very different from the statutory tax rate. As shown in Chart 1, in 2011 the effective tax rate for taxpayers earning less than $25,000 was only 0.93 percent, while the tax rate for those earning more than $200,000 was 3.69 percent—despite everyone paying a flat, statutory tax rate of 5 percent. Some people have long clamored for a “progressive” income tax with higher statutory tax rates for higher income, but thanks to these tax credits Illinois already has a de facto progressive income tax.
Overall, many working families in Illinois will find themselves trapped by the EITC rather than helped by it. Expanding the state EITC will only dig the hole deeper for those people working desperately to better their economic situation. These families would be better off not using the money to expand the EITC, as Quinn suggests, but instead lowering the personal income tax rate or increasing the personal exemption for all taxpayers.
1 For a history of the EITC see: Hall, Arthur P. and Moody, J. Scott, “Growth of the Earned Income Tax Credit,” Tax Foundation, Special Report, No. 53, September 1995, http://taxfoundation.org/sites/taxfoundation.org/files/docs/7b76310a7234556cb06bdc66974385bb.pdf
2 Mulligan, Casey, “How Obamacare Wrecks the Work Ethic,” The Wall Street Journal, Oct. 2, 2013. http://online.wsj.com/news/articles/SB10001424127887323623304579061423122639430