Options for a State Earned Income Tax Credit

Options for a State Earned Income Tax Credit MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • DECEMBER 18, 2014 AN LAO REPORT 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY In June 2014, the Legislature directed our office to prepare a report on options for implementing a state earned income tax credit (EITC). This report fulfills that requirement. (While this report discusses options for a state EITC, it does not make recommendations on the topic.) The Federal EITC Reduces Poverty and Encourages Work, but Improper Payments are a Problem. The federal EITC is an income tax credit that increases the after-tax income of low-income workers. Evidence from academic studies suggests that the federal EITC causes paid work participation among single mothers to be higher than if the EITC did not exist. It also reduces poverty to some extent for tens of millions of people. Evidence from the federal Internal Revenue Service (IRS) also suggests that improper federal EITC payments are an issue. Roughly a quarter of federal EITC payments go to people who are in fact eligible for a smaller payment or are not eligible for the EITC at all. Most State EITCs “Piggyback” on the Federal EITC. About half of the states provide their own version of the federal EITC. Most state EITC programs piggyback on the federal EITC, meaning that they are set up such that a taxpayer’s state EITC benefit is a fixed fraction of his or her federal EITC benefit. Options for a State EITC. The structure of a state EITC would depend on the state’s policy goals. We identify potential policy goals, and present three options that are consistent with these goals for the Legislature’s consideration, as described below. These options are best viewed as building blocks that could be mixed and matched to meet the Legislature’s objectives. • Piggyback on the Federal Credit. The first option would piggyback on the federal EITC, matching 15 percent of the federal credit. This option would provide a relatively small benefit to a large number of people and would likely be simpler to administer. This option would encourage both part-time and full-time employment. • Focus on Working Families With the Lowest Incomes. The second option would be available only to federal EITC filers with very low earnings. This option would provide a larger benefit to a smaller number of people and could be more difficult to administer. This option would also encourage work participation, focusing on part-time rather than full-time employment. • Supplement Federal Credit for Childless Adults. The third option would build on the federal EITC benefit for filers with no dependent children, who currently receive much smaller credits than filers with children. This option would similarly provide a larger benefit to a smaller population and could be more difficult to administer. This option would also encourage work participation, focusing on part-time rather than full-time employment. Potential Implementation Issues Include Addressing Improper Payments and Outreach. Regardless of the structure of a state EITC, the state would need to consider what level of resources should be devoted to limiting improper payments and to encouraging eligible workers to claim the credit. www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO REPORT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT INTRODUCTION The EITC is a provision of the federal income to prepare a report with options for a state EITC tax code that allows taxpayers with total income and analysis of the costs, benefits, and trade-offs below a certain level to reduce their tax liability associated with these options. This report fulfills by an amount that depends on their “earned that requirement. A list of stakeholders we income,” which primarily includes wages and consulted in the course of developing this report self-employment income. (Earned income does not can be found in Appendix 1. include such sources as interest income, retirement In this report, we first discuss the structure income, or unemployment benefits.) Many states and effectiveness of the federal EITC. This is have EITC provisions in their own income tax followed by a brief discussion of current state-level laws which supplement the federal EITC and in EITCs. We then examine the key decisions state most cases are patterned after the federal EITC. policymakers would face in designing an EITC for California does not have its own EITC. In June California and present some options. We conclude 2014, in its Supplemental Report of the 2014-15 with some general implementation considerations Budget Package, the Legislature directed our office that would arise regardless of how a state EITC were structured. BACKGROUND ON THE FEDERAL EITC History. The federal EITC was established taxable income and then applying the relevant in 1975. Initially, it was intended to compensate tax rates. This is in contrast to a deduction, which lower-income workers for the federal payroll is used to reduce taxable income before rates are taxes that fund the Social Security and Medicare applied. The EITC is a “refundable” credit, meaning programs, and the amount of the credit was that if the amount of a taxpayer’s EITC is greater limited to the taxpayer’s payroll tax liability up than his or her liability before applying the credit, to a certain income level. Over time, its purpose then the federal government actually owes the became to increase the rewards to paid work and taxpayer money for that year. For example, if a reduce poverty. It was expanded significantly in person’s tax liability excluding the EITC is $200 1986, 1990, and 1993 to the point where its benefits and the calculated EITC amount is $500, then the greatly exceed payroll tax liabilities for most final liability including the EITC is negative $300: beneficiaries. The EITC has become a major federal the federal government owes the taxpayer $300. In antipoverty program with a total cost of $64 billion contrast, if the credit were “nonrefundable,” the in 2012, spread over nearly 28 million tax returns. taxpayer’s liability could not be reduced below zero even if the EITC amount were greater than the Structure of the Federal EITC liability excluding the EITC. EITC Can Reduce Liability Below Zero. As the As Income Increases, Credit Amount Rises, name suggests, the EITC is a federal tax credit. This Then Phases Out. The EITC benefit schedule means that its value is used to reduce a taxpayer’s depends on the number of dependent children final federal income tax liability, after computing the taxpayer has and on whether they are filing a www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO REPORT single or joint tax return. In every case, as shown in Taxpayers With Dependents Get Bigger Figure 1, the EITC has: Benefit. The setup of the EITC for single and jointly filing (married) taxpayers for tax year 2014 • A “phase-in” range of earned income where is outlined in Figure 2 and displayed graphically in the total EITC amount steadily increases Figure 3. The credit amount is considerably bigger with every dollar earned. For the example for parents than it is for childless filers. The increase shown in Figure 1, the taxpayer receives in the credit for the second child is far smaller than 40 cents in credit for each dollar earned over for the first, the increase for the third child is far this range. smaller than for the second, and there is no increase • A “flat” range where the taxpayer gets the in the EITC benefit for any child beyond the third. maximum possible EITC amount for their For joint filers, the amount of earned income at filing status and number of dependents, and which the EITC begins to phase out is higher (by additional earned income does not affect $5,430 in 2014). This is consistent with overall federal the amount of the EITC benefit. For the income tax policy that includes broader income example shown in Figure 1, the taxpayer brackets and bigger standard deductions for joint Graphic Sign Off would receive the maximum benefit of filers than for single filers. $5,460 over this range. The following exSamecprleest ailrluystrate how the phase-in and phase-Aount apleyrscetntages shown in • A “phase-out” range where the total EITC Figure 2 would be apMplPieAd to calculate the EITC in amount declines steadily with every dollar 2014 for different hoDuseehpouldtys. earned. For the example shown in Figure 1, • A single mother with two dependent the taxpayer would lose about 21 cents in children has $12,000 of earned income, credit for each dollar earned over this range. which is less than the endpoint of the phase-in range. She receives 40 percent of her income, or Figure 1 $4,800, as an EITC benefit. Basic Structure of the Federal EITC • Another single mother Credit Amount, Single Filer With Two Dependent Children, 2014 Tax Year with two children has $6,000 $14,000 of earned income. Because her income is within 5,000 the flat range, she receives 4,000 the maximum EITC benefit of $5,460. If her income were 3,000 $17,000, her EITC would 2,000 still be $5,460 as her income Phase-In Flat Phase-Out would still be within the flat Range Range Range 1,000 range. • A married couple with 10,000 20,000 30,000 40,000 $50,000 Earned Income one child has $38,000 of 6 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #140567 Template_LAOReport_mid.ait AN LAO REPORT earned income. Their EITC benefit is $950. As individuals who receive public assistance increase Their maximum possible benefit would be their earnings, these increased earnings are offset $3,305, but because their income is within by reduced assistance. This reduces the individual’s the phase-out range their EITC is reduced incentive to work and to increase earnings. by roughly 16 cents for every Figure 2 dollar of income Federal Earned Income Tax Credit Provisions above $23,260, 2014 Tax Year the endpoint of Number of Dependents the flat range. 0 1 2 3+ Maximum EITC benefit $496 $3,305 $5,460 $6,143 Federal EITC Affects Endpoint of phase-in range 6,480 9,720 13,650 13,650 Work Incentives Single filers only: Work Incentives Endpoint of flat range 8,110 17,830 17,830 17,830 Endpoint of phase-out 14,590 38,511 43,756 46,997 Determined by Earnings Graphic Sign Off range Opportunities and Public Joint filers only: Secretary Assistance Participation. Endpoint of flat range 13,540 23,260 23,260 23,260 Analyst Endpoint of phase-out 20,020 43,941 49,186 52,427 An individual’s decision range MPA whether to work and for Phase-in percentagea 7.65% 34.00% 40.00% 45.00% Deputy how many hours depends Phase-out percentageb 7.65 15.98 21.06 21.06 a on many factors, including The phase-in percentage indicates the number of cents by which a worker’s total EITC benefit increases for each dollar the worker earns within the phase-in range. the wages that can be b The phase-out percentage indicates the number of cents by which a worker’s total EITC benefit declines for each dollar the worker earns within the phase-out range. received from available work opportunities, the amount of those earnings that Figure 3 will be lost to taxation, and EITC Benefit Schedule how the amount of any public Credit Amount for Single Filers, 2014 Tax Year assistance the individual receives may change due $7,000 to additional earnings. 6,000 Three or More Dependents Participation in public 5,000 assistance programs matters Two Dependents for work incentives because 4,000 means-tested programs— 3,000 One Dependent meaning those that are available only to individuals 2,000 and families with income 1,000 and assets below certain No Dependents levels—generally phase out 10,000 20,000 30,000 40,000 $50,000 the amount of assistance Annual Earned Income provided as earnings increase. www.lao.ca.gov Legislative Analyst’s Office 7 ARTWORK #140567 Template_LAOReport_mid.ait AN LAO REPORT Take-Home Resources From Additional the household’s additional take-home resources Earnings Depend on Earnings Level. Figure 4 would be just under $70. In other words, of the displays the amount of monthly take-home $100 in new gross income, the family would keep resources an individual would receive if he or she just over two-thirds. Further $100 increases in increased monthly earnings by $100 increments. monthly earnings would result in somewhat less in This represents the effective benefit to an individual additional take-home resources, but generally not of increasing earnings, after accounting for less than $45 for each $100 increment of additional earnings lost to taxes and reduced public assistance. earnings. One notable exception is when monthly For example, suppose a single parent with two earnings are increased from $2,200 to $2,300, at children receives major forms of public assistance, which point the household is estimated to actually including cash aid and welfare-to-work services lose resources. This results from our assumption through the California Work Opportunity and that the household would become inelGigirbalep fohri c Sign Off Responsibility to Kids (CalWORKs) program, health coverage through Medi-Cal at this point Secretary food assistance through the CalFresh program, and would begin paying monthly premiums for and health coverage through the California health insurance (as reduced by federaAl nsuablysisdties Medical Assistance (Medi-Cal) Program. As provided through the federal Patient PMroPteAction shown in the figure, if the parent increased his and Affordable Care Act). In general, Dthee plouwtyer the or her earnings from nothing to $100 per month, amount of take-home resources available from a and is assumed not to claim the federal EITC, given increase in earnings, the less the incentive an individual has to increase earnings. Figure 4 Change in Take-Home Resources From Each Additional $100 in Monthly Earnings $120 100 Including Federal EITC 80 60 40 Excluding Federal EITC 20 0 -20 -40 -60 500 1,000 1,500 2,000 2,500 3,000 3,500 $4,000 Monthly Earned Income Note: Includes effects of CalWORKs, CalFresh, the premium costs of health coverage either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Assumes a $10 hourly wage. Tax rates and benefit amounts are for the 2014 tax year. 8 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #140567 Template_LAOReport_large.ait AN LAO REPORT Under Federal EITC, Take-Home Resources work decisions. For example, suppose a parent is Increase at Lower Earnings Levels, Decrease at currently out of the labor force and considering Higher Levels. Unlike many public assistance whether to take employment for 20 hours per week programs, the federal EITC benefit is structured at $10 per hour. If this parent is enrolled in the to increase with earnings over a certain range of same major public assistance programs described income. For example, if the same single parent earlier, he or she would need to balance the benefit were to increase monthly earnings from nothing of increased earnings (roughly $900 dollars per to $100 and claim the federal EITC, the increase in month, assuming 4.33 weeks per month) against take-home resources would be nearly $110. In other taxes and the loss of public assistance benefits. words, the household would receive more than the Assuming the parent has two dependent children amount they earned, notwithstanding the effect of and does not claim the federal EITC, we estimate taxes and declining public assistance benefits. As that about half of the increase in gross income described earlier, the federal government pays the would be offset by increased payroll and income individual a percentage on top of their earnings. taxes and reduced public assistance. In other words, This increases the person’s incentive to work. For even though the nominal wage of the employment further $100 increases in earnings, the federal EITC opportunity is $10 per hour, these offsetting continues to increase the amount of take-home reductions mean the individual would effectively resources received above what they would have receive an average wage of only $5.41 per hour. been without the EITC, until the end of the credit’s However, the federal EITC provides significant phase-in range is reached at about $1,200 of resources as earnings increase. Its benefit makes monthly earnings. For monthly earnings between up for most of the loss from taxes and other $1,300 and $1,500, the federal EITC has no effect public assistance programs, increasing the average on incremental take-home resources, meaning that effective wage for the employment opportunity to the parent’s incentives to increase earnings are the $9.56 per hour. Thus, the federal EITC substantially same as they would have been without the EITC. increases work incentives above what they would be This is because the EITC’s value does not change otherwise. Figure 5 (see next page) displays several over this flat range. For increases in monthly other examples of how different employment earnings to $1,500 and beyond, the EITC begins decisions are affected by the federal EITC. to phase out, meaning that additional take-home Does the Program Work? resources from additional earnings are less than they would have been without the EITC. Over this EITC Directly Reduces Poverty by Providing range, the EITC reduces the parent’s incentive to Resources to Low-Income Households. By work. providing additional resources to low-income Work Incentives Over Discrete Intervals individuals and families, the EITC directly reduces of Hours Worked. Figure 4 shows the changes the number of individuals that are considered to in incentives individuals would face if they had be in poverty (poverty being defined as having the flexibility to make small changes in their resources that are less than established poverty earnings levels. It may be useful to consider the thresholds). In 2012, over 3.2 million Californians work incentive effects of the federal EITC over filed for the federal EITC. The combined value of discrete intervals of work hours, as this may these claims was nearly $7.3 billion (including both more accurately reflect individuals’ available reduced income tax liability and direct refunds). www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO REPORT We estimate that roughly 10 million Californians or flat ranges of the federal EITC) and those were in a household that benefited from the federal who have relatively low initial skill levels. The EITC. Of these 10 million, we estimate that the national employment rate of single mothers federal EITC kept roughly 750,000 individuals increased from 73 percent in 1984 to 85 percent out of poverty, as defined by the U.S. Census in 2003, and numerous academic studies suggest Bureau’s Research Supplemental Poverty Measure that much of this increase was due to several (SPM), described in greater detail in a nearby EITC expansions over that period. Although box. This reduces the state’s SPM poverty rate conceptually the EITC should be expected to to 23.4 percent—2 percentage points lower than decrease work effort among individuals in the it would have been absent the federal EITC. phase-out range, evidence suggests that this (A detailed description of our methodology to effect is minor in practice. Evidence does suggest estimate poverty impacts can be found in Appendix a small reduction in work participation and 2.) This direct reduction to poverty accounts only hours worked among the lower-earning adults in for the additional resources received from the two-earner households, typically married women. EITC—it does not account for additional resources EITC Linked to Improved Child Educational received by families because of increased labor and Health Outcomes. Recent academic studies market participation or work effort, as described have established a link between the increased below. As a result, this estimate understates the family resources provided by the federal EITC federal EITC’s full poverty impact. and both short- and long-term improvements The EITC Encourages Work Among Single in children’s educational outcomes. Increased Parents, Slightly Discourages Work Among resources from the federal EITC have also been Second Earners. Conceptually, the federal EITC linked to improved infant health outcomes, such greatly increases a single parent’s incentive to as reduced incidence of low birth weight. A listing work, especially if the available work is part of some research articles relating to EITC effects time or for low wages. The real world evidence is included in Appendix 3. is consistent with that, suggesting that the EITC Interaction With Other Antipoverty Policies spurs an increase in work effort among single mothers. This effect is particularly prominent Minimum Wage Changes Can Affect EITC for relatively low-earning workers (those whose Benefits. Both the minimum wage and the federal earnings would place them in the phase-in EITC are broadly conceived as antipoverty policies intended to Figure 5 increase the rewards to Federal EITC and Changes in Work Incentives paid work. These two For a Single Filer With Two Dependent Children policies interact, as we Weekly Hours of Work Average Effective Hourly Wage discuss below. Before After Without Federal EITC With Federal EITC Change California’s minimum wage is set to rise from 0 20 $5.41 $9.56 +$4.15 20 40 3.65 4.23 +0.58 $9 to $10 per hour at 0 40 4.53 6.90 +2.37 the beginning of 2016. Note: Includes effects of CalWORKs, CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Assumes a Evidence suggests that $10 hourly wage. Tax rates and benefit amounts are for the 2014 tax year. increasing the minimum 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT The Research Supplemental Poverty Measure Background on Poverty Measurement. Poverty is often defined as the condition of having insufficient resources to achieve a minimum standard of living. In general, measuring poverty requires (1) counting the resources that a household has available for meeting basic needs and (2) comparing these resources against a threshold that approximates the cost for that household to achieve the minimum standard of living. If a household’s resources are less than the poverty threshold, all members of the household are considered poor. Official Poverty Measure (OPM) Was Developed in Early 1960s. The federal government’s primary poverty measurement methodology, which we refer to as the OPM, has been in place since the early 1960s. The OPM defines resources as pre-tax cash income, which includes many forms of income including earnings and some government transfer payments (like Social Security retirement benefits), but excludes the effect of government transfers that take place through the tax system (such as the federal earned income tax credit) and some other major means-tested assistance programs (most notably CalFresh food assistance). Poverty thresholds under the OPM are defined as three times the cost of a low-cost food budget in the 1950s, adjusted annually for inflation. (Surveys at that time indicated that low-income households spent roughly one-third of their resources on food.) These thresholds vary by family size and composition, but are identical for similar families across the continental U.S. Research Supplemental Poverty Measure (SPM) Differs From OPM. In 2011, the U.S. Census Bureau began publishing a second set of poverty statistics under a new methodology referred to as the SPM. The SPM methodology uses a more comprehensive resource definition that includes, among other things, the effect of income taxes paid and credits received, as well as other major means-tested assistance programs. Unlike OPM poverty thresholds, SPM poverty thresholds are adjusted for the household’s housing circumstances (including the regional cost of housing). As a result, SPM poverty thresholds vary significantly among states, and are generally higher in California than in most other states (due to California’s relatively high housing costs). The SPM Allows for Estimating Poverty Effects of Antipoverty Policies. Because the SPM resource definition is comprehensive enough to include most government transfer programs, the SPM methodology can be used to estimate the impact that different policy choices may have on the number of individuals in poverty. Throughout this report, we provide estimates of the number of individuals moved out of poverty that were calculated using the SPM methodology on survey data made available by the U.S. Census Bureau. We note that the SPM methodology, and our estimates, do have some limitations that are described in Appendix 2. These estimates are intended only to provide a rough sense of the magnitude of potential effects in order to facilitate comparisons among competing policy options, but are subject to uncertainty and should be interpreted with caution. www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO REPORT wage may reduce employment somewhat among two months after they are received would be people who were previously making less than the counted against the CalWORKs asset limit, which new minimum wage. The remaining workers who is $2,000 for most families, unless the benefits were previously below the new minimum wage are placed in a restricted account or a qualifying would benefit from higher wages, which would retirement or educational savings account. As increase their earned income under the EITC. a result, CalWORKs recipients who claim the The effect of a minimum wage increase on federal EITC generally must either spend the the total amount of benefits provided through benefits within two months of receiving them, the federal EITC is not immediately clear, as place the benefits in an approved account, or be workers could see their EITC payments rise or discontinued from CalWORKs assistance. Should fall depending on their family status and on how the state adopt its own EITC, it could choose many hours they work. For single parents, the whether state EITC benefits would be considered phase-out range starts at about $18,000 a year, as income and assets. which is less than the $20,000 a worker would Issues With Improper Payments earn by working full time (50 weeks at 40 hours per week) at $10 an hour. A number of full-time Improper Payments a Common Problem. or near-full-time workers would thus move The federal EITC has historically had a high level into or further down the phase-out range as a of improper payments to people who claimed a result of the minimum wage increase, and their bigger credit under the EITC (or in rare cases, a EITC payments would decline. Minimum wage smaller credit) than they were in fact eligible for. workers in two-income households would also Some incorrect claims stem from honest mistakes likely see lower EITC benefits, as they are likely in reporting income or confusion about which to be within the phase-out range even before parent gets to claim a child as a dependent, but the minimum wage is increased. On the other others are a result of deliberate fraud. The IRS hand, single parents with wages below the new estimates that nearly half of EITC returns from minimum wage who work less than full time and/ 2006 to 2008 claimed a credit amount larger than or for less than a full year would likely start out the filer was in fact eligible for, while less than within the phase-in range, and thus would see a 10 percent of returns claimed an amount that was bigger EITC benefit if the minimum wage were too small. increased. The IRS estimates that the dollar value of EITC Has Little Impact on Eligibility for improper claims was between 29 percent and Major Public Assistance Programs. Because the 39 percent of total claims, or between $14 billion substantial resources made available through the and $19 billion annually from 2006 through federal EITC could potentially affect eligibility 2008. Of this amount, they estimate that (among for means-tested public assistance programs, other things) $7 billion to $10 billion of improper federal and state law require that federal EITC claims were due to misreporting the number of benefits cannot be considered when determining qualifying dependents, $3 billion to $4 billion eligibility for many programs. However, there from misreporting self-employment income, are exceptions. One example is the CalWORKs and roughly $1 billion from misreporting wage program. Under current state law, federal EITC income. A reference to a recent IRS analysis on benefits that the recipient saves for longer than EITC compliance can be found in Appendix 3. 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT These estimates do not account for IRS efforts and 26 percent in federal fiscal year 2013, or to prevent or recover improper payments. After between $13.3 billion and $15.6 billion (reflecting accounting for such enforcement efforts, the growth in total EITC payments). overpayment percentage was between 22 percent STATE-LEVEL EITCS As of tax year 2014, 25 states and the District of Past Legislative Proposals for a California Columbia had EITC provisions in their own income EITC. Bills to create a state EITC in California have tax laws. As shown in Figure 6, the vast majority of been introduced on several occasions. As shown these states piggyback on the federal EITC, meaning in Figure 7 (see next page), the majority of past that a taxpayer’s state EITC benefit is simply a fixed Figure 6 percentage of his or her federal EITC benefit. For State EITCs in 2014 example, in Vermont a taxpayer’s state EITC benefit State EITC as is always 32 percent of his or her federal EITC Percent of benefit. Thus, if the taxpayer’s federal EITC were State Federal EITC Refundable? $1,000, his or her Vermont EITC would be $320—for District of Columbia 40.00% Yes a combined EITC amount of $1,320. In most states, Vermont 32.00 Yes New York 30.00 Yes the state EITC is refundable just as the federal EITC. Connecticut 30.00 Yes Variations in State EITC Design. In this Maryland 25.00 Yesa section, “percent” means the percentage of the Delaware 20.00 No New Jersey 20.00 Yes taxpayer’s federal EITC benefit that the state allows Virginia 20.00 No as an additional credit for the same year. Two Kansas 17.00 Yes states have credits that are partially refundable: Massachusetts 15.00 Yes Iowa 14.00 Yes Maryland gives taxpayers the option of taking Illinois 10.00 Yes either a 25 percent refundable credit or a 50 percent Nebraska 10.00 Yes nonrefundable credit, but not both. Rhode Island New Mexico 10.00 Yes Ohio 10.00 No allows up to a 25 percent credit, but just 15 percent Indiana 9.00 Yes of this amount (3.75 percent of the federal credit) Oregon 8.00 Yes is refundable. Two states deviate from the standard Michigan 6.00 Yes Maine 5.00 No practice of making the state EITC a flat percentage Oklahoma 5.00 Yes of the federal EITC: Minnesota’s EITC phases in Rhode Island 3.75 Yesb and out at different earned income levels than the Louisiana 3.50 Yes federal EITC and does not provide a higher benefit States With Variable EITC Percentages: Minnesota 24-37%c Yes for filers with three or more dependents, effectively Wisconsin 0-34 Yes matching between 24 percent and 37 percent of States With EITCs in Law but Not Currently in Effect: the federal credit for lower levels of earned income. Colorado 10% Yes Washington 10 Yes Wisconsin has no state credit for childless workers, a Maryland also provides taxpayers the option of a 50 percent nonrefundable credit. 4 percent for one child, 11 percent for two children, b Rhode Island allows up to a 25 percent credit, but just 15 percent of this amount (3.75 percent of the federal credit) is refundable. and 34 percent for three or more. c Over phase-in and flat ranges. www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO REPORT Figure 7 Legislative Proposals Considered, But Not Passed, to Create a California EITC Legislative Session Bill (Author) Proposed State EITC Structure 1999-00 AB 1854 (Cedillo) Fully refundable credit equal to 15 percent of the amount of the filer’s federal EITC. 1999-00 SB 1421 (Solis) Same as above. 2001-02 AB 106 (Cedillo) Same as above. 2003-04 SB 224 (Cedillo) Same as above. 2007-08 AB 21 (Jones) Nonrefundable credit equal to 4 percent of taxable income for low to moderate income taxpayers, up to a maximum of $200. 2011-12 AB 1196 (Allen) Fully refundable credit equal to 15 percent of the amount of the filer’s federal EITC. Refundable portion of the credit would have been limited to the amount of revenues generated by a proposed income tax surcharge. 2011-12 AB 1974 (Dickinson) Fully refundable credit equal to 15 percent of the amount of the filer’s federal EITC. 2013-14 SB 1189 (Liu) Nonrefundable credit equal to 15 percent of the amount of the filer’s federal EITC. proposals would have created a fully refundable for a state EITC, such as state EITCs that do not state EITC equal to 15 percent of the amount of piggyback on the federal credit amount or that a tax filer’s federal EITC. More recently, some are nonrefundable. None of these proposals were legislation has considered alternative structures adopted by the Legislature. OPTIONS FOR A CALIFORNIA EITC Were the state to enact an EITC, its design • Encourage Work. As mentioned earlier, would depend on the state’s overarching policy the federal EITC appears to noticeably goals for the credit. Below, we outline some increase participation in paid work among possible policy goals for the Legislature’s single mothers. There is an argument that consideration and describe the key decision encouraging work is a legitimate policy points in designing a state EITC to meet one or goal in its own right. Work experience another policy goal. enables people to develop the skills, habits, and connections that can help them Possible Policy Goals eventually move into higher-paying jobs, The goals of a potential state EITC would and this is especially valuable for EITC presumably align with the federal program’s goals recipients who tend to be young. of alleviating poverty and encouraging work. • Supplement Resources of Working The state could also consider additional policy Families at Specific Income Levels. The objectives. Below, we describe three possible policy federal EITC is widely understood as an objectives. antipoverty program, and as mentioned 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT earlier the evidence suggests that poverty to administer. It would lead to a lower number of (however measured) would be higher new state returns than a refundable credit would, without it. as eligibility would be restricted to people who are already required to file a state return. The • Fill In Perceived Gaps in the Federal disadvantage of a nonrefundable credit is that it EITC. By design, the federal EITC provides would reach only the highest-income people who a much bigger benefit for households are currently eligible for the federal EITC. with children under the age of 18 than Because of the design of California’s income it does for childless singles or couples. If tax, a nonrefundable credit would have essentially state policymakers view this disparity as no impact here. State tax rates applicable to the inappropriate, they could focus a state lowest brackets of taxable income are very low: for EITC on childless adults. a single parent who files as a head of household, the first $15,508 of income (after subtracting out the Key Decision Points in Designing a State EITC standard or itemized deductions) is taxed at just Relationship to Federal Credit. Most states use 1 percent and the next $21,235 at just 2 percent. On the federal EITC as a starting point and set up their top of that, any tax liability computed that way is own EITCs as a flat percentage of the taxpayer’s reduced by the state’s personal exemption credits federal credit amount. This is administratively of $108 for each adult and $333 for each dependent simple, as it often adds just a single line to the child. As a result, the population of single parents state’s tax return with no need for the new forms who both qualify for the federal EITC and have that are usually required for new state tax credits any state income tax liability is limited to people or deductions. These state credits are restricted to with just one dependent child who make between people who actually took the federal credit, so the $37,788 and $38,511. Moreover, single parents state does not have to set up a separate process to within this narrow income range have state tax determine whether taxpayers are eligible for the liabilities of less than $15 per year. The situation credit. One downside is that if the state conforms is similar for childless adults and for couples with to the federal EITC, it foregoes the possibility of children. Because a nonrefundable credit would designing a credit more specifically tailored to benefit such a narrow range of people and for such the state’s policy goals. For example, the federal a small amount, we do not believe that it merits EITC is restricted to people who have valid Social consideration. Security numbers. If the Legislature wished to Total Level of Funding. A state EITC would provide benefits to residents who do not have Social affect the state’s budget just as any other spending Security numbers, it would not be able to simply program or tax credit or deduction does. One piggyback on the federal credit. decision point would be how much money the Refundability. Some states offer nonrefundable state wished to commit to a state EITC. For any credits that cannot reduce a taxpayer’s liability given dollar amount the state is willing to commit below zero. Under a nonrefundable credit, only to an EITC, the state faces a trade-off between the those filers whose liability in the absence of number of people that would benefit from an EITC the EITC would be greater than zero would be and the size of the benefit that each recipient could eligible for the EITC at all. The advantage of a get. Whatever EITC structure the state chose, it nonrefundable state credit is that it is far easier could be modified initially or over time to fit within www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO REPORT a target funding amount consistent with legislative • What Are Potential Effects on Work priorities and available budgetary resources. Incentives? We discuss how each of Target Populations. As discussed above, the the options would affect the way that state could deviate from the federal EITC structure low-income households’ total resources if it wants to target the benefits in a different way. change as they increase their work For example, the state could enact a state EITC participation. We focus on common that would modify the federal EITC’s disparities incremental changes in work participation, in benefits between parents and childless workers. such as moving from no employment to The state could also potentially target benefits to working 20 hours per week, or moving workers at particular earnings levels. from 20 hours per week to 40 hours per week. LAO O ptiOns fOr L C egisLAtive OnsiderAtiOn • What Is the Potential Administrative Burden? We describe, at a high level, The decision points discussed above could lead how the different options compare in to many different possible structures for a state terms of complexity and administrative EITC, and its eventual form would depend on the burden both for the state and for eligible Legislature’s priorities and objectives. To facilitate tax filers. We also provide estimates of the Legislature’s consideration of priorities, we total administrative costs developed by provide three potential state EITC options that are the Franchise Tax Board (FTB). We note tied to different broad policy goals as described that in preparing these estimates FTB above. has assumed that it would be required to Comparison Criteria. To illustrate the benefits, perform robust fraud and error prevention, costs, and trade-offs of these different options, we outreach, and education activities for each compare the options using the following criteria: option. Estimates provided by FTB appear • What Is the Potential for Direct Poverty reasonable and consistent with activities in Reduction? We provide estimates of other states, but the amount of focus FTB the number of individuals that would assumes for these activities may differ from be removed from poverty by each of the Legislature’s priorities. the options. These estimates, as noted previously, account only for the direct • What Is the Revenue Loss for the State? effect of the additional resources provided Finally, we provide an estimate of the to households through the state EITC potential revenue loss that would result options and exclude any potential changes from implementing each of these options. in earnings resulting from changes Our estimates reflect federal EITC data in the number of hours worked. As a from 2012. For discussion of how these result, these estimates understate the revenue losses could change in later years, full poverty reduction of each option. see the nearby box entitled “Projecting For more information on our estimation the Future Revenue Loss of a State EITC.” methodology and its limitations, see We also note that the state has choices Appendix 2. for how to treat these revenue losses in its budgetary accounting system, which may 16 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT have implications for school funding under Option 1: Piggyback on Federal Credit Proposition 98, as described in the box on As noted above, one possible policy goal the next page, entitled “Effects of Revenue for a state EITC is to strengthen incentives to Losses on Proposition 98.” work by increasing the return from work at low Options as Building Blocks. While each of the wages. The first option we present would magnify options discussed below could be implemented as the existing work incentives and disincentives presented, we note that it is more helpful to think (encouraging or discouraging work depending of these options as building blocks that could on the taxpayer’s income) created by the federal be mixed, matched, and modified to meet the EITC by piggybacking on the federal credit’s Legislature’s policy objectives. As we describe the design. Specifically, this option represents a fully options, we also give examples of ways the options refundable state EITC that would be equal to could be altered. 15 percent of the federal EITC, consistent with past Projecting the Future Revenue Loss of a State EITC Were a state earned income tax credit (EITC) to take effect in 2015 or a later year, the budget impact could be higher or lower than the estimates shown in the main text, which were based on tax year 2012 data. The revenue loss of a state EITC would likely increase over time, but it would depend on several factors, as described below. • Minimum Wage Increases. California’s statewide hourly minimum wage increased from $8 to $9 at the start of 2014, and will increase again to $10 at the start of 2016. As mentioned earlier in the section entitled “Interaction With Other Antipoverty Policies,” the impact on the total revenue loss of the federal EITC would be uncertain. At the state level, the impact of the minimum wage change on the revenue loss of option 1 would likewise be uncertain. Because options 2 and 3 phase out much more quickly than option 1, it is likely that this minimum wage increase would move filers into the phase-out ranges, further down the phase-out ranges, or above the eligibility limits for these options, thus reducing the potential revenue loss. • Changes in the Economy. The size of the federal EITC program (the number of recipients and the total revenue loss) has typically grown over time, even during periods when the EITC itself was not expanded. The total number of jobs in the state also typically grows over time, and some of the new jobs will pay wages that qualify employees for the EITC. This pattern is not constant from year to year. Going forward, both the net change in the number of lower-paying jobs and the wages paid by these jobs are uncertain. • Inflation. The size of a taxpayer’s federal EITC benefit is indexed to inflation, meaning that it rises or falls every year with the change in an estimated price index. Assuming that a state EITC were also indexed for inflation, this would tend to increase the overall revenue loss of the EITC every year. www.lao.ca.gov Legislative Analyst’s Office 17 AN LAO REPORT legislative proposals. The amount of this state EITC the estimated number of individuals moved above option for different levels of annual earned income other multiples of the SPM poverty threshold. is displayed in Figure 8. Changes to Work Incentives. Option 1 Poverty Reduction. We estimate that roughly piggybacks on the federal credit, so the incentive 10.3 million Californians were in households to work over the phase-in range increases, the that would have benefited from this option in incentive to work over the flat range stays the same, 2012 if it had been available. Of those benefiting and the disincentive to work over the phase-out from this option, we estimate that the additional range also increases. As shown in Figure 10 (see resources provided would move roughly 120,000 page 20), option 1 increases the effective hourly individuals out of poverty (above 100 percent of wage that a single filer with two dependent children the SPM poverty threshold). This is equivalent to would receive when moving from no work to a 0.32 percentage point reduction in the state’s working 20 hours per week by 63 cents. This SPM poverty rate. Figure 9 (see page 20) displays represents an increased incentive to work. Option 1 Effects of Revenue Losses on Proposition 98 “Revenue Losses.” In this report we discuss the potential state personal income tax revenue losses if a state earned income tax credit (EITC) were to be approved. Specifically, revenue losses in this report refer to the amount of credits that would benefit state EITC filers. Most of these credits would be refundable; that is, the tax credit would be applied first to any income taxes due from the EITC filer, with the balance paid directly to the filer, essentially as an income tax refund. As discussed below, however, revenue losses need not be booked on the revenue side of the state budget. Choices in this regard could mean a state EITC affects the Proposition 98 minimum funding guarantee for schools and community colleges in different ways. Effects if Booked on Revenue Side of the Budget. If, for example, the revenue losses from a state EITC were booked on the revenue side of the budget—that is, as a net reduction of personal income tax revenues deposited in the General Fund—this would tend to result in a reduction of the Proposition 98 minimum guarantee. That is because year-over-year growth in state revenues is one factor that drives the Proposition 98 minimum guarantee upward in certain years. If a state EITC resulted in slower growth in state revenues in one or more years, that would tend to reduce the Proposition 98 guarantee below what it would be otherwise. In general, state income tax credits— currently, virtually all of them nonrefundable credits—are booked on the revenue side of the budget in this manner. Effects If Booked on Expenditure Side of the Budget. Alternatively, the state could book the revenue losses from a state EITC on the expenditure side of the budget—essentially as an appropriation of state General Fund moneys to EITC filers each year. Precedent exists for this type of treatment. In the past, certain refundable tax credits have been booked as appropriations in Item 9100 of the annual state budget (Tax Relief). One such example was the prior refundable renters’ personal income tax credit. Under current budgetary conventions, treating the state EITC as an annual appropriation generally would avoid the revenue interactions with Proposition 98 described above. 18 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT would also increase the effective hourly wage when EITC would be eligible for this option. However, moving from no work to working 40 hours per we assume that only 90 percent of individuals who week or when moving from working 20 hours per claim the federal EITC would choose to file for week to 40 hours a week, but by smaller amounts. the state EITC. Most federal EITC recipients are Graphic Sign Off Administrative Burden. Of the three options not required to file state tax returns because their Secretary we present in this report, option 1 is conceptually taxable income is so low, and many would likely Analyst the simplest to administer. Because the amount not be aware of the new state EITC especially in the MPA of the state credit would be equal to a specific first few years. Were the credit available in 2012, percentage of the federal credit, the state could ask we estimate that 2.9 million state EITC claims Deputy for very little additional information from filers would have been filed. The FTB estimates that beyond the amount of their federal EITC. Some its costs for administering a state EITC broadly states (such as Michigan) simply add lines to their consistent with option 1 would be $20.1 million, income tax form for the filer to list his or her federal EITC Figure 8 amount and then calculate Option 1: Piggyback on Federal Credit the state EITC amount by State Credit Amount for Single Filers, 2014 Tax Year applying the appropriate percentage. Other states $900 (such as New York) require 800 Two Dependents filers to submit much of 700 600 the same information as is 500 required for the federal EITC, 400 including earnings from 300 wages and self-employment 200 and identification and 100 No Dependents ages of dependents. The 10,000 20,000 30,000 40,000 $50,000 administrative costs to Annual Earned Income the state of California for option 1 would depend to Combined State and Federal Credit Amount for Single Filers, some extent on how much 2014 Tax Year information the state required $7,000 filers to provide. Two Dependents 6,000 In any case, a state EITC Combined State and Federal EITC 5,000 Federal EITC Only consistent with option 1 would result in an increased 4,000 number of income tax 3,000 returns, as many individuals 2,000 who would be eligible for it 1,000 No Dependents are not currently required to file. All individuals who 10,000 20,000 30,000 40,000 $50,000 Annual Earned Income are eligible for the federal www.lao.ca.gov Legislative Analyst’s Office 19 ARTWORK #140567 Template_LAOReport_mid.ait AN LAO REPORT including $3.4 million for processing, $13 million revenue loss in 2012 would have been around for enforcement activities, and $3.7 million for $65 million for each additional percent of the education and outreach. federal EITC that is matched by the state EITC. Revenue Loss. Had a state EITC consistent Option 2: Focus on Working with option 1 been available in tax year 2012, we Families With Lowest Incomes estimate that this credit would have resulted in reduced personal income tax revenue of roughly As noted previously, the state could choose $1 billion. to focus resources on individuals and families at Potential Modifications. The choice of what certain income levels. One example would be to percentage of the federal EITC to match under a focus the benefits of a state EITC on those families piggybacked option is somewhat arbitrary. For that have the very lowest incomes. Option 2 would example, if the state EITC were to match 30 percent accomplish this by matching the federal EITC of the federal EITC, we estimate that the number of dollar for dollar for all annual earnings up to individuals moved out of poverty would be roughly about one-half of the level required to obtain the 250,000 (an SPM poverty rate reduction of about maximum federal EITC benefit (in other words, 0.7 percentage points). Associated changes in work halfway through the phase-in range). For a single incentives and disincentives would roughly double, parent with two dependents in tax year 2014, this as would the estimated revenue loss ($2 billion would be $6,825 in annual earned income, as the in 2012). In general, we estimate that the state’s federal phase-in range ends at $13,650. Option 2 would then phase out at Figure 9 the same rate, such that Option 1: Piggyback on Federal Credit the state credit would Poverty Impacts in 2012 fully phase out just as the maximum federal Number of Individuals in Households Receiving State EITC 10,325,000 Number of Individuals Moved Above: EITC benefit is reached. 50 percent of SPM poverty threshold 43,750 The amount of this state 100 percent of SPM poverty threshold 120,750 EITC for different levels 150 percent of SPM poverty threshold 44,000 200 percent of SPM poverty threshold 14,050 of annual earned income SPM = Research Supplemental Poverty Measure. is displayed in Figure 11. As the figure shows, the Figure 10 practical effect of this Option 1: Piggyback on Federal Credit option is to make the phase-in range of the Changes in Work Incentives for a Single Filer With Two Dependent Children combined federal and state Weekly Hours of Work Average Effective Hourly Wage EITCs steeper, such that With Federal With Federal Before After EITC Only And State EITC Change the maximum benefit is reached earlier and the flat 0 20 $9.56 $10.19 +$0.63 20 40 4.23 4.32 +0.09 range is longer, benefitting 0 40 6.90 7.25 +0.35 individuals and families Note: Includes effects of CalWORKs, CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Assumes a $10 with earnings in the hourly wage. Tax rates and benefit amounts are for the 2014 tax year. federal phase-in range. 20 Legislative Analyst’s Office www.lao.ca.gov Graphic Sign Off AN LAO REPORT Secretary (This structure allows for the state credit to phase out). Because option 2 fully phases out at a level of Analyst out while the federal credit is still phasing in.) earnings below the equivalent of a full-time job at MPA Poverty Reduction. We estimate that roughly $10 per hour, individuals moving from no work Deputy 2.7 million Californians were in households that to full-time work miss the benefit of this credit would have benefitted from this option in 2012. entirely and would experience no change to their We estimate that these additional resources would incentives. have moved roughly 45,000 individuals out of poverty Figure 11 (above 100 percent of the Option 2: Focus on Working SPM poverty threshold). This Families With Lowest Incomes is equivalent to a reduction in the state’s SPM poverty State Credit Amount for Single Filers, 2014 Tax Year rate of 0.12 percentage $3,000 points. Figure 12 (see next Two Dependents page) displays the estimated 2,500 number of individuals moved 2,000 above other multiples of the SPM poverty threshold. 1,500 Changes to Work Incentives. Much like the 1,000 federal EITC, option 2 would 500 strengthen work incentives No Dependents over its phase-in range 10,000 20,000 30,000 40,000 $50,000 but reduce them over its Annual Earned Income phase-out range. Specifically, for the hypothetical household consisting of Combined State and Federal Credit Amount for Single Filers, a single parent and two 2014 Tax Year dependent children, option 2 $6,000 Two Dependents significantly increases the take-home resources made 5,000 Combined State and Federal EITC available when transitioning Federal EITC Only 4,000 from no work to part-time work at $10 per hour, as 3,000 shown in Figure 13 (see next page). This increase in 2,000 work incentives, however, 1,000 would be reversed for a No Dependents similar parent transitioning from part-time to full-time 10,000 20,000 30,000 40,000 $50,000 Annual Earned Income work (as the credit is phased ARTWORK #140567 www.lao.ca.gov Legislative Analyst’s Office 21 Template_LAOReport_mid.ait AN LAO REPORT Administrative Burden. Conceptually, option 2 state EITC that is broadly consistent with option would likely be administratively more burdensome 2 would cost $7.1 million annually, including for the state and for filers because credit amounts $2.3 million for processing, $3.8 million for would be determined by a separate state schedule. enforcement activities, and $1 million for education This might require that the state request additional and outreach. The average administrative cost of information from filers or require that filers option 2 would be about $10 per return compared perform additional calculations. However, because to about $7 per return for option 1. fewer filers would be eligible for option 2, the total Revenue Loss. Had a state EITC consistent administrative costs would be lower than the costs with option 2 been available in tax year 2012, we to administer option 1. Unlike option 1, most tax estimate that this credit would have resulted in filers who qualify for the federal EITC (those with reduced personal income tax revenue of roughly higher incomes) would not qualify for option 2. $450 million. We estimate that roughly 785,000 tax filers would Potential Modifications. Depending on have been eligible for option 2 had it been available available resources, the Legislature could consider in 2012. We assume that 90 percent of these, or enacting a state EITC similar to option 2 but roughly 700,000, would have actually filed for the with a smaller benefit amount. For example, if credit. The FTB estimates that administering a option 2 were reduced by half, we estimate that the number of individuals moved out of poverty Figure 12 would be roughly Option 2: Focus on Working Families With Lowest Incomes 20,000, for an SPM Poverty Impact in 2012 poverty rate reduction of Number of Individuals in Households Receiving State EITC 2,675,000 0.05 percentage points. Number of Individuals Moved Above: Associated changes to 50 percent of SPM poverty threshold 56,250 work incentives and 100 percent of SPM poverty threshold 45,250 150 percent of SPM poverty threshold 6,200 disincentives would 200 percent of SPM poverty threshold 3,575a be reduced roughly a This estimate is based on a very limited number of observations and should be interpreted with caution. by half, as would the SPM = Research Supplemental Poverty Measure. estimated revenue loss ($220 million). Figure 13 Alternatively, if the Option 2: Focus on Working Families With Lowest Incomes Legislature wished to Changes in Work Incentives for a Single Filer With Two Dependent Children focus on families with the lowest incomes but Weekly Hours of Work Average Effective Hourly Wage also encourage full-time With Federal With Federal and Before After EITC Only And State EITC Change work, it could create a 0 20 $9.56 $10.66 +$1.10 hybrid between options 20 40 4.23 3.13 -1.10 1 and 2 that would, in 0 40 6.90 6.90 No change addition to building on Note: Includes effects of CalWORKs, CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Assumes a the federal EITC over the $10 hourly wage. Tax rates and benefit amounts are for the 2014 tax year. phase-in range, increase 22 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Graphic Sign Off the maximum benefit provided by the federal different levels of annual earned income. As can be Secretary EITC through the flat range. The Legislature could seen in the figure, option 3 would be available only Analyst also consider focusing resources on families with to filers with no dependents. MPA higher earnings, which could partially offset work Poverty Reduction. We estimate that Deputy disincentives created by the federal EITC as its roughly 3.2 million Californians would have benefits are phased out. benefitted from this option in 2012. We estimate Option 3: Supplement Figure 14 Federal Credit for Option 3: Supplement Federal Credit for Childless Adults Childless Adults State Credit Amount for Single Filers, 2014 Tax Year As noted previously, the Legislature may wish to $800 No Dependents enact a state EITC that would 700 compensate for perceived 600 gaps in the federal EITC. 500 In March 2014, the Obama administration released a 400 proposal to increase the 300 federal EITC for filers with 200 no dependents. (There have 100 also been other congressional proposals of this type.) 10,000 20,000 30,000 40,000 $50,000 Under the administration’s Annual Earned Income proposal, the phase-in rate and maximum benefit for filers with no dependents Combined State and Federal Credit Amount for Single Filers, would roughly double and 2014 Tax Year the maximum amount of annual earned income $6,000 allowed to still receive the 5,000 Combined State and Federal EITC federal EITC would be Federal EITC Only increased by over $2,000. 4,000 Option 3 would create a state 3,000 EITC that, when combined with the existing federal 2,000 EITC, would equal the 1,000 No Dependents expanded federal EITC for filers with no dependents, as 10,000 20,000 30,000 40,000 $50,000 proposed by the President. Annual Earned Income Figure 14 displays the amount of this state EITC for www.lao.ca.gov Legislative Analyst’s Office 23 ARTWORK #140567 Template_LAOReport_mid.ait AN LAO REPORT these additional resources would have moved part-time to full-time work (as the credit phases roughly 21,000 individuals out of poverty (above out). Because option 3 fully phases out below the 100 percent of the SPM poverty threshold). This is level of earnings that are equivalent to a full-time equivalent to a reduction in the state’s SPM poverty job at $10 per hour, individuals moving from no rate of 0.06 percentage points. Figure 15 displays work to full-time work would miss the benefit of the estimated number of individuals moved above this credit entirely and would experience no change other multiples of the SPM poverty threshold. to their incentives. Changes to Work Incentives. As with the Administrative Burden. Similar to option 2, previous options, option 3 would strengthen option 3 would be more burdensome to administer work incentives over its phase-in range but reduce than option 1 because it would rely on a separate them over its phase-out range. Specifically, for a state credit schedule and may require that filers household consisting of a single individual with provide additional information and perform no dependents, option 3 increases the take-home additional calculations. However, also similar to resources made available when transitioning from option 2, fewer filers would be eligible for option 3 no work to part-time work, as shown in Figure 16. than for option 1 and as such overall administrative This increase in work incentives is reversed for costs would be lower than for option 1. Unlike the a similar single individual transitioning from previous two options, some tax filers who do not qualify for the federal EITC would qualify Figure 15 for this state EITC— Option 3: Supplement Federal Credit for Childless Adults specifically, filers with Poverty Impacts in 2012 no dependents and with Number of Individuals in Households Receiving State EITC 3,200,000 earned income just above Number of Individuals Moved Above: 50 percent of SPM poverty threshold 28,500 the current maximum 100 percent of SPM poverty threshold 21,000 income allowed for the 150 percent of SPM poverty threshold 20,425 federal EITC. We estimate 200 percent of SPM poverty threshold 12,425a a that roughly 1 million This estimate is based on a very limited number of observations and should be interpreted with caution. tax filers would have SPM = Research Supplemental Poverty Measure. been eligible for option 3 had it been available in Figure 16 2012. We assume that Option 3: Supplement Federal Credit for Childless Adults 90 percent of these, or Changes in Work Incentives for a Single Filer With No Dependent Children roughly 900,000, would have actually filed for the Weekly Hours of Work Average Effective Hourly Wage credit. The FTB estimates With Federal With Federal Before After EITC Only And State EITC Change that administering a state EITC that is 0 20 $9.46 $10.14 +$0.68 20 40 4.12 3.44 -0.68 broadly consistent with 0 40 6.79 6.79 No change option 3 would cost about Note: Includes effects of CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Assumes a $10 hourly wage. $13.8 million annually, Tax rates and benefit amounts are for the 2014 tax year. 24 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT including $2.1 million for processing, $10.3 million of the federal credit.) This encourages these for enforcement activities, and $1.4 million for parents to work and to keep current on their child education and outreach efforts. This works out to a support obligations, potentially fostering improved cost of about $15 per return. relationships between noncustodial parents and Revenue Loss. Had a state EITC consistent their children. The costs and potential poverty with option 3 been available in tax year 2012, we impacts of such an option in California would estimate that this credit would have resulted in depend on how the credit is structured. reduced personal income tax revenue of roughly Summary of LAO Options $400 million. Potential Modifications. Although option 3 Figure 17 (see next page) summarizes key would increase the maximum amount of earnings features of the three options described above. a filer with no children could have and still claim Assessment of Trade-Offs. As noted above, the the EITC, option 3 would still be fully phased out structure of any state EITC adopted in California before reaching earnings equivalent to working will depend on the policy goals the Legislature full-time at $10 per hour. If the Legislature wished wishes to achieve. While various options can to increase incentives to work up to full-time at low meet multiple policy goals, some options are wages, it could consider a variant of option 3 that suited to particular goals. For example, option 1 is would extend the flat region such that it phased out well-suited to address goals of strengthening work at the same level of earnings as the federal EITC incentives and providing increased resources to for filers with dependents. We estimate that this low-income working families. One drawback of variation would dramatically increase the number option 1 is that it distributes significant resources of eligible filers (to about 1.3 million) and also to a large number of individuals and families, increase revenue loss (to roughly $700 million) such that providing a given benefit to all eligible and the number of individuals moved above SPM individuals results in a relatively higher revenue poverty thresholds (to roughly 70,000). loss. Option 1 also does not address concerns The Legislature could consider focusing about the amount of assistance received by filers resources of a state EITC on noncustodial parents, without dependents. Option 2 is more focused than who are considered childless adults for purposes option 1 and is well-suited to provide additional of the federal EITC. For example, New York State resources to working families with the very lowest provides an EITC that piggybacks on the federal incomes. Focusing the resources provided by EITC in most respects. Under a straight piggyback a state EITC more narrowly allows for a more credit, noncustodial parents would be eligible substantial benefit to be provided to fewer people. for a very small state EITC benefit (matching a At the same time, providing benefits to fewer percentage of the small benefit provided through households limits the number of individuals moved the federal EITC). However, New York’s state above poverty thresholds. Option 2 encourages EITC offers noncustodial parents who are current part-time work more than option 1, but does not on their child support obligations the option of encourage full-time work, as option 1 does. Option claiming the state EITC as if they had custody of 3 addresses potential concerns about the low their children, which provides a higher benefit. federal EITC received by filers with no dependents. (Noncustodial parents use the same EITC schedule Because option 3 is more focused, a more as custodial parents do, but get a lower percentage substantial benefit can be provided to fewer people. www.lao.ca.gov Legislative Analyst’s Office 25 AN LAO REPORT Figure 17 Summary of LAO Options Option 1: Option 2: Focus on Option 3: Supplement Piggyback on Working Families With Federal Credit for Federal Credit Lowest Incomes Childless Adults Direct Poverty Impact Individuals moved above SPM poverty threshold 120,750 45,250 21,000 Change in SPM poverty rate -0.32% -0.12% -0.06% Estimated 2012 Revenue Loss $1 billion $450 million $400 million Change in Work Incentive Currently not working and considering 20 hours per +$0.62/hour +$1.10/hour +$0.68/hour weeka Currently not working and considering 40 hours per +$0.35/hour None None weekb a Displays change due to state EITC in average effective wage when transitioning from no work to 20 hours of work at $10 per hour. Assumes a single filer with two dependent children, unless otherwise noted. Includes effects of CalWORKs, CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Tax rates are for the 2014 tax year. b Displays change due to state EITC in average effective wage when transitioning from no work to 40 hours of work at $10 per hour. Assumes a single filer with two dependent children, unless otherwise noted. Includes effects of CalWORKs, CalFresh, the premium costs of health coverage provided either through Medi-Cal or subsidized coverage provided through Covered California, and state and federal income and payroll taxes. Tax rates are for the 2014 tax year. SPM = Research Supplemental Poverty Measure. As with option 2, the number of individuals moved incentives to work full-time, unless it is modified as out of poverty may be more limited. Option 3 discussed above. is also relatively less effective at strengthening POTENTIAL IMPLEMENTATION ISSUES Addressing Improper Payment Concerns EITC Enforcement Activities in Other States. In the course of preparing this report, we State Would Have to Determine Appropriate discussed enforcement activities with officials of Level and Focus of Enforcement Efforts. As agencies in some states that currently administer described above, the level of improper payments EITCs. Across these states, certain aspects of in the federal EITC is a significant issue. Were enforcement efforts were common. For example, the state to adopt its own EITC, it would need to the states focused more on preventing improper dedicate some resources to reducing improper payments before they happen than on recovering payments from taxpayer errors or fraud. However, them after sending them out. Common preventive it is not possible to completely eliminate improper measures include (1) real-time verification of some payments in a state EITC because there is an information with available electronic sources (such inherent trade-off between dollars saved through as Social Security numbers with the federal Social enforcement efforts and dollars spent to finance Security Administration) and (2) stopping payment those activities. The state ultimately might wish of refunds in cases where the claims have a high to consider what an acceptable level of improper likelihood of containing errors until the claim payments would be and how to focus enforcement can be verified. For example, the states we spoke funds and activities to achieve that goal. 26 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT with have developed methodologies to flag claims self-employment income. On the other that fit certain criteria that would indicate higher hand, a wage-only EITC would likely likelihood of a common error, such as reporting reduce the level of enforcement staff for self-employment income in an amount that EITC fraud prevention. The FTB estimates provides the maximum EITC benefit. that restricting an EITC to wage income The level of enforcement activity varies would reduce the associated administrative somewhat across states (due to differences in costs by about 10 percent. The tax revenue priorities, relative values of those states’ EITC loss from a wage-only EITC would likely be benefits, and the number of claims that are about 10 percent smaller than a comparable processed). For example, the state of Minnesota, EITC that also covers self-employment which had 355,000 federal EITC recipients in 2012 income, as self-employment income compared to 3.2 million in California, reports accounts for 11 percent of federal EITC that they devote 12 full-time enforcement staff to recipients’ earned income. EITC enforcement during the peak season. New • Delay Payment Until More Administrative York State, which processes about 1.6 million state Data Are Available for Verification. EITC claims, reports that during peak season they One challenge the state may face in have well over 100 staff devoted to enforcement limiting improper payments is the need activities. to balance timely refunds against the lag Options for Limiting Improper Payments. in availability of some administrative In addition to the activities described above, data that could be helpful in enforcement the Legislature could consider other options efforts. For example, wage information to structure a state EITC to reduce the level of reported to the state as part of the improper payments. Unemployment Insurance program could • Restrict to Wage Income. As mentioned be used as a check on the wage information above, the IRS estimates that the cost of reported by state EITC claimants, but improper payments due to misreporting this information would likely not be self-employment income is three to available early enough in the year to allow four times as large as for wage income, it to be used for enforcement purposes. despite the fact that total reported wage The information resulting from IRS income on all EITC returns is more enforcement efforts is also not available than eight times the amount of total early enough to be used in processing reported self-employment income. If refunds. The state could consider delinking policymakers view fraud prevention as a state EITC from the income tax return, a major concern, they could consider and provide the benefit as a rebate at a later restricting an EITC to wage income. This time. The State of Washington, which has would have some drawbacks. By adopting no state income tax, has approved (but not a different definition of income than the funded) a state EITC that is expected to federal EITC, the state would lose the function in a similar way. simplicity of piggybacking on the federal credit. A wage-only EITC would also be detrimental to individuals with legitimate www.lao.ca.gov Legislative Analyst’s Office 27 AN LAO REPORT Considering Outreach to Maximize Take-Up annually that they may be eligible for the federal EITC and provide information on how to claim The IRS estimates that in 2010, only 71 percent the credit. Enacting a state EITC may further of California tax filers who qualified for the federal increase awareness of the federal EITC and increase EITC claimed it. The state has pursued some participation on the natural. If a state EITC is efforts in the past to increase participation in the enacted, the Legislature could consider whether federal EITC, including enacting requirements additional activities are warranted to promote that employers and state departments that interact participation and maximize the credit’s effects. with low-income workers inform them at least CONCLUSION The federal EITC is a large antipoverty The Legislature would have many decisions to program. It reduces poverty and generally make and trade-offs to consider in crafting a state encourages work, particularly among low-wage and EITC to meet its policy objectives, including how low-skilled single parents. Were the state to adopt closely to link a state credit to the federal EITC and a supplemental EITC structured similarly to the whether to focus the benefit broadly or narrowly. federal EITC, it likely would have similar effects. Should the state enact an EITC, it may wish to consider ways to limit improper payments. 28 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT APPENDIX 1: ORGANIZATIONS CONSULTED In the development of this report we consulted with various organizations, listed below. Our analysis and findings are our own. • California Budget Project. • California Taxpayers Association. • Center on Budget and Policy Priorities. • County Welfare Directors Association of California. • Franchise Tax Board. • Michigan Senate Fiscal Agency. • Minnesota Department of Revenue. • Minnesota House of Representatives Research Department. • National Conference of State Legislatures. • New York State Senate Finance Committee. • New York State Department of Taxation and Finance. • Office of the Chief Financial Officer of the District of Columbia. • Public Policy Institute of California. • University of California Davis Center for Poverty Research. • Western Center on Law and Poverty. www.lao.ca.gov Legislative Analyst’s Office 29 AN LAO REPORT APPENDIX 2: POVERTY IMPACT ESTIMATION METHODOLOGY Data Sources. Throughout this report, we present estimates of the number of individuals moved out of poverty assuming the enactment of different options for a state earned income tax credit (EITC). To develop these estimates, we used Supplemental Poverty Measure (SPM) Public Use Research Files from 2010 through 2013 and the Current Population Survey Annual Social and Economic Supplement, both made available by the U.S. Census Bureau. These data sources provide detailed survey information on a sample of between 5,300 and 7,400 California households each year from 2010 through 2013 (about 27,000 households total). These data sources also include Census Bureau calculations used to determine the SPM poverty status of each household, including calculations of the household’s SPM poverty threshold and total resources that are compared against that threshold. General Steps in Methodology. The general steps in our methodology are as follows: • Estimate Federal EITC Benefit. The datasets include an estimate of each household’s federal EITC benefit; however, the intermediate values used to develop these estimates are not publicly available. In order to be consistent in how estimates were developed across all state EITC options and the federal EITC, we used information available in the datasets to approximate federal EITC benefits calculated by the Census Bureau. When comparing numbers of returns, total benefits, and poverty impacts, our approximation is close to the Census Bureau estimates. • Estimate State EITC Benefit. We then used the same information to estimate the amount of state EITC each household would receive under the various options. • Adjust SPM Resources to Include State EITC. We then added the total state EITC benefit received by members of each household to the other resources that are measured against the household’s SPM poverty threshold. • Count the Number of Individuals That Move Above Poverty Threshold. Once the state EITC benefit is assigned, some households cross over poverty thresholds. We counted the number of individuals in each of these households to arrive at a number of individuals moved out of poverty. Detailed Estimation Results. Appendix Figure 1 provides the detailed results of our estimation. (Confidence intervals were calculated using replicate weights provided by the Census Bureau.) Limitations. Our methodology has some limitations, as described below. • Major Public Assistance Benefits Are Underreported. The datasets feature reported survey data for various pieces of information, including earnings and receipt of public assistance. It has been shown that a significant portion (nearly half in some cases) of total 30 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Appendix Figure 1 Detailed Poverty Estimates Federal EITC State EITC As Estimated by As Estimated U.S. Census Bureau By LAO Option 1 Option 2 Option 3 Individuals Moved Above 50 Percent of SPM Threshold Number 362,500 372,500 43,750 56,250 28,500 90 percent confidence interval +/-44,004 +/-44,826 +/-17,519 +/-19,082 +/- 9,582 Percent of California population 0.96% 0.99% 0.12% 0.15% 0.08% 90 percent confidence interval +/-0.12% +/-0.12% +/-0.05% +/-0.05% +/-0.03% Individuals Moved Above 100 Percent of SPM Threshold Number 760,000 752,500 120,750 45,250 21,000 90 percent confidence interval +/-74,025 +/-69,090 +/-26,114 +/-17,067 +/-7,567 Percent of California population 2.02% 1.99% 0.32% 0.12% 0.06% 90 percent confidence interval +/-0.20% +/-0.18% +/-0.07% +/-0.05% +/-0.02% Individuals Moved Above 150 Percent of SPM Threshold Number 235,750 248,750 44,000 6,200 20,425 90 percent confidence interval +/-41,948 +/-43,593 +/-15,175 +/-5,017 +/-8,883 Percent of California population 0.62% 0.66% 0.12% 0.02% 0.05% 90 percent confidence interval +/-0.11% +/-0.12% +/-0.04% +/-0.01% +/-0.02% Individuals Moved Above 200 Percent of SPM Threshold Number 41,000 42,250 14,050 3,575a 12,425a 90 percent confidence interval +/-14,682 +/-15,710 +/-9,212 +/-3,549 +/-5,716 Percent of California population 0.11% 0.11% 0.04% 0.01% 0.03% 90 percent confidence interval +/- 0.04% +/-0.04% +/-0.02% +/-0.01% +/-0.02% Individuals in Affected Households Number 10,275,000 10,325,000 10,325,000 2,675,000 3,200,000 90 percent confidence interval +/-253,330 +/-259,499 +/-259,499 +/-143,938 +/-158,331 Percent of California population 27.22% 27.35% 27.35% 7.06% 8.45% 90 percent confidence interval +/-0.68% +/-0.70% +/-0.70% +/-0.38% +/-0.42% Individuals in Poverty Number 8,844,250 8,852,750 8,732,000 8,807,500 8,831,750 90 percent confidence interval +/-148,980 +/-148,980 +/-147,856 +/-149,502 +/-148,810 Percent of California population 23.43% 23.46% 23.14% 23.34% 23.40% 90 percent confidence interval +/-0.65% +/-0.65% +/-0.65% +/-0.65% +/-0.65% a These estimates are based on a very limited number of observations and should be interpreted with caution. Confidence intervals were calculated using replicate weights provided by the U.S. Census Bureau. Confidence intervals primarily reflect uncertainty due to sampling error, and do not necessarily reflect uncertainty caused by other data limitations described in this appendix, including underreporting of public assistance and incorrect assignment of EITC benefits. Because these sources of uncertainty are not necessarily reflected in confidence intervals, the true level of uncertainty is higher than displayed in this figure. SPM = Research Supplemental Poverty Measure. www.lao.ca.gov Legislative Analyst’s Office 31 AN LAO REPORT benefits received through major programs like Temporary Assistance for Needy Families (known as California Work Opportunity and Responsibility to Kids in California) and the Supplemental Nutrition Assistance Program (known as CalFresh in California) are not reported in the data set. As a result, the SPM methodology that relies on these datasets overstates the extent of poverty by failing to account for these underreported benefits. Underreporting these other public benefits may result in our estimates of the poverty impact of the state EITC options being overstated, as some of whom that we estimate would be moved above the poverty threshold may already be above the threshold once underreported benefits are accounted for. • Federal and State EITC Amounts Are Assigned Rather Than Reported. Unlike other major forms of public assistance, the federal EITC is not reported in the datasets. Rather, Graphic Sign Off it is assigned based on what other reported information indicates the household would be eligible for. (All households that are determined to be eligible based on survey data are Secretary assumed to claim the EITC.) As discussed above, our approach for assigning state EITC Analyst benefits is similar. When comparing the numbers of returns and total credit amounts as MPA determined by the datasets against administrative records of how many individuals actually Deputy received the federal EITC from the Internal Revenue Service (IRS), total credits claimed as calculated from the survey data understate the actual reported total credits by up to 21 percent. Appendix Figure 2 displays the total federal EITC credit amounts for California as calculated from the datasets when using the Census Bureau estimate of federal EITC amounts, when using the LAO estimate of Appendix Figure 2 federal EITC amounts, Total Federal EITC Benefits in California: Estimated Versus Actual and actual credit amounts reported by (In Billions) IRS. This discrepancy Census Bureau $8 Estimates can likely be attributed LAO Estimates to a combination 7 IRS Actuals of (1) improper 6 payments, (2) 5 sampling error, and 4 (3) errors in assigning 3 federal EITC amounts 2 in the survey data. 1 The fact that the 2010 2011 2012 2013a datasets consistently estimate total benefits a Administrative data from the IRS on the 2013 tax year are not yet available. IRS = Internal Revenue Service. below administrative ARTWORK #140567 32 Legislative Analyst’s Office www.lao.ca.gov Template_LAOReport_mid.ait AN LAO REPORT totals for the federal EITC implies who our state EITC estimates likely understate their full poverty impact. We note that not all state income tax filers that are eligible for a state EITC will file, particularly in early years of implementation. This effect should somewhat offset the understatement of benefits observed in the dataset. Caution Should be Used in Interpreting Estimates. Given the limitations described above, estimates of poverty impact for the various state EITC options are intended to provide a rough sense of the magnitude of potential effects in order to facilitate comparisons among competing policy options, but are subject to uncertainty and should be interpreted with caution. www.lao.ca.gov Legislative Analyst’s Office 33 AN LAO REPORT APPENDIX 3: SELECTED STUDIES AND REPORTS This appendix lists some, but not all, of the resources we consulted in the course of preparing this report. These references link to more detailed information on the effects of the federal earned income tax credit (EITC) and the nature and extent of noncompliance in the federal EITC. Dahl, G. and Lochner, L. (2012). The Impact of Family Income on Child Achievement: Evidence from the Earned Income Tax Credit. American Economic Review 2012, 102(5). http://econweb.ucsd.edu/~gdahl/papers/children-and-EITC.pdf Eissa, N. and Hoynes, H. (2005). Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply. National Bureau of Economic Research Working Paper. http://www.nber.org/papers/w11729.pdf Hoynes, H., Miller, D., and Simon, D. (2012). Income, the Earned Income Tax Credit, and Infant Health. National Bureau of Economic Research Working Paper. http://www.nber.org/papers/w18206 Internal Revenue Service (2014). Compliance Estimates for the Earned Income Tax Credit Claimed on 2006-2008 Returns. http://www.irs.gov/pub/irs-soi/EITCComplianceStudyTY2006-2008.pdf Meyer, B. (2010). The Effects of the Earned Income Tax Credit and Recent Reforms. In Tax Policy and the Economy, Volume 24 (2010). National Bureau of Economic Research. http://www.nber.org/chapters/c11973 34 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT www.lao.ca.gov Legislative Analyst’s Office 35 AN LAO REPORT LAO Publications This report was prepared by Justin Garosi and Ryan Woolsey, and reviewed by Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 36 Legislative Analyst’s Office www.lao.ca.gov