Lawmakers Envision Different Paths for the Child Tax Credit

Debate on how to reform the Child Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (CTC) is heating up as lawmakers offer competing ideas. The credit was most recently boosted temporarily in 2021 under President Biden’s American Rescue Plan Act (ARPA), and just a few years prior, Republicans gave it their own temporary boost under their 2017 taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform package, the Tax Cuts and Jobs Act (TCJA).

With the 2021 expansion in the rearview mirror and the expiration of the 2017 expansion on the horizon, lawmakers are trying to chart a course for the credit’s future, navigating trade-offs for how much the policy will cost, how it will affect work incentives, who will be eligible for it, and how to improve the administration of the credit. Balancing the trade-offs is inherently challenging because policymakers place differing levels of importance on each factor and have different ideas about the CTC’s purpose.

As the table below illustrates, the CTC currently provides up to $2,000 per child, phasing in when earned income exceeds $2,500 and phasing out when income exceeds $400,000 for joint filers. Up to $1,600 of the credit is refundable in 2023, and the refundable portion is called the Additional Child Tax Credit (ACTC). The current design expires after 2025, at which point the CTC will shrink to a $1,000 credit that phases in when income exceeds $3,000 and phases out when income exceeds $110,000 for joint filers.

In 2021, the ARPA temporarily boosted the CTC in three main ways. First, the maximum credit was $3,600 for children under age 6 and $3,000 for children ages 6 to 17. Second, it did not phase in with earned income, meaning the full amount was available to households with no or low income. And third, half the credit was made available in advance monthly payments. At tax filing time, taxpayers received any remaining amount of credit they were due.

As lawmakers decide how to structure the CTC moving forward, they will have to weigh revenue, distributional, economic, and administrative trade-offs of various options. Often the trade-offs interact, and sometimes they work in opposing directions.

Recent Designs of the Child Tax Credit

Source: Author summaries of tax law and legislative proposals. Revenue costs from the Joint Committee on Taxation’s Estimates Of Federal Tax Expenditures and Estimated Revenue Effects Of H.R. 1319, The “American Rescue Plan Act Of 2021.”

Revenue Trade-Offs

According to estimates from the Joint Committee on Taxation (JCT), the annual cost of the current CTC in 2023 amounts to $120.6 billion, under the design set by the TCJA. After the temporary TCJA design expires after 2025 and the credit reverts to its old design, the cost of the CTC will fall to $61.5 billion in 2026. In contrast, the ARPA expansion nearly doubled the annual cost of the CTC, adding an estimated $105.1 billion to the TCJA cost, for a total annual cost of roughly $220 billion.

Estimating the revenue effect of extensions is complex because the rest of the TCJA, which changed nearly every aspect of the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. code, expires after 2025. As such, lawmakers need to consider the CTC design and cost in the context of the changing tax code.

The bottom line: expanding the credit by boosting the maximum value, expanding the age range, or altering phase-ins and phaseouts can cost a significant amount of federal revenue.

Distributional Trade-Offs

The tax code adjusts for household size to better reflect differences in ability to pay. It has historically used the combination of several provisions, including different-sized standard deductions, personal and dependent exemptions, and credits for children and other dependents to adjust tax burdens for the number of people in a household.

The effect on taxpayers differs by provision. For instance, an exemption reduces taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. by a set amount, so its value depends on the taxpayer’s marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. ; higher-income households receive a larger benefit. In contrast, a tax credit reduces tax liability dollar for dollar, providing a more equitable adjustment of tax liability. Further, the CTC is refundable, meaning it can completely zero out tax liability and provide a refund payment to taxpayers.

Because the current CTC requires taxpayers to have a certain level of earned income to begin receiving the credit, households with no income receive no benefit (though they have no individual income tax liability to offset), while households with low income receive a limited benefit.

Eliminating the earned income requirement would significantly alter the distribution of the credit by increasing the benefit to low-income households and providing a full benefit to households without income. Such a change would transform the policy beyond a tax adjustment for household size into a child benefit irrespective of tax burdens, which, as we’ll discuss soon, has important administrative trade-offs.

The Congressional Research Service (CRS) estimates that prior to the ARPA, 84 percent of families with children received the CTC; under the ARPA, which removed the phase-in, that share rose to 96 percent, with the largest increase among families with children in poverty.

The bottom line: the distribution of the CTC depends on its purpose—if its purpose is to adjust tax burdens for household size, then households without taxable income won’t benefit.

Economic Trade-Offs

The CTC can affect labor supply decisions through its changes to marginal tax rates, or the tax a person faces as they earn an additional dollar of income.

Historically, the CTC has phased in with earned income, which means in order for a taxpayer to benefit, they must have income. The phase-in creates a work incentive, resulting in lower marginal tax rates when income falls within the phase-in range. Research indicates that marginal tax rates have a statistically significant impact on labor supply decisions through what’s known as a substitution effect: because of lower marginal tax rates, people receive additional compensation for each hour worked, and respond by increasing work.

By removing the phase-in, the ARPA design increased marginal income tax rates on low-income taxpayers. If marginal income tax rates were higher on a permanent basis, we should expect to see a substitution effect, or reduced labor force participation over time as taxpayers react to higher marginal tax rates. The literature points to a range of three to eight years for such a response to occur.

Tax Foundation previously estimated that the ARPA design would boost the after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. of the bottom quintile by 10 percent, while reducing hours worked for the bottom quintile by 0.6 percent. That compares to a boost in hours worked of 1.8 percent for the bottom quintile under permanent TCJA policy, but a smaller 1.3 percent increase in after-tax income.

All three iterations of the credit have phaseouts, which increase marginal tax rates on income for taxpayers in the phaseout range. The number of taxpayers and amount of income exposed to the phaseout, as well as the phaseout rate, determine the ultimate impact it has on hours worked.

The bottom line: phasing in the credit reduces marginal tax rates, which can encourage labor force participation, while phasing out the credit increases marginal tax rates, which can discourage labor force participation. Altering the phase-ins and phaseouts thus has economic trade-offs lawmakers must consider.

Administrative Trade-Offs

The primary task of the IRS is to collect federal tax revenue, but lawmakers have also saddled the agency with the responsibility of administering social policy through the tax code, most notably with refundable tax credits like the Additional Child Tax Credit (ACTC) and Earned Income Tax Credit (EITC). The relationship, residency, and identification tests legally required to qualify for the CTC are difficult for taxpayers to comply with and for the IRS to enforce, especially for families with complex living arrangements.

In 2022, $5.2 billion of the $32.8 billion in refundable CTC payments were overpayments, implying an error rate of 16 percent. Overpayments result from taxpayer errors, confusion, or sometimes outright fraud. The IRS claims the overpayments result from factors beyond its control: “Although error rates for EITC, ACTC, and AOTC [American Opportunity Tax Credit] remain high, the IRS attributes these refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit (EITC). overclaims to their statutory design and the complexity taxpayers face when self-certifying eligibility for the refundable tax credits and not to internal control weaknesses, financial management deficiencies, or reporting failures.”

Reducing overpayments by simplifying the credit’s requirements and reevaluating the design of other related policies should be prioritized in any additional reforms to the CTC. Lawmakers should also consider the potential of moving social benefits out of the tax code to be administered by an agency such as the Social Security Administration.

The bottom line: the current structure of the CTC is highly complex and contributes to the problem of overpayments. Expanding the CTC without addressing its complexity could exacerbate overpayments.

The Path Forward

After the end of 2025, the CTC will revert to its pre-TCJA structure if lawmakers do not reform the credit by then. Representative Vern Buchanan (R-FL) has introduced legislation, the TCJA Permanency Act, which would permanently extend the individual elements of the TCJA including the CTC, while Senator Michael Bennet (D-CO) has reintroduced the Working Families Tax Relief Act which would continue the ARPA CTC and the ARPA EITC on a permanent basis.

Beyond the three iterations of the CTC that have been tried in practice over the last decade, policymakers have proposed alternative ideas to reform the credit (a selection is shown in the table below).

Selected Reform Proposals for the Child Tax Credit

	Sen. Romney’s Family Security Act 2.0	Rep. James’ Reignite Hope Act of 2023	Brookings Institution Hamilton Project	Tax Foundation Growth & Opportunity Plan
Maximum Credit	$4,200 for children under 6; $3,000 for children ages 6 to 17	$4,500 for children under 6; $3,500 for children ages 6 to 17	$3,600 for children under 6; $3,000 for children between ages 6 to 17	$2,000
Maximum Refundable Credit	Full amount	Full amount	Full amount	Full amount
Phase-In	Yes; maximum credit is proportional to earnings under a $10,000 earnings threshold, for example, at $5,000 in earnings a household would receive 50 percent of the maximum credit. Equivalent to 42% for children under 6 and 30% for children ages 6 to 17 in first year, earnings threshold is indexed to inflation thereafter which slightly lowers the rates.	Yes; 15.3% with earned income beginning at the first dollar of income	Yes; 30% beginning at the first dollar of income	Yes; 15% with earned income above $2,500
Phaseout	Yes; 5% above $400,000 for joint filers and $200,000 for single filers	Yes; 5% above $400,000 for joint filers and $200,000 for single filers	Yes; 1% above $110,000 for joint filers and $75,000 for single filers	Yes; 5% above $100,000 for joint filers and $50,000 for single filers
Other Notes	Administered through SSA; reforms the Earned Income Tax Credit, deduction for state and local taxes paid (SALT), head of household filing status, and Child and Dependent Care Tax Credit.	Creates a separate $3,500 for certain workers in qualified Opportunity Zones.	All dollar amounts indexed to inflation.	All dollar amounts indexed to inflation.

Source: Author review of legislative and think tank CTC reform proposals.

Senator Mitt Romney’s (R-UT) Family Security Act 2.0 would transform the current CTC into a monthly child benefit and reform other family policy. It would provide a maximum of $4,200 for children under age 6 or $3,000 for children ages 6 to 17, with an earnings threshold of $10,000 to receive the full amount. Households under the threshold would receive a proportional credit; for example, at $2,500 of earnings, a household would receive 25 percent of the maximum credit. The credit would phase out when adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” exceeds $400,000 for joint filers, up to $2,800 of the credit would be available during pregnancy, and the Social Security Administration would oversee payments.

Representative John James (R-MI) recently introduced a bill to permanently increase the CTC to a fully refundable $4,500 for children under age 6 and $3,500 for children ages 6 to 17, increase the phase-in rate to 15.3 percent, and begin the phase-in at the first dollar of earned income. It would also establish a new $3,500 tax credit for critical workers within Opportunity Zones.

Another proposal, from researchers with the Brookings Institution’s Hamilton Project, would borrow from the ARPA and TCJA. It includes a maximum credit amount of $3,000 for children between the ages of 6 and 17 and $3,600 for children under 6. Families with no earnings would receive half the credit, with the remaining half phasing in at 30 percent beginning at the first dollar of earned income. The credit would phase out at 1 percent beginning at $75,000 for single filers and $110,000 for married joint filers. All dollar thresholds would be indexed to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. .

Tax Foundation’s Growth and Opportunity tax reform option includes a $2,000 CTC that would phase in with earned income above $2,500 at 15 percent and phase out at 5 percent when income exceeds $50,000 for single filers and $100,000 for joint filers. All dollar thresholds would be indexed to inflation.

As the TCJA expiration nears, lawmakers face difficult choices in reforming the CTC. While revenue, distributional and economic effects are important, lawmakers should also focus on simplifying the rules and reducing the administrative challenges.

Share this article