August 8, 2013

Case Study #9: The Child Tax Credit

Download (PDF) Fiscal Fact No. 387: Case Study #9: The Child Tax Credit

These results are part of an eleven-part series, The Economics of the Blank Slate, created to discuss the economic effects of repealing various individual tax expenditures. In these reports, Tax Foundation economists use our macroeconomic model to answer two questions lawmakers are considering:

  1. What effect does eliminating these expenditures have on GDP, jobs, and federal revenue?
  2. What would be the effect on GDP, jobs, and federal revenue if the static savings were used to finance tax cuts on a revenue neutral basis?

For an overview of the project, click here. For links to articles from the rest of the series, click here.

Key Points:

Eliminating the Child Tax Credit would:

  • Increase tax revenues by $47 billion on a static basis;
  • Increase GDP by $14 billion; and
  • Increase revenues by $50 billion on a dynamic basis;
  • Increase employment by the equivalent of approximately 110,000 full-time workers; and
  • Produce little change in hourly wages.

Eliminating the Child Tax Credit and trading the static revenue gains for individual rate cuts would:

  • Allow for an across-the-board rate cut of 4.8 percent;
  • Increase GDP by $90 billion per year; and
  • Increase federal revenues by $21 billion on a dynamic basis;
  • Increase employment by the equivalent of approximately 536,000 full-time workers; and
  • Increase hourly wages by 0.1 percent

The Child Tax Credit was enacted in 1997 and in its current form provides a tax credit of $1,000 for each eligible child under the age of seventeen. If the credit exceeds the filer's tax liability, it may be partially or entirely refundable depending on the filer's earned income. The credit lowers the marginal tax rate on very low incomes. In particular, at very low income levels, the credit may create a negative marginal tax rate of 15 points because each extra dollar of earned income makes 15 more cents of the credit eligible for refund. By contrast, the credit phases out at a 5 percent rate per eligible child over an adjusted gross income (AGI) range of $75,000-$95,000 for single filers and heads of households ($110,000-$130,000 for joint filers). The phase-out produces a marginal tax rate spike of 5 percentage points for each eligible child. For instance, if a couple has two eligible children, their AGI is $115,000, and their AGI rises to $116,000, they will lose $100 of the credit. That is an effective marginal tax rate of 10 points on top of what the couple's marginal rate would be otherwise.

The Joint Committee on Taxation classifies the Child Tax Credit as one of the larger tax expenditures, costing $56.8 billion in 2012 including the refundable portion. When the Tax Foundation's model runs a conventional static revenue estimate that assumes taxes have no effect on growth, it estimates the added federal revenue from repealing the credit would be $47 billion in 2012.

Eliminating the credit would have growth effects pulling in opposite directions, and the net effect is positive. Ending the phase-in of the refund would increase marginal tax rates for some filers with very low incomes. But abolishing the credit would end the income-based phase-out and would lower marginal tax rates for the many filers within the phase-out zone. Based on the taxpayer information in the IRS Public Use File, our dynamic model estimates that the rate spike due to the phase-out is the dominant effect, and that labor and capital supplies would be slightly greater without the credit than with it. Our model predicts that eliminating the credit would raise GDP by $14 billion and lift federal revenue by $50 billion, which is slightly higher than the static estimate due to the positive growth feedback. (See Chart 1.)

Suppose the assumed revenue gain is based on the conventional static estimate and used to pay for an across-the-board reduction in individual income tax rates.[1] As indicated in Chart 2, rates could be lowered 4.8 percent (for example, the 15 percent bracket would become 14.3 percent). The lower marginal rates and higher after-tax returns on labor and capital would lead to a larger economy and the positive economic feedback would offset some of the revenue cost of the tax reduction. The model estimates that trading the Child Tax Credit for lower tax rates would boost GDP by a net $90 billion and federal revenue by a net $21 billion, once the economy had fully adjusted. The higher GDP and pre-tax incomes would partially offset the loss of the tax credit for low-income households, although the net effect would be less redistribution.

Growth is just one of the factors to consider when evaluating the Child Tax Credit and may not be among the main factors. Nevertheless, it should not be ignored.

Finally, we determined the impact of these scenarios on employment and wages. We found that eliminating the Child Tax Credit would increase employment by the equivalent of about 110,000 full-time workers with little change in the hourly wage. With the rate cut offset, employment would increase by the equivalent of about 536,000 full-time workers and hourly wages would rise by 0.1 percent.

[1] We assume proportional cuts in all of the ordinary income tax bracket rates but no cuts in the lower tax rates on capital gains and qualified dividends.

A 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.

Tax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans.

A tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat.

Adjusted gross income (AGI) is a taxpayer’s total income minus certain “above-the-line” deductions. It is a broad measure that includes income from wages, salaries, interest, dividends, retirement income, Social Security benefits, capital gains, business, and other sources, and subtracts specific deductions.

The 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.

A 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.