Evaluating Options to Help Low-Income Households

May 4, 2021

In our new book, Options for Reforming America’s Tax Code 2.0, we illustrate the economic, distributional, and revenue trade-offs of 70 tax changes, including several that would boost the incomes of poor households specifically. Below we evaluate some options that would provide the largest direct relief to low-income taxpayers but would have little impact on economic growth. We then compare these options to others that would be less effective for helping this group.

For many low-income households, payroll taxes comprise a larger share of their tax burden than individual income taxes do. In fact, due to tax credits such as the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC), many taxpayers do not have any federal individual income tax liability at all and will in some cases receive a tax refund. Consequently, expanding credits is the most effective way to target low-income households.

Table 1. Three Effective Options to Help Households in the Bottom Quintile
  Conventional change in after-tax income 2022 Conventional change in after-tax income 2031 Long-run dynamic change in after-tax income Conventional 10-year revenue GDP
Double EITC for Childless Workers +1.0% +1.0% +1.0% -$35.5 billion <+0.05%
Double EITC for Childless Workers and Reduce Marriage Penalty +3.0% +3.0% +3.1% -$164.0 billion +0.1%
Make CTC Fully Refundable +4.7% +0.6% +0.6% -$72.3 billion <-0.05%

Source: Tax Foundation General Equilibrium Model, March 2021

One option for helping low-income households would be to double the EITC for workers without qualifying children. Currently, childless workers are only eligible for a small credit, while households with qualifying children receive a large subsidy. Since the EITC phases out with income, it is well-targeted to vulnerable populations. Doubling the credit for childless workers increase incomes for those in the bottom quintile by 1 percent. The change would decrease marginal tax rates on households in the EITC phase-in range but increase marginal tax rates on households in the phaseout range, resulting in a negligible impact on GDP. 

Pairing this tax change with a reform to the EITC’s marriage penalty would further boost incomes of low-income households. Phaseout thresholds differ between single/head of households and married joint filers in a way that makes joint filers eligible for a smaller credit than when the two people would file their taxes individually. This option would reduce this marriage penalty by increasing the phaseout threshold for married joint filers to double the threshold for non-married filers. The combination of this and the expansion of the EITC for childless workers would raise incomes for those in the bottom quintile by 3 percent. The aggregate marginal tax rate on labor would fall slightly due to the offsetting effect between phase-in and phaseout changes.

Of the three options considered here, making the CTC fully refundable would have the largest immediate impact on low-income households. Unlike the EITC, which is fully refundable, the CTC currently limits refundability to $1,400 through 2025 and phases in above a certain income threshold. This option would eliminate both the refundability cap and the phase-in. This change would increase incomes of those in the bottom quintile by 4.7 percent in 2022. However, as the size of the credit is set to fall under current law after 2025, the impact would be smaller over time.

As noted, since many low-income taxpayers already face zero or negative effective income tax rates, options that reduce taxable income or statutory marginal rates will be less effective in boosting their incomes. Below we consider three options that have only trivial impacts on low-income taxpayers.

Table 2. Three Less Effective Options to Help Households in the Bottom Quintile
  Conventional change in after-tax income 2022 Conventional change in after-tax income 2031 Long-run dynamic change in after-tax income Conventional 10-year revenue GDP
Increase Standard Deduction by 25% 0% <+0.05% <+0.05% $-622.7 billion <+0.05%
Restore Personal Exemption <+0.05% 0% 0% -$774.4 billion 0%
Make Charitable Deduction “Above-the-Line” 0% <+0.05% <+0.05% -$289.3 billion <-0.05%

Source: Tax Foundation General Equilibrium Model, March 2021

Increasing the standard deduction by 25 percent for all filers would not bring targeted benefits to the lowest quintile of income earners. Many households in that income range have incomes lower than the existing standard deduction, and an even larger number already have no tax liability thanks to partially nonrefundable tax credits. Restoring the personal exemption faces similar problems. The personal exemption is economically comparable to a deduction, and as such, people in the lowest quintile will not benefit much given that their taxable income is already very close to zero. 

Finally, making the charitable deduction above-the-line would allow every taxpayer to deduct their charitable giving, rather than only those who itemize their deductions. However, taxpayers in the bottom quintile do not have significant tax liability to reduce in the first place. As a result, this option would only raise the bottom quintile’s income by about 0.05 percent. The model does not include the potential benefit for low-income taxpayers that increased tax incentives for charitable giving may provide, but there is reason to doubt the efficacy of this policy in increasing contributions to charities. The Tax Cuts and Jobs Act of 2017 reduced the incentive to itemize, but despite this reduction in incentives, charitable giving did not fall significantly after 2017.

While strong economic growth—fueled by higher levels of investment, productivity, and jobs—will lift after-tax incomes over time, policies that provide relief by immediately boosting after-tax incomes of lower-income households are also available. As lawmakers consider such policies, they should keep in mind the trade-offs among them.

Options for Reforming America’s Tax Code 2.0

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A 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.

A tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in tax refunds. Overpaying taxes can be viewed as an interest-free loan to the government.

The standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes.

A marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples.

The federal child tax credit (CTC) is a partially refundable credit that allows low- and moderate-income families to reduce their tax liability dollar-for-dollar by up to $2,000 for each qualifying child. The credit phases out depending on the modified adjusted gross income amounts for single filers or joint filers.

After-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 after-tax income.

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.

Taxable 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.

The Earned Income Tax Credit (EITC) is a refundable tax credit targeted at low-income working families. The credit offsets tax liability, the total amount of tax debt owed by an individual, corporation, or other entity to a taxing authority like the Internal Revenue Service (IRS), and can even generate a refund, with EITC amounts calculated on the basis of income and number of children.