Closer Look at Option to Restructure EITC/CTC to Help Low-Income Households

June 1, 2021

Our new book Options for Reforming America’s Tax Code 2.0 models several tax proposals that would help low-income taxpayers with little impact on overall economic growth. Here we take a closer look at the most extensive of these proposals: restructuring the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) based on the Family Security Act proposed by Sen. Mitt Romney (R-UT) in February.

We find that this restructuring would have significant positive impacts on low-income households, while boosting growth slightly due to changes in the marginal tax rates on labor during the phase-in and phaseout of the credits.

The CTC reduces a taxpayer’s tax liability based on the number of qualifying children under age 17 in their household. The credit is partially refundable up to $1,400 and phases out at $50 for every $1,000 in income above $200,000 for single filers and $400,000 for joint filers. After 2025, the credit is set to drop from $2,000 to $1,000, due to the expiration of the 2017 Tax Cuts and Jobs Act. The option here would retain the phaseout but make the credit fully refundable and more than double its value. The total credit would increase to $4,200 per child under age 6, and $3,000 per child from ages 6 to 17. It would also eliminate the minimum income requirement, currently set at $2,500 ($3,500 after 2025) for earned income.

Unlike the CTC, the EITC is a fully refundable tax credit. It reduces a taxpayer’s liability based on earned income and number of qualifying children. Taxpayers with children are eligible for a much larger credit than childless taxpayers, for whom the credit maxes out at $530 (temporarily increased for 2021 to approximately $1,500). Like the CTC, the EITC also phases out over a certain income range. The option here would retain the phaseout but change the benefits to a maximum credit of $1,000 per adult and an extra $1,000 for households with dependents.

The combined CTC and EITC reforms would benefit taxpayers across income distributions, with the largest benefits for low-income households. The bottom quintile would see incomes increase by 3.3 percent on a long-run dynamic basis.

Table 1. Effects of Restructuring CTC and EITC on Taxpayers in the Bottom Quintile
Conventional Change in After-Tax Income 2022 +5.5%
Conventional Change in After-Tax Income 2031 +3.2%
Long-Run Dynamic Change in After-Tax Income +3.3%
Conventional 10-Year Revenue -$1,414.4 billion
GDP +0.1%

Source: Options for Reforming America’s Tax Code 2.0.

The changes would have a slight impact on economic growth, increasing long-run GDP by 0.1 percent, due to the changes in marginal tax rates on labor. The changes to the credit schedules for both the EITC and CTC would alter the marginal tax rates in both the phase-in and phaseout ranges of the credits. The net effect would be a slight reduction in marginal tax rates, boosting labor supply.

As we’ve noted in a previous post discussing options to help low-income households, expanding the CTC and EITC would be more effective for helping those at the bottom than cutting statutory marginal income tax rates or increasing the standard deduction. Although, ultimately, policies that boost growth over time will improve the prospects of low-income households, policymakers interested in immediate relief could also consider reforms to tax credit programs.

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.

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.

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.

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.