EITC: Erroneous Claims Run High

Today’s BNA Daily Tax Report contains an interesting story on the Earned Income Tax Credit. It reports that 17 percent of taxpayers claim this credit, and up to one-fourth of these claims are paid erroneously.

First, a little background. The EITC concept was the brainchild of Milton Friedman, who conceived of a refundable credit or “negative income tax” as a means of delivering a welfare benefit to those working in low-wage jobs. In effect, the credit becomes a form of subsidy to adults, and particularly families with children, who are working their way up the economic ladder. Although these individuals pay social security, sales, and other forms of taxation, most are not earning enough to be paying federal income taxes. Instead, they receive a “refund” (a misnomer, admittedly, for those without tax liability) based on filing a claim for the EITC.

Though this approach appears to avoid a separate welfare bureaucracy and it also requires work to earn the credit, which is something welfare programs have not done well, there are still complexities associated with claiming the credit. The IRS has sought out volunteers to provide income tax assistance for lower-income Americans (the VITA program) in order to help those eligible for the credit to claim it. Thus, unpaid volunteer hours are also associated with this program in lieu of some government bureaucrats.

For lower-income taxpayers, particularly those with dependent children, the benefit does make a difference. The maximum credit for a taxpayer with two children is $4,400 (2005). However, that maximum is achieved at AGI of $11,000 (i.e., you get 40% of the first 11,000). Beginning at $14,370, the credit phases out, reaching zero at $35,263. (See Rev. Proc. 2004-71). In effect, you lose the credit at a rate of about 21% - which is much higher than the applicable tax bracket you are likely to be in. (Other possible credits may also be available, including the Child credit, which is partially refundable. Some states also have EITC programs - more on that to come in a later blog.)

Here are a few thoughts:
(1) A program in which one fourth of funds are paid out in error raises serious concerns about administrative effectiveness. According to a 1999 IRS study, overpayments of EITC claims were estimated between $8.5 and $9.8 billion.
(That study is referenced in a 2005 report to Congress, which can be found here:
http://www.irs.gov/pub/irs-utl/irs_earned_income_tax_credit_initiative_final_report
_to_congress_october_2005.pdf) (You may have to paste this in your browser due to wrapping problems.)

False claims or erroneous claims about eligible children are thought to comprise the largest share of these erroneous payments. Thus, additional compliance efforts might produce some savings here

(2) The indirect payment approach, which avoids a welfare bureacracy, still involves administrative costs. The BNA article indicates that about 45% of individual tax audits involve EITC. Many of these are apparently of the “letter audit” variety, as the IRS official in charge is quoted as saying that only 5 percent of the audit budget is spent on the EITC.

A recent press release from Commissioner Everson gives us this perspective on enforcement: “Last year, the IRS produced direct enforcement revenues of more than $43 billion from collection, audit and document-matching efforts. This reflects better than a 4-1 return for every dollar invested in the total agency budget. Increased enforcement funding makes good sense and contributes to deficit reduction.”
(See http://www.irs.gov/newsroom/article/0,,id=134880,00.html)

Assuming about $10 billion is spent to collect that $43 billion, then perhaps half a billion is spent auditing EITC (i.e., 5 percent of $10 billion). Who knows how much more would have to be spent to make a dent in as much as $10 billion being paid out erroneously.

(3) Despite the fact that there is probably money to be gained for the government till through more enforcement efforts here, taking on this issue is a political hot potato. The issue suffers from the same kind of blame-shifting we engaged in as kids: I may have done wrong, but my brother did worse.

With a tax gap (estimated difference in legal liability over collections) totaling more than $345 billion, one might argue that there are a lot of people out there who are not paying their legal liability. Targeting the tax shelter industry addresses this concern, and that has proven politically popular. However, the latest from Commissioner Everson indicates that enforcement efforts on abusive tax shelters netted only $2 billion last year.
See http://tax.cchgroup.com/news/headlines/2006/nws32806.htm .

When we tried the shifting blame game on my parents, that usually meant my brother and I were both sent out to clean the barn or some other unpleasant task – a just result. We need to respond more like my parents, I think, in keeping a judicious eye on all forms of tax abuse. The reality is that human beings are not angels – and that applies to all humans. In fact, that is quite a good note to end on before the Easter/Passover holidays.

EAM