Tuesday, May 5, 2009

[Group 5] The Minnesota Working Family Credit: Another Government Giveaway or Sound Economic Policy?

In 1991, Minnesota created the Working Family Credit (WFC), based on the Federal Earned Income Tax Credit (EITC). The EITC has been around since 1975, when it was included in an economic stimulus package (sound familiar?). It was small, only $400 for families with children, but 6.2 million families still claimed the credit in its first year. The credit was made permanent in 1978, expanded significantly in 1986 under President Ronald Reagan, and doubled in size under President Clinton in 1993. It was in 1993 that a small credit for single working adults was added.

The EITC is one of the largest and generally considered the most successful anti-poverty programs of the Federal government. It's also one of the few US social welfare programs widely adopted outside North America. It may be surprising to learn that the origin of the EITC can be traced to a proposal by conservative economist Milton Friedman. He had originally suggested a negative income tax, which would have replaced all welfare programs with a cash payment that declined as income rose. Despite the support of then President Nixon, Congressional opposition to the idea led instead to the creation of the EITC.

The EITC, and the WFC, is a means-tested tax credit that applies only to earned income. The credit is calculated through a formula that considers the number of dependent children, shown below. A taxpayer’s EITC increases for every dollar earned until a maximum earned income threshold is reached but the credit does not decrease until a much higher phase-out threshold is reached. The credit is structured this way to decrease the disincentive for individuals and families at the maximum earned income threshold.

The first state to establish its own state EITC was Rhode Island in 1986. Since then, twenty-two more states and the District of Columbia have created their own credits. Like the Federal credit, most state credits are refundable. Only 4 states do not provide refundable credits: Connecticut, Delaware, Maine, and Virginia. There are 18 states with a state income tax, but without a state version of the EITC credit. Households can claim both the Federal EITC and their state credit; they are not mutually exclusive.

Eligibility for these credits is based on the Federal EITC standard. Every state, except Minnesota, calculates its credit as a fraction of the Federal credit.

In 1998, Minnesota restructured its Working Family Tax Credit and renamed it the Working Family Credit. The old credit was set at 15% of the EITC and was scheduled to increase to 25% in 1998, but the Legislature was increasingly concerned with disincentives created by the interaction of the credit with wages and the state's welfare programs. So, the legislature created a two-tier system that increases the maximum benefit, so net income does not decline as a recipient works more hours. Unlike the EITC, when the maximum benefit is reached, the Minnesota state credit increases to a second and higher maximum. The state credit only begins to phase-out when earned income reaches a new higher floor. This change was made to address the relative regressiveness of state income taxes and increase the work incentive.

Most studies indicate that the EITC and similar state credits create a meaningful work incentive and raise low-income working families out of poverty. In 2003, it was estimated that EITC lifted 4.4 million families above the poverty line. It is also estimated that 60% of the increase in employment of single mothers is also because of the credits.

Although the EITC and related state credit programs are generally regarded as effective and successful, there are some common issues associated with them. These problems include: work disincentives, low participation rates, and tax filing costs. Another criticism sometimes leveled at the program is that it does not address poverty for indigent non-working adults. This latter criticism seems to miss the point of the credit. Minnesota has already addressed the first problem with the 1998 revisions to its credit formula. To address some of the other concerns, we recommend the following actions: increase outreach to eligible populations, especially non-native English speakers; ensure free tax filing services are available in low-income communities; and monitor WFC usage and job participation. We believe these actions will provide a solid first step toward addressing common problems with the WFC and increase the credit's effectiveness.

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