The US Earned Income Tax Credit

  40. Considerable interest has been expressed by the Government in the United States' Earned Income Tax Credit (EITC). The EITC is a refundable tax credit that provides benefits to low income families with children. The EITC was introduced in 1975. It was expanded in the tax reform acts of 1986, 1990 and 1993. In 1996 the total cost of the EITC to the federal government was $25 billion, and 18 million families received the credit. Only taxpayers who work are eligible for the credit. The EITC is generally received as part of a taxpayer's annual tax refund cheque at the end of the tax year, and the amount of the credit is based upon total earnings in the previous year. The credit is larger for families with two or more children than for families with one child. Lone parents and married parents receive the same amount of the credit.[68]

  41. Professor Jeffrey Liebman of Harvard University has published a Report on the US Earned Income Tax Credit experience.[69] His findings include:

  -  EITC has helped many people from welfare to work - his previous research studied the 1987 expansion of the scheme and concluded that 500,000 lone mothers were working because of the EITC who would not otherwise be working (compared to 4.5 million lone mothers then receiving Aid to Families with Dependent Children).

  -  EITC has helped reduce both income inequality (through transfer of resources to low income workers) and poverty (although it does little or nothing for those with no labour market income).

  -  EITC has a high participation (take-up) rate but the US Inland Revenue Service has estimated that about one third of EITC recipients were ineligible for the payment.

  -  Overall EITC appeared to be inexpensive to administer compared to the welfare system.[70]

  42. Most reaction to an Earned Income Tax Credit in submissions to the Committee tended to be negative in tone. The Child Poverty Action Group's memorandum listed what they believed to be the most obvious disadvantages:

-  Payment would go to the main earner rather than carer, transferring resources from `handbag to wallet'.

-  All tax payers would need to file a tax return, giving details of work activity over the year, which may be particularly complex for people on low incomes who move disproportionately frequently in and out of work.

-  For some, the fact that this structure would discourage marriage may well be an issue, more would be gained through filing separately.

-  Low income couples would lose rights to independent taxation.

-  Fraud rates are astronomical - tax payers `invent' children (although receipt of Child Benefit might be one way of countering that in the UK) and overstate earnings to attract more rebate.

-  It does not avoid the poverty trap - in the USA EITCs interact with food stamps to create familiar problems.

-  It does not provide any immediate incentive to work - payment could be made as much as 16 months later (for Family Credit 90 per cent of claims are processed in 5 days).

-  Expenditure on EITC has increased exponentially - from $1.7bn in 1986 rising to $18bn in 1996.[71]

  43. The Trades Union Congress[72] believed that Family Credit achieved in Britain the objectives that EITC achieved in the US and that EITC brought a number of potential disadvantages similar to those outlined by the Child Poverty Action Group. The Institute of Public Policy Research provided a further analysis of the advantages and disadvantages of the Earned Income Tax Credit.[73] Professor Piachaud thought that Family Credit amounted to an Earned Income Tax Credit but that Family Credit was based on sounder principles.[74] Professor Minford agreed that EITC seemed to be "another way of crafting the slopes" and "seems in many ways worse" than the current British system.[75] The Child Poverty Action Group believed that the only advantages are presentational and even these were questionable.[76]

  44. Arguably, Family Credit already delivers the benefits identified for EITC : encouraging work, reducing inequality and poverty. The differences between the two countries and their respective tax and benefits systems are reflected in the different mechanisms for administering and delivering the payments. EITC pays benefits after the end of the tax year, rather than Family Credit's weekly payment. The EITC is based on the annual tax return of the family whereas most people in the UK do not have to submit annual tax returns.

  45. Mr Chris Kelly summed up some of the differences between the American and British contexts in which any tax credit system would operate:

    "You cannot simply pick up the US system and transplant it over here. If you could then there would not be any need to do the work we have been doing. The US earned income tax credit system forms part of a system which is different in a number of very different respects from the system that we operate over here both in terms of the number of people who have annual tax returns, the fact that people are used to having repayments of tax at the end of the year whereas with our system it tends not to happen for the majority and the fact that we have a very extensive system of other benefits whereas the US does not apart from food stamps."[77]

  46. Crucially, as Ms Fran Bennett pointed out, the US has no universal benefit for children so that EITC is in part substituting for Child Benefit.[78] The US has only a very marginal form of help with housing costs so that interaction with the EITC is not a significant factor in work incentives. On the other hand, the UK has a very widespread and relatively generous system of Housing Benefit. It is Housing Benefit's interaction with Family Credit, or any other benefit that replaced it, that exacerbates the poverty trap in the UK.

  47. Andersen Consulting referred to attempts in other countries to integrate the tax and benefits system: some negative income pilots were conducted in the late 1960s and early 1970s in the United States and Canada, but these were not taken any further.[79] Recommendations were made for various versions of integration in Canada, Australia and the Netherlands between the mid 1970s and the mid 1980s, but none was implemented.[80] We will be looking further at what lessons can be usefully learned from the experience of other countries.

  48. International conventions determine whether Governments can classify their actions as public expenditure or taxation. The physical action of transferring money to an individual or a family from government always counts as public expenditure. Not levying taxation that might otherwise be due (for example the tax-free personal allowance) is allowed to count as a reduction in taxation. Therefore, if an individual (or family) were receiving a negative tax payment (EITC) this would count as public expenditure. A note from HM Treasury described the Government guidelines for national accounting:

    "The classification of payments associated with an earned income tax credit would depend on the details of the system. Where the amounts `credited' are no larger than an individual's total tax liability, and the tax credit is an integral part of the tax system and administered by the Inland Revenue, then an earned income tax credit is likely to score as reducing tax receipts. But making cash payments in respect of tax credits to people who have no tax liability to offset their credits against is likely to score as public spending. The control regime for the public finances is, of course, a matter for the Government. If an earned income tax credit were introduced, the Government would need to decide whether to replicate national accounting conventions within the control regime."[81]

  49. In the UK, Mortgage Interest Tax Relief acts as a precedent. MIRAS is formally part of the income tax code but essentially is simply a flat rate mortgage subsidy to all mortgagors. As the extract from Inland Revenue Statistics below shows, for tax-payers (as it is formally part of income tax) it is treated as a reduction in taxation and for non tax-payers, it is treated as public expenditure:

    "Before the introduction of the mortgage interest relief at source scheme, people who did not pay income tax obtained a similar reduction in their interest payments under the Option Mortgage Scheme. This scheme was funded by the Department of the Environment. Borrowers are now able to deduct income tax at the available rate from their interest payments irrespective of the level of their taxable income. Any payments to lenders for interest paid by non-taxpayers are treated as public expenditure, rather than tax relief. Similarly, since 1992-93, the part of payments made to lenders for interest paid by lower rate taxpayers which covers the difference between the basic rate and the lower rate of tax is treated as public expenditure."[82]

  50. If these same principles were applied to an EITC of exactly the same structure as Family Credit currently has, Table 4 shows the likely effects on public expenditure. The calculations have been performed using the 1995-96 Family Resources Survey, for each Family Credit recipient deducting the income tax paid from the Family Credit amount received. The remaining Family Credit would still be treated as public expenditure. The first block of Table 4 shows the most likely results. This assumes that Family Credit could only be deducted from the recipient's income tax bill. It shows that only 9 per cent of total Family Credit paid merely offsets income tax charged. This means that recorded public expenditure could be reduced by just over £200m. The second section calculates a similar figure but deducts Family Credit from both income tax and NICs. In the third section, it is assumed that joint assessment applies so the receipt of Family Credit can offset against the family's income tax liability. The fourth includes NICs on a joint basis.

Table 4: Comparative effects on public expenditure of alternative methods of accounting for Family Credit