STATE WELFARE REFORM: INTEGRATING TAX CREDITS AND...

STATE WELFARE REFORM: INTEGRATING TAX CREDITS AND INCOME TRANSFERS PAUL WILSON* & ROBERT CLINE**

INTRODUCTION

A major goal of welfare reform is the provision of greater incentives to move from welfare to self-sufficiency. A common reform strategy is to increase work incentives by raising the amount that a low-income family can gain by working. There are three distinct ways to do this: reform AFDC itself; provide low-income workers with guaranteed access to low- cost health insurance; and/or provide targeted tax credits to low-income working families through the federal and state tax systems. Recent incremental reforms have used each of these three ap- proaches, with changes in the tax system having the most powerful impact. This piecemeal approach to reform has created a complex system of overlapping and uncoordinated programs, as summarized in Table 1. Changes in individual programs have been made with little un- derstanding of how they interact and af- fect the entire system.

This paper examines the impact of the combined tax and transfer systems on

*St Olaf College, Northfield, MN 55057

**Minnesota Department of Revenue, Tax Research, St Paul,

MN 55146

Minnesota’s low-income families, ex- tending earlier Minnesota studies by Steuerle and Wilson (1987) and Michael and Manzi (1993). It then discusses the potential for integrating the tax credit and direct transfer programs at the state level. Minnesota is a leader in using its tax system to provide targeted benefits to low-income families. It has also pro- gressed further than most states in health care reform by introducing a state-funded, sliding-scale health insurance subsidy for low-income families not qualifying for Medicaid. Ongoing discussions by state policymakers are exploring how the integration of the tax and transfer systems might reduce complexity, lower administrative costs, and increase the power of work incentives. With a refundable child and dependent care credit, a state earned income tax credit, a generous property tax credit, and a subsidized health insurance program, Minnesota provides an excellent case study for an initial discussion of the issues related to integrating tax credit and transfer programs.

The first section of this paper describes the components of the tax and transfer system in Minnesota. The second section

655

TABL

E 1

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uses a unique database to exarnine the overlap among programs and to show how benefits are distributed by poverty decile. The third section illustrates how federal and Minnesota tax credits, combined with Minnesota’s sliding-scale health insurance subsidy, now offset much of the work drsincentives created by AFDC, food stamps, and Medicaid. It also illustrates how these tax credits and the health Insurance subsidy reduce work incentives at higher income levels as they are phased out. The concluding sections examine issues raised in integrating tax credit and direct transfer programs and describe initial efforts at integrating the two at the state level.

ALTERNATIVE PATHS ‘TO RESTORING WORK INCENTIVES

Families qualifying for AFDC have always faced strong work disincentives. Since 1982, the benefit-reduction rate for AFDC has been ‘100 percent. Each dollar of earnings beyond $90 per month reduces AFDC benefits (net of day care costs) by a full dollar, so little is gained by working. These strong work disincentives are common knowledge, but low- ering the benefit-reduction rate is costly. A lower benefit-reduction rate would either increase the number of working households qualifying for AFDC, thereby raising the cost to the government (and making more people subject to the earnings disincenltives); or it would require a cut in benefits for nonworking recipients, hurting those most in need. Furthermore, economists have generally concluded that AFDC households will respond little to increased work incentives within the current transfer system (Mof- fitt, 1992). Given this relatively small estimated response, economic efficiency argues for a rapid phaseout of benefits (a high benefit-reduction rate).’

Despite these arguments, both the federal and state governments have acted

to increase work incentives. From a policy perspective, a system that fails to re- ward those attemptin to make the

Ip transition from welfa e to work. is unacceptable to most people, whether liberal or conservative. Increasing the net gain from working is there/fore a common feature of recent reforms in AFDC, in subsidized health insurance programs, and (most emphatical/y) in targeted tax credits.

Since 1990, over 20 states have received waivers of federal reqluirements’ to en- able the states to exderiment in their AFDC and food stam’ programs.’ Min-

I nesota’s experiment, ike those in at least 13 of the other Istates, inc:reases work incentives by reducing the AFDC benefit-reduction rates. Each dollar of earnings will reduce the combined AFDC and food stamp payment by only $0.62, so the family gains $0.38.3 This experi- mental program, begun in April 1994, will enroll up to ten oercent of Minne- sota’s AFDC families. iln addition, experiments are under way~at both state and federal levels to integrate AFDC and food stamp programs~. This paper does not include a discussion of these AFDC reform experiments. Instead, it examines the existing AFDC an food stamp programs for the other 0 percent of Min nesota’s AFDC famili B s, for whom the benefit-reduction rate1 remains at 100 perceni (as shown in ,Table 1).

Recent federal changes in Medicaid have also been designed t reduce work disincentives. Until rece 4 tly, workers who earned their way off pelfare lost Medi- caid eligibility immedibtely. This sudden and total loss of Medicaid coverage created serious work disincentives, because low-wage jobs rarely include employer- provided health insurance. Federal changes in Medicaid eligibility rules (effective in 1990) have ~significantly re- duced this problem. F/ledicaid eligibility is now extended for d full year if a fam-

658

I THE STATES, TAXES, AND THE FEDERAL SOCIAL AGENDA

ily loses eligibility because of increased earnings. In addition, federal law increased the income levels at which young children lose Medicaid coverage, and Minnesota raised these limits even further in 1991.

Minnesota’s sliding-scale health insurance program (MinnesotaCare), begun in 1992, goes even further in reducing the impact of losing Medicaid coverage (See Cline, 1993). MinnesotaCare provides subsidized insurance for families with incomes up to 275 percent of the poverty level who have no access to employer- provided insurance (and do not qualify for Medicaid). The subsidy phases out as income increases, with families paying an insurance premium ranging from 1.5 percent of income (at 133 percent of the poverty threshold) to 8.8 percent (at 275 percent of poverty). This program eliminates the “cliff” that occurs when earning a few more dollars results (a year later) in the loss of Medicaid eligibility. Instead, MinnesotaCare phases out the health insurance subsidy slowly as income rises. MinnesotaCare is a large entitlement program. By 1997, up to 136,000 Minnesota households could be receiving over $300 million of insurance subsidies through MinnesotaCare.

Federal and state tax credits also have a major impact on work incentives, offsetting much of the work disincentives created by the AFDC and food stamp programs. Most important are the expanded federal and state earned income tax credits. When fully phased in (in 1996), the recently expanded federal earned income tax credit (EITC) will provide a two-child, low-income working family with a 40 percent subsidy on the first $8,425 in earnings. The EITC is refundable, providing benefits to working families who owe no income tax (and would otherwise not file a tax return). For a family with two children, it effec-

tively raises the minimum wage from $4.25 per hour to $5.95 (for the first 1,980 hours of work). The EITC is phased out at a marginal tax rate of 21.06 percent for incomes between $11,000 and $27,000.4

Minnesota’s state EITC, called the Work- ing Family Credit (WFC), now equals 15 percent of the federal EITC. For a family with two children, this raises the wage subsidy from 40 percent to 46 percent (and effectively raises the minimum wage to $6.20 per hour). It also increases the phaseout rate from 21.06 percent to 24.22 percent. The 1993 expansion of the federal EITC, coupled with the simultaneous increase in Min- nesota’s credit from ten to 15 percent of the federal, will increase state WFC payments from $12 million in fiscal year 1993 to an estimated $36 million in fiscal year 1997. This tripling of the size of the Minnesota program has occurred without a detailed examination or public discussion of its structure and interaction with other tax credit and transfer programs.

The Minnesota tax system includes two other tax credits that are also targeted toward low-income families. First is Min- nesota’s child and dependent care credit (CDCC). Unlike the federal child care credit, the Minnesota credit is tightly targeted toward low-income families. It starts with the dollar amount of the federal credit, but the Minnesota CDCC dif- fers in two important respects: (1) the Minnesota credit is refundable; and (2) the credit is completely phased out at an income level near $29,000. This credit pays up to 30 percent of eligible child care expenses for low-income families, even those who pay no state income tax. In the phaseout range, the state CDCC creates another set of positive

659

marginal tax rates (10.3 percent for a family with two or more children).

Table 2 contrasts the distribution of the Minnesota credit with that of the federal child care credit, showing how its benefits are tightly targeted to lower-income households. The federal CDCC is usually justified as a reduction in taxable income to account for an expense of working, but the state CDCC is clearly a transfer targeted at low-income working families.5

The other Minnesota tax credit targeted to low-income households is the property tax credit (PTR) for renters. This circuit-breaker refund program pays a portion (declining from 91 to 50 percent as income rises) of property taxes ex- ceeding a threshold percent of income (1 .O percent up to 3.5 percent). The PTR is refundable, with a maximum of $1,000. It is phased out with income, with no credit fair renters where income exceeds $35,000.

DISTRIBUTION OF TRANSFERS AND CREDITS

The first step in evaluating the feasibility of integrating tax and transfer programs is to identify the distribution and actual overlap of current programs. This information is also important in understand- ing the actual level of marginal tax rates faced by taxpayers receiving income transfers and tax credits. A unique database recently developed by the Tax Re- search Division of the Minnesota Depart.- ment of Revenue can be used to identify this distribution in Minnesota. The database matches tax return and income transfer information by social security number for a stratified sample of households selected to represent the Minne- sota population. (Minnesota Department of Revenue, 1993).

The primary sources of information for this income distribution database are the

individual income tax returns (federal and state) and property tax refund forms filed with the Department of Revenue. Social security numbers were used to link other income sources with taxpayer information, including social security benefits, public assistance payments (AFDC, general assista,nce, and supple- mental aid), workers’ compensation, and unemployment compensation. This database is used to identify the number of recipients and dollar a,mounts of selected tax credits and transfer payments received by Minnesota households in 1990.

The earned income tax credits (both state and federal) have been greatly expanded since 1990. To see the impact of that expansion, the database was used to estimate what each family’s EITC and WFC would have1 been in 1990 based on 1996 law (deflated to 1990 dolYars).6

Table 3 provides an overview of the scope and cost of Minnesota’s transfer and tax credit system. Over 550,000 Minnesota households (27 percent of the population) receive cash transfers and tax credits from at least one program. Benefits totaled almost $1 .l bil- lion, including MinnesotaCare subsidies. As shovvn in Table 3, the combined cost of the expanded EITC and WFC in Min- nesota, almost $200 million, would have been 60 percent as large as AFDC transfers in 1990.

Table 3 also provides some information on the overlap of the tax and transfer system in Minnesota. The overlap cate- gories focus on AFDC recipients, EITC recipients, and those receiving both EITC and AFDC. Almost 20,000 households received both AFDC and EITC benefits during calendar year 1990. This repre- sents almost 25 percent of all AFDC recipients, far larger than the proportion of Minnesota AFDC recipients working

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TABLE 3 MINNESOTA CASH TRANSFERS AND TAX CREDITS

Type of Transfer/Credit Number

of Households

Transfer/Credit Amount

Total Average

(Thousands) ($ Millions)

Total Recipients EITC/WFCa 130.5 $195.4 $1,497 PTR (Renters) 241.4 76.0 315 GA 76.5 93.0 1,216 AFDC 81 .O 331.8 4,096 Federal CDCC 135.4 50.0 369 Minnesota CDCC 32.0 8.5 266 MinnesotaCareb 136.1 303.3 2,229

Total Amount gl,os8.0

Single Program Recipients EITC 77.4 $110.5 $1,428 PTR 178.5 53.6 300 GA 55.8 69.1 1,237 AFDC 36.6 145.9 3,986 CDCC 112.1 43.7 390

Multiple Program Recipients EITC and PTR or CDCC 32.6 $63.5 $1,948 AFDC and EITC 19.8 107.6 5,546 AFDC and PTR or CDCC 30.1 173.8 5,774

Total Households Receiving Transfers or Credits’ 553.9

Total Households 2,072.5 _------.--- --.-- -..- ‘EITC and WFC estimates are based on 1990 recipients and 1996 federal EITC parameters with dollars deflated to 1990 levels. bNumber of rectpients and dollar amounts are based on estimates of levels of participation and costs projected for fts- cal vear 1999: the dollalr amounts were deflated to 1990 levels. ‘Exiludes MinnesotaCare recipients.

in a given month (13 4 percent).7 The difference between the proportion of AFDC recipients working in a single month and the portion working at some time during the year reflects the high turnover rates in AFDC and points out the different time perspectives In annual tax credit and monthly transfer programs. Over 30,000 AFDC households (37 percent of the total) received either property tax refunds or a child and dependent care creldit. The overlap between EITC (WFC) and PTR or CDCC included 33,000 households.

Other significant overlaps cannot be estimated with the Minnesota database, because it includes only cash programs. Al- most all AFDC families receive food stamps and Medicaid. According to the

Green I3ook, 39 percent of all Minnesota AFDC households live in subsidized housing, while another ten percent are homeowners.8 Those In subsidized housing are not generally eligible for a property tax refund, explaiining the low overlap between PTR and ,AFDC. Almost all of ,the AFDC households who are homeowners will receive homeowner property tax refunds (not shown in Table 3). The overlap between the MinnesotaCare health insurance subsiidy and EITC or CDCC is also likely to be large. The limited overlap between AFDC and these other programs should also be stressed, given the desire to increase work incentives for those leavings AFDC (and for other low-income ho#eholds not qualifying for AFDC). As shown in Table 3, non-AFQC households comprise 85 per-


cent of those receiving EITC and the vast majority of those receiving child care credits and property tax refunds. Accord- ing to the Green Book, only half of those receiving food stamps also receive AFDC, and only one-quarter of those living in subsidized housing are on AFDC. There is also little overlap between MinnesotaCare and AFDC. Yet, each of these programs provides substantial benefits to those just beyond the income limits of AFDC.

Table 4 presents the 1990 distribution of Minnesota transfer payments and tax credits by population deciles based on federal poverty levels. The first decile, for example, includes the poorest ten percent of households in Minnesota-those with comprehensive money income below 60 percent of the poverty threshold.

In 1990, the poverty thresholds were $6,652 for an individual and $13,359 for a family of four, so the first decile includes single people with incomes below $3,390 and families of four with incomes below $8,015.

The distribution and overlap in Minneso- ta’s tax credit and transfer systems help to identify two distinct dimensions of the integration discussion. For AFDC recipients, the focus is on coordinating welfare transfers and tax credits and reducing work disincentives as recipients move .into jobs. Coordination and integration for these people could be imple- mented through the current welfare administrative structure. But for non-AFDC taxpayers, the focus is on coordinating tax credits, which are more effectively administered by federal and state tax

TABLE 4 MINNESOTA DISTRIBUTION OF 1991 TAX CREDITS AND CASH TRANSFERS BY

POVERTY THRESHOLD DECILES” (Amounts in Millions, Number of Recipients in Thousands)

Seventh First Second Third Fourth Fifth Sixth to Tenth Total

Percent of Poverty 61%

Earned income Tax Credit Amount $24.2 Number of recipients 11.1

Property Tax Refund (Renters) Amount $6.8 Number of recipients 22.9

General Assistance Amount $45.5 Number of recipients 51.2

AFDC Amount $124.7 Number of recipients 32.7

Child and Dependent Care Credits Amount $0.6 Number of recipients 1.8

MinnesotaCare Amount $0.0 Number of recipients 0.0

Total Amount $201.8

105% 153% 205% 259% 313% over 313%

671.1 $64.4 $29.5 $5.5 $0.4 $0.3 31.5 40.9 33.4 12.1 0.8 0.7

$195.4 130.5

$14.5 51.1

$17.8 49.5

$15.8 43.4

$10.0 28.4

$6.2 $4.8 23.3 22.7

$75.9 241.3

$16.8 14.1

$10.8 5.4

$9.3 2.4

$5.0 1.2

$3.7 $1.9 0.6 1.5

$93.0 76.4

$128.4 28.4

$51.4 11.8

$18.1 4.8

$3.4 1.4

$3.2 $2.7 0.7 1.1

$331.9 80.9

$0.9 4.9

$3.5 13.7

$9.4 27.7

$7.5 23.8

$6.9 $29.9 19.7 75.9

$58.7 167.5

$87.9 33.0

$103.8 45.1

$80.8 40.0

$25.4 14.0

$5.4 $0.0 4.0 0.0

$303.3 136.1

$319.6 $251.7 $162.9 $56.8 $25.8 $39.6 $1,058.2

‘The MinnesotaCare distribution by decile is based on Department of Human Services projections; all other distribu- tions are from the Minnesota Tax Incidence Study database.

663

agencies. However, with the significant expansion of the ElTC/WFC and the adoption of subsidized health insurance for non-AFDC taxpayers, there is a new transition zone between transfers and credits, whrch will require a coordinated effort by welfare and tax agencies to achieve income transfer and work incentive objectives.

THE IMPACT OF THE TAX AND TRANSFER SYSTEM ON THE GAIN FROM WORK

To illustrate the combined impact of the tax and transfer system on work incentives, consider a hypothetical single parent with two children, living in Minne- sota, who qualifies for AFDC. How much would this parent gain by working, con- sidering the interactions between transfer programs and federal and state tax credits? In the analysis that follows, we consider two variations on this question:

(1) What is the total gain from working full time (compared to not working at all)?

(2) What is the marginal gain from working additional hours for some- one already employed?

To simplify the analysis, we make the following additional assumptions: (1) day care costs equal 20 percent of earnings; (2) the family rents an (unsubsidized) apartment for $400 per month; (3) the family files a head of household tax return without iternizing deductions; and (4) the potential job does not include employer-provided health insurance (so the family will qualify for MinnesotaCare subsidized insurance if Medicaid eligibility ends).”

Total Gain from Work

Table 5 calculates taxes, transfers, and tax credits for this hypothetical family (in 1994), assuming several different potential wage rates and hours of work. With

no earnings, this family receives $6,384 in AFDC benefits and $2,757 in food stamps, for a total of’ $9,141. The entire farnily also qualifies for Medicaid. Be- cause working may ehd the family’s elk- gibility for Medicaid, we need to place a value on these Medic

$ id benefits. The

calculations in Table assume that Med- icaid is valued at costc$1,550 per adult and $725 per child.“~ Adding this $3,000 benefit to AFDC and food stamps gives a total of $12,14’1 in direct transfers (see Table 5, column 1).

Working full-time at a minimum-wage job, this individual would earn $8,840. After paying $676 in social security taxes, $1,768 for child care, and losing $5,992 in AFDC (but ~gaining $215 in food stamps”), the family’s net income before credits is $12,760, an increase of only $619. In the absence of the tax credits, the gain from work amounts to only seven percent of total earnings (see column 3). The tax credits greatly increase the gain from work, however. This full-time minimum-wage worker receives 163,370 in federal EITC, a Minne- sota Working Family Credit of $506, and a Minnesota refundable child care credit of $530. The family’s1 property tax refund declines by $35,~ but the credits add a net total of $41371 to the gain from work. Earning $8,840 results in a net increase of $4,99b after all transfers and credits, equal to 156.4 percent of earnings. The tax credits have lowered the cost of working from 93.0 percent of earnings to 43.6 percent of earnings.”

The above full-time, minimum-wage worker would still be covered by Medi- caid. The Importance of MinnesotaCare in restoring work inc by the case of a t

ntives is illustrated full- ime worker at 150

percent of the minimum wage (see column 4 in Table 5). At this level of earnings, the family loses ‘all AFDC and the parent’s Medicaid benefits (valued at $1,550). Net income before credits and MinnesotaCare rises by only six percent

TABL

E 5

TOTA

L G

AIN

FR

OM

W

OR

K (S

ING

LE P

AREN

T PL

US

TWO

C

HIL

DR

EN)

Wag

e R

ate

(Per

cent

of

m

inim

um

wag

e)

Hou

rs

per

Wee

k

- $4

.25

100%

20

-

0 SO

0%

$10.

63

$12.

75

$17.

00

=I

250%

30

0%

400%

a

40

$4,4

20

37%

$4.2

5 $6

.38

$8.5

0 10

0%

150%

20

0%

40

40

40

58.8

40

$13,

260

$17,

680

74%

11

2%

149%

40

$22,

100

186%

$2

6,52

0 22

3%

40

2 s3

5,oo

O

a 29

5%

P u

$0

$338

$6

76

----a

-- 83

38

8676

$0

$884

$1

,768

$1,0

14

114

-&- $2

,652

$1,3

53

777

311

62,4

41

$3,5

36

$1,6

91

1,44

0 57

6 ‘8

3,70

7

$2,0

29

2,10

3

3$7k

$4,4

20

$4,8

00

$2,6

78

2 3,

375

ITi

1,35

0 z

J7,4

03

$

84,8

00

$6,3

84

$3,9

28

2,75

7 2,

669

3,00

0 3,

000

812,

141

99,5

97

$12,

141

$12,

795

$0

$0

8392

2,

972

3,00

0 86

.364

12,7

60

$0

$12,

760

$2,0

50

1,45

0 ‘6

3,50

0

$12,

934

$1,4

54

$14,

388

$1,4

50

81,4

50

$13,

153

$1,3

22

$14,

475

Bo

Net

In

com

e be

fore

C

redi

ts

$12,

141

$12,

795

$13,

973

$1,9

32

$15,

905

bo

60

$16,

747

$22,

797

$1,4

40

SO

$18,

187

$22,

797

$1,7

68

$3,3

70

265

506

$960

$712

--$

m--

265

686

‘B2,

984

530

677

85,0

83

$17,

843

$2,8

94

61,9

63

434

294

114

777

743

919

593

474

84,7

78

84,4

27

$1,0

32

155

1017

72

0 35

8 -Y

tzy%

r

6101

15

1,

008

252

195

‘81,

571

Net

In

com

e Af

ter

Cre

dits

$1

2,85

3 $1

5,77

9 $1

9,16

6 $1

8,90

2 $1

9,18

7 $1

9,75

8

-.Yfs

a-

$23,

757

14.8

%

7.0%

6.

0%

5.7%

8.

3%

17.4

%

30.4

%

14.8

7.

0 16

.9

13.2

17

.0

22.8

30

.4

66.2

56

.4

47.6

34

.2

28.7

26

.0

31.2

Earn

ings

Pe

rcen

t of

po

verty

le

vel

Taxe

s (b

efor

e C

redi

ts)

Soci

al

Secu

rity

(em

ploy

ee

shar

e)

Fede

ral

inco

me

tax

Stat

e in

com

e ta

x To

tal

Chi

ld

Car

e C

ost

(bef

ore

Cre

dits

)

Dire

ct

Tran

sfer

Pa

ymen

ts

AFD

C

Food

st

amps

M

;did

ia;id

(v

alue

d at

co

st)

Net

In

com

e be

fore

C

redi

ts

or

Min

neso

taC

are

Min

neso

taC

are

Hea

lth

insu

ranc

e Su

bsid

y

Tax

Cre

dits

Fe

dera

l EI

TC

Stat

e EI

TC

Fede

ral

child

ca

re

cred

it St

ate

child

ca

re

cred

it Pr

oper

ty

tax

refu

nd

(rent

ers)

To

tal

Cre

dits

Tota

l G

ain

from

W

ork

(Per

cent

of

Ea

rnin

gs)

Befo

re

cred

its

or

Min

neso

taC

are

Afte

r M

inne

sota

Car

e Af

ter

Min

neso

taC

are

and

tax

cred

its

of earnings. With MinnesotaCare, the gain rises to 16.9 percent of earnings, and the tax credits increase it further to 47.6 percent. Clearly, the existence of MinnesotaCare and the tax credits has succeeded in offsetting much of the work disincentives created by the welfare system.13

Figure 1 illustrates1 the results of Table 5 graphically, showing how effectively MinnesotaCare and the tax credits restore work incentives in each of these seven cases, offsetting much of the work disincentives of phaseouts for AFDC and food stamps, the social security tax, and income taxes (before credits). Figure 2 shows the impact of MinnesotaCare and the tax credits on the total gain from work at every earn-

ings level up to $35,000.14 Minnesota- Care and the tax credits raise the total gain from working at @very level of earnings.

Marginal Gain from Work

Using tax credits to restore work. incentives for low-income workers comes at a cost, of course. A tax credit that provides work inc:entives while it is phased in will create work disi centives while it is phased out. Targete I tax credits are no magic bullet. The additional work incentives for those beloinl the poverty level are paid for by raising the marginal tax rates on those somlewhat above the poverty level. In this seInse, the tax credits have much the same effect as a reduction in the benefit-reduction rate in the AFDfE program. Cloaking a policy in

FIGURE 1 Total Gain from Work as Percent of Earnings

(Single Parent plus Two Children)

80

56.4 r-1 I

$4,420 $8,840

41.6

;I

34.2 31.2

$13,260 $17,680 $22,100 $26,5/20 $35,000 Total Earnings

Before MinnesotaCare and Tax Credits

Increase Due To cl

Increase Due To MinnesotaCare Tax Credits

660


FIGURE 2 Total Gain from Work


12,000

10,000

1 8 6,~

c

d . 4,000

54~

0 4,420 8,840 13,260 17,680 22,100 26,520 35,m

TOtdEhllgS

----- -___

new clothes may disguise the trade-offs, but it does not eliminate them.”

before MinnesotaCare and the tax credits is approximately the same as the total gain after MinnesotaCare and the tax ’

The marginal gain from work is shown credits. As a result, any increase in the by the slope of the lines in Figure 2. At marginal gain from work at lower levels an income of $35,000, the total gain of earnings (shown as a steeper positive

667

slope) must be matched by a decrease in the marginal gain at higher incomes (shown as a flatter slope). Note the flat- ness of the line representing the total gain after tax credits and MinnesotaCare between $13,260 and $26,520.

Table 6 shows the marginal cost of work for this hypothetical family faced with the combined tax and ,transfer system. The first column in Table 6 shows the impact of a small increase in hours worked if the parent was initially working half-time at the minimum wage. If earnings rose by !$lOO, the social security tax would take $7.65, child care would take an additional $20, and AFDC benefits would fall by $80 (while food stamps would rise by $9). Before consid- ering the tax credits, the $100 of add/- tional earnings would raise net income by only $1.35. However, the federal and state ElTCs would add $46 to earnings, while Minnesota’s refundable day care credit would add an additional $6. The property tax credit would fall by $1.50. After all credits, the net impact of the extra $100 in earnings is a gain of over $51.85.

At higher rncome levels, however, each of these tax credits is phased out. Dur- ing the phaseout, the credits reduce the incentive to work The EITC and WFC are phased out between $11,000 and $27,000. In that range, each $100 of extra earnings recluces the family’s combined EITC and WFC by $24.22. Minne- sota’s refundable child care credit is phased out between $15,180 (or some- what higher, depending on child care costs) and $28,830. Once the phaseout begins, each additional $100 of earnings reduces this family’s credit by $10.30. If this Minnesota family earned $26,520 and worked a little more to earn an extra $100, the family’s state and local tax payments (net of property tax refund) will rise by almost $70.16 In addition, if the family were receiving subsidized

668

health insurance through Minnesota- Care, the insurance prjemium would rise by almost $20. Adding child care and other work expenses, ihe marginal gain from work is negative~(see Table 6, column 6). At an income of $35,000, however, after the phaseout of the credits and the MInnesotaCare subsidy is com- pleted, the marginal gain from work is large and positive, equal to about half of gross earnings.

Figures 3, 4, and 5 graphically show the marginal cost of working. Figure 3 shows the marginal cost of working (as a percentage of gross earnings) before credits and MinnesotaCare. Figure 4 shows the individual contribution of MinnesotaCare and each tax credit to the marginal cost of working. Figure 5 shows the marginal cost of working after credits and MinnesotaCare. For a half-time worker at the minimurn wage, the tax credits raise the marginal gain from 1.35 percent of earnings to 51.85 percent of earnings. For a full-time minimurn-wage worker, the marginal gain from work also increased, but only slightly. At higher levels of earnings, however, the tax credits substantially reduce the marginal gain from work.

Incentive Effects and Tax-Transfer Design

Will workers respond to the positive and negative work incentives shown in these tables? The apparent power of tax credits may be diluted for three reasons: lack of information, filing complexity, and delay in receiving #benefits.

The earnings-reduction rates under AFDC and food stamps are well known, but people have less klnowledge of tax credits and their phaseout rates. A major public information campaign in Minne- sota has successfully abvertised the benefits available through’the earned income tax credits, but very few people understand how the phaseouts work. As

TABL

E 6

GAI

N

FRO

M

WO

RKI

NG

A

FEW

AD

DIT

ION

AL

HO

UR

S AS

PER

CEN

T O

F AD

DIT

ION

AL

EAR

NIN

GS

(SIN

GLE

PA

REN

T PL

US

TWO

C

HIL

DR

EN)

200%

40

25

0%

40

$22,

188

212%

300%

40

$26,

520

255%

400%

40

s35.

8w

295%

Wag

e (P

erce

nt

of

Min

imum

W

age)

H

ours

/ W

eek

Earn

ings

Pe

rcen

t of

po

verty

le

vel

Taxe

s (b

efor

e C

redi

ts)

Soci

al

Secu

rity

(em

ploy

ee

shar

e)

Fede

ral

inco

me

tax

Stat

e in

com

e ta

x To

tal

Chi

ld

Caf

e C

ost

(bef

ore

Cre

dits

)

AFD

C

and

Food

St

amps

AF

DC

Fo

od

stam

ps

Tota

l

Mar

gina

l C

ost

of

Wor

k,

befo

re

Cre

dits

(F

igur

e 3)

Tax

Cre

dits

an

d H

ealth

C

are

Subs

idy

Fede

ral

EITC

St

ate

EITC

Fe

dera

l ch

ild

care

cr

edit

Stat

e ch

ild

care

cr

edit

Prop

erty

ta

x re

fund

(re

nter

s)

Min

neso

taC

are

Tota

l C

redi

ts

and

Subs

idy

(Fig

ure

4)

Mar

gina

l C

osts

of

Wor

k af

ter

Cre

dits

(F

igur

e 5)

Mar

gina

l G

ain

from

W

ork

(afte

r C

redi

ts)

100%

20

$4,4

20

42%

100%

40

s8.8

40

85%

150%

40

$13,

268 127%

$1

7,68

0 170%

7.65

%

15.0

0 6.

00

28.6

5%

7.65

%

7.65

%

7.65

%

15.0

0 6.

00

28.6

5%

20%

7.65

%

15.0

0 6.

00

28.6

5%

20%

7.65

%

15.0

0 6.

00

28.6

5%

20%

7.65

%

15.0

0 6.

00

28.6

5%

20%

7.65

%

20%

7.65

%

20%

20

%

80%

-9

71%

98.6

5%

80%

-6

74%

101.

65%

27%

27

%

75.6

5%

0% 48

.65%

0%

0% 48

.65%

0% 48

.65%

48

.65%

-40.

00%

0.

00%

-6

.00

0.00

0.

00

0.00

-6

.00

-6.0

0 1.

50

1.50

21.0

6%

21.0

6%

21.0

6%

21.0

6%

3.16

3.

16

3.16

3.

16

-15.

00

- 15

.00

-4.6

0 0.

00

-4.4

0 -3

.60

10.3

0 10

.30

2.40

2.

40

2.90

4.

60

19.1

0 58

.22%

13

.50

46.3

2%

0.00

2.

10

-4.5

0%

9.32

%

2.40

10

.42%

0.

00

-50.

50%

0.

00%

48.6

5%

51.3

5%

48.1

5%

51.8

5%

97.1

5%

2.85

%

84.9

7%

15.0

3%

59.0

7%

94.9

7%

5.03

%

106.

87%

-6.8

7%

40.9

3%

FIGURE 3 Marginal Cost of Work before Tax Credits and Health Care Subsidy


20

0 $4,420 $8,840 513,260 $17,680

Total Earnings $22,100 $26,420 $35,000 ~ _-------____ ------ --__i_

Tax Jsefore Credit AFDC + Food Stamps - c J Day Care Coqts 1

noted by Lipman and Williamson (1994), the complexity of the system of tax credits hides the high marginal tax rates during their phaseout, reducing any work disincentive effects.

Filing complexity reduces the power of tax credits by discouraging participation. Refundable tax credits require a family to complete tax returns even though they would not otherwise need to file. Given the large benefits provided by the federal EITC, participation rates are high (but so are error rates).j7 Filing complexity is more of a problem for Minnesota’s child care credit, vvhich requires comple- tion of both the federal CDCC form (whether the famiAy is eligible or not) and the state CDCC form. The Minne- sota credit IS phased out based on comprehensive cash income (not adjusted gross income), adding further complexity. The property tax refund also phases

out based on a comprehensive rneasure of income.

The impact of tax credits is also limited by their delayed timing. Benefits are generally received in ttie following year, in the form of a tax re, und. k This contrasts starkly with dire+ transfer programs, where benefits Iare received monthly. The delay in dealizing these tax benefits may seriously /Irode the power of the tax credits if potential workers face cash flow problems.

COORDINATION OF S$TE TAX AND TRANSFER PROGRAMS~

The expansion of feder I and state EITC programs raises import nt questions about the interaction a i d coordination of the two principal stdte cash transfer programs, AFDC and the ElTC/WFC. The


FIGURE 4 Impact of Tax Credits and Health Care Subsidy

(Single Parent plus Children)

cw ’ I 1 I 1 I I I

$4,420 $8,840 513,260 517,680 $22,100 $26,520 635.ooo Total Ehmings

state BITC C3 Federal Dep. Cam Cr.

cl hIinnesomCare

AFDC program, like food stamps and other direct transfers, provides monthly transfer payments through a labor- intensive, county administered system that gathers ongoing detailed information about the eligibility status of recipients. Eligibility requirements are complex, benefits are based on a comprehensive measure of income, and there is a strict asset test. In contrast, tax credits are administered through the state or federal income tax system with annual returns and payments and with less recipient information on assets and income and less ongoing compliance monitoring.18 The difference between direct transfer programs and tax credits are highlighted in Table 1.

Successful integration must first reconcile two fundamentally different views of the correct accounting period for determining eligibility and transfer/credit

amounts. AFDC and food stamps both use a monthly accounting of income to calculate benefits. By definition, tax credits use an annual accounting frame. If an AFDC family earns a high income in one month, that is never deemed to reduce the family’s past AFDC payment. In other words, AFDC is not based on an averaging of monthly incomes. Each month stands alone. In contrast, annual tax credits cannot be calculated as the sum of 12 separately determined monthly tax credits based on monthly incomes. Yet as Wiseman (1993) has co- gently argued, a 12-month delay in receiving tax credits may seriously erode their value as a work incentive. Integrat- ing the tax and transfer systems requires a way to provide tax benefits on a monthly basis.

Early attempts to provide monthly tax credits have been unsuccessful. When

671

FIGURE 5 Marginal Cost of Work after Tax Credits and Health Care Subsidy

(Single Parent plus Two Chlldrtw)

140 r-----

$4,420 $8,840 $13,260 $17,680 $22,100 $26,520 $35,OOa Total h-nings

the advance payment option for the EITC was introduced in 1979, Campbell and Pierce (1980, lp. 7) described the objective of this employer-based monthly payment option as follows: “It is based on the belief that the poor cannot af- ford a one-year accounting period. By increasing take-home pay more promptly, the provision for advance payment is intended to provide greater incentive to work.” Whether by choice of EITC recipients or lack of support by employers, however, less than one percent of EITC recipients currently participate in the advance payment mechanism.

Another important issue in coordinating tax and transfer systems is the definition of income. Because they are not generally based on a comprehensive measure of income, tax credits have difficulty in targeting the “working poor.” Use of

federal adjusted gross ipcome to determine eligibility for the dITC/WFC can result in tax credits being paid to households with little earned ~income but significant wages and salaries and un- earned income. This can occur if net tax losses from farming, sole proprietorships, or other pass-through qctivities offset wages and salaries. Thq EITC does not have comprehensive income and asset tests like AFDC, so benefits cannot be as effectively targeted.

One possible approach to coordinating transfer and credit programs could be to adopt a more comprehhnsive definition of money income and tlo institute an asset test in the operation of the ElTC. This @change would adopt more of the targeting approach fouid in the administration of AFDC and other transfer programs. O’Neil and Nelqstuen (1994)

672


have recently suggested this change to reduce EITC payments to recipients with low earnings but significant wealth. What this suggestion points out is that an integrated, coordinated tax-transfer system may have structural and administrative features that draw from both the current income transfer and tax credit systems.

Two of Minnesota’s tax credits are already based on a comprehensive measure of income. Both the Minnesota child care credit and the property tax refund calculate benefits based on a definition of income that includes components not otherwise reported on tax forms. They have already taken this important step toward an integrated approach, though the Department of Reve- nue has difficulty checking the validity of these components of comprehensive income.

STATE PROPOSALS TO INTEGRATE TAX AND INCOME TRANSFER PROGRAMS

A number of states are beginning to experiment with integration of the tax- transfer systems. The Michigan Depart- ment of Social Services has developed a proposal that would integrate the EITC advance payment for families with children into the existing public assistance program. Under the proposal, recipients of AFDC, state family assistance, and food stamps would voluntarily apply to the Department of Social Services, instead of employers, for the advance payment. Recipients would report monthly earnings to the Department and would be sent separate monthly checks identified as advance EITC payments. Before payment, the Department would review a recipient’s earnings and verify that the recipient was not receiving advance payments from an employer on the same earnings. Department workers would in- form public assistance recipients of the advance payment program, explain how

to avoid overpayments, and provide information necessary to file annual federal income and EITC forms. By integrating the EITC advance payment option with the public assistance structure, Michigan expects to increase participation and improve compliance in the EITC program. The anticipated benefits for public assistance recipients include increased monthly cash flow and greater work incentives.

A similar concept for increasing the role of tax agencies in the advance EITC system is outlined in Holt (1992). Under this proposal developed by the Milwau- kee Advance Payment Working Group, employers would send monthly wage re- ports including social security numbers for employees filing W-5 forms (advance EITC) to the IRS or other contracted ser- vice. The processing agency would use additional information from the W-5 forms, such as wage data for a family’s second earner, to more accurately calculate the advance EITC. The IRS or other agency could either pay the advance payment directly to the recipient or no- tify employers of the correct amount to be included in monthly paychecks. The wage reporting system described in the Milwaukee study could significantly shorten the wage reporting lag inherent in using payroll tax data.

In Minnesota, the Departments of Hu- man Services, Revenue, and Jobs and Training have been jointly studying the feasibility of providing a monthly advance payment option for all recipients of the federal EITC and the state WFC through state agencies. The nonem- ployer-based advanced payment system is being discussed as part of a broader proposal to integrate and coordinate a number of state and federal cash transfer and tax credits programs targeted to lower-income households. The long-run objective is to integrate four tax credit programs (EITC, WFC, CDCC, and PTR)

673

into a centralized monthly cash transfer system. The credits would also be coordinated with public assbstance and other monthly transfer programs to create a unified, monthly tax-transfer system in Minnesota “’

Similar to the Michigan proposal, the Minnesota working group is recom- mending an initial pilot project that would provide coordinated tax credits and transfers for AFDC recipients. Monthly information on income earnings and expenses is currently available for these recipients and could be used to determine monthly prepayments for working AFDC recipients and to verify eligibility. Lessons learned from this pilot project would guide the development of an expanded system covering the entire population of households eligible for the tax credit programs.

The details of a unified tax-transfer system are still being debated, but the following general characteristics of the system are emerging frorn the interagency discussions :

(1)

(2)

(3)

(4)

Households would file a single, simplified form to qualify for all of the credits simultaneously. Eligibility requirements and definitions would be coordinated to reduce the information needed to apply for the credits. The Departmient of Revenue would be primarily responsible for processing applications and determining monthly prepayments. Recipients would receive a single, monthly check. Ideally, electronic fund transfers would be used in the payment process. With IRS approval, administration of the EITC advance payment system would be moved from employers to the Department of Revenue. At the end of the year, a simplified, final return would be filed with the Department of Revenue to reconcile

(5)

(6)

(7)

03)

advance payments with actual credits To prevent unacceptable levels of fraud and noncompliance in the advance payment system, a timely, cost-effective method of verifying monthly data will have to be developed. This will require a new part- nership among state agencies and with the IRS and may involve an alternative federal/$tate wage reporting system. A system of partial advance payments of the tota) expected credits should be used ta avoid significant positive liabilities on annual returns. Reductions in state payments for federal income tax withholding and FICA could be us e d to fund the EITC monthly advance payment. Outreach efforts of the Department of Revenue, Depattment of Human Services, IRS, and other state agencies should be coordinated to maxi- mize participation in the advance payment program.

The Minnesota proposals to convert tax credits to monthly advance payments are designed to encourage the movement from welfare to the workforce by providing monthly income supplements for low4ncome workers. However, as clearly pointed out earlier in this paper, these targeted credit programs also come with high marginal tax rates in the phaseout ranges that may create a significant work disincentive. An mportant policy issue needing further study is the extent to which an expansioni in monthly advance payments will increase the visibil- ity, and therefore the disincentive effects of the phaseouts.

Conclusion

Minnesota’s experience with the uncoordinated growth in tax credit and income transfer programs has #identified a number of issues that must be addressed to

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integrate the two systems. The tax and transfer systems involve different objectives and administrative features that must be reconciled in the process of integration. States are now beginning to explore ways to achieve greater simplifi- cation, administrative cost savings, increased work incentives, and effective targeting of benefits in this complex system. This discussion of the operation and characteristics of the Minnesota tax- transfer system suggests that, because the tax and welfare systems are now so intertwined, fundamental welfare reform will require simultaneous and significant changes in both systems.

ENDNOTES

The authors would like to thank members of the Tax Research Division for their significant contributions to the paper. Tom Rosholt provided detailed computer analysis of the distribution of taxes and transfers. Bobbi O’Keefe developed graphics for the paper. Finally, the authors would like to thank Mary Buechner for her invaluable assistance in the prepara- tion of the entire document.

’ The efficiency argument for a high earnings- reduction rate is summarized in Sheiner (1994). Although Sheiner focuses on the phasing out of health insurance subsidies, the same analysis can be applied to the phaseout of other transfer programs.

* These state experiments are described in Min- nesota House of Representatives (1994).

j The net gain would actually be higher, as ex- plained below, because tax credits would out- weigh the social security tax on the extra earnings.

4 For3 more detailed discussion of the recent expansion in the EITC, see Scholz (1994) and Munnell (1994).

5 A 1994 change in the Minnesota CDCC ex- tends eligibility to two-parent families in which one parent stays home to care for a child under one year of age. This so-called “stay-at-home-moms” provision obviously creates a new work disincentive.

6 Starting in 1994, childless couples and single persons over the age of 25 will also be eligible for a smaller EITC and WFC. Because the sample lacks information on age, these benefits are not included in the numbers pre- sented in Table 3.

’ U.S. House of Representatives, Green Book (1991, Table 37, p. 710).

a U.S. House of Representatives, Green Book (1991, Table 38, p. 712). It is also assumed that work is spread evenly over the entire year, so monthly benefits can be calculated at annual rates. The one-year extension of Medicaid benefits and the added work incentives during the first four months on AFDC are ignored. Only the employee share of social security tax is included. The health insurance package through MinnesotaCare is assumed equivalent to Med- icaid, so the only difference is in the premium charged. Unless the employer pays at least half of the cost of health insurance, the family would be eligible for MinnesotaCare, which would often be less costly than buying insurance through the employer.

10 Costs are from the 1993 Green Book (U.S. House of Representatives, 1993, Table 24, p. 1664). The costs refer to AFDC children and AFDC adults in Minnesota in 1991, adjusted upward to account for inflation between 1991 and 1994. This may overstate the value of Medicaid to the extent that the uninsured would still receive subsidized health care, funded either by charity or through higher prices paid by insured households. The increase in food stamps as income rises illustrates the complex interaction among transfer programs. If earnings increase by $100, AFDC falls by $80 (because day care costs, which rise by $20, are deductible). In determining food stamp benefits, net income is defined as

Earnrngs - O.Z(earnings) + AFDC - child care costs - excess housing costs

The $100 increase in earnings causes AFDC to fall by $80, child care costs to rise by $20, and excess housing costs to rise by $10. So food stamp net income falls by $30. Given the 30 percent phaseout rate for food stamps, the famrly will receive $9 more in food stamps.

‘* Ironrcally, if child care costs were zero (per- haps because a grandparent is willing to watch the children), the family’s net income before tax credits and MinnesotaCare would actually fall by 0.9 percent of gross earnings. (The family would no longer receive AFDC, and the parent would lose Medicaid coverage.) MinnesotaCare turns that 0.9 percent loss into a 16.1 percent gain. The tax credits increase the gain further to 59.5 percent of gross earnings.

l3 In the absence of child care costs,

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14

15

16

/ Anne L. Alstott (1994) provides an excellent discussion of the institutional differences and constraints that make the integration of AFDC and EITC programs difficult. These differences include a more narrowly defined income concept for the EITC, no asset test for the EITC, a more limited EITC deftnition of household income, annual versus monthly accounting periods, and different levels of voluntary compliance. Integration issues are also discussed in Steuerle (1990) and Forman (I 993). As discussed earlier, Minnesota has just begun an experimenl:al program to issue single monthly checks fair AFDC, food stamps, and housing subsidies.

REFERENCES

Alstott, Anne L. “The Earned Income Tax Credit and Some Fundamental InstItutional Dilemmas of Tax-Transfer integration.” /Wiona/ Tax ~ourna/

47 No. 3 (September, 1994): 609-620. Campbell, Colin D. and William L. Pierce. The Earned Income Credif. Washington, D.C.: Ameri- can Enterprise Institute, 1980. Cline, Robert. “State Financing of Health Care Reform.” Proceedings of the 85th AIVNJJ/ Con- ference. Columbus, OH: National Tax Associa- tion, 1993, 52 -59. Forman, Jonathan Barry. “Synchronizing Social Welfare Programs and Tax Provisions.” Tax Notes (April 19, 1993): 417-23. Holt, Stephen D. “Improvement of the Advance Payment Option of the Earned Income Credit.” Tax Notes (December 14, 1992): 1583-88. Holtzblatt, Janet. “Administenng Refundable

MinnesotaCare raises the gain from work from 17.0 to 27.9 percent. The tax credits In- crease it further to 52.1 percent of gross earnings. The lowest line in Figure 2 (“Before credits and MinnesotaCare”) has three vertical “cliffs.” The first (at $10,640) occurs when the parent loses Medicaid eligibility. The second (at $15,431) occurs when the family loses eligibility for food stamps. The third (at $19,784) occurs when the two children lose Medicaid eligibility Tax credits such as the EITC may also create strong marriage penalties. See Steuerle and Juffras (1991) for a good discussion of these additional incentive problems. These numbers ignore any increase in income tax rates needed to finance the tax credits. For a discussion of compliance issues, see Holtzblatt (1992).

Tax Credits: Lessons from the EITC Experience.” Proceedinigs of the 84th A+ua/ Conference on TJXJtiOn . IColumbus, OH: vational Tax Associa- tion, 1992, 180-85. Lipman, Francine J. and J

r mes E. Williamson

“Recent Proposals to Redes gn the EITC: A Re- ply.” Tax ,Notes (February 218, 1994): 1175-80. Michael, Joel and Nina Vvjanzi. “Effective Mar- ginal Tax Rates on Lower-Income Wage Earners: The Impact of State Taxes.” State Tax Notes (May 3, 1993): 1052-63. Minnesota House of Representatives, Re- search Department. We/f&re Reform in the AFDC frogran?. St. Paul, M/I, February, 1994. Minnesota Department af Revenue. Minne- sota Tax incidence Study. St. Paul, MN, October, 1991 and November, 1993, Moffitt, Robert,. “lncentivq Effects of the U.S. Welfare System: A Review.” /ournJ/ of Economic Literature (March, 1992): I-61 Munnell, Alicia H. “The C~oming of Age of the Earned Income Tax Credit.” NTA Forum (Winter, 1994.). O’Neil, Cherie J. and Linda B. Nelsestuen. “The Earned Income CreditI: The Need for a Wealth Restriction for Eligitpility Determination.” Tax Notes, (May 30, 1994): 1189-1201. Scholz, John Karl. “The Egrned Income Tax Credit: Participation, Compliance and Antipov- erty Effectiveness.” Nationa/ TJX ./ourna/ (March, 1994): 63-85. Sheiner, Louise,, “Marginal Tax Rates and Health Reform.” h’JtiOnJ/ Tax /OUrnJ/ 47 No. 3

(September, 1994): 497-518. Steuerle, C. Eugene and Jason Juffras. “A $1,000 Tax Credit for Every Child: A Base for the Nation’s Tax, Welfare, qnd Health System.” Washington, D.C.: Urban lmstitute Policy Paper, April, 1991 Steuerle, C. Eugene. “The Integration of Tax and ‘Transfer Systems Part I: Negative Income Taxes.” T,IX Notes (December 31, 1990): 1581- 82. Steuerle, C. Eugene and Paul Wilson. “The Taxation of Poor and Lower-Income Workers.” Tax Notes (February 16, 19b7): 695-711. U.S. House of Representdtives, Committee on Ways and Means. The Green Book: Back- ground Material and Data on Programs within the lurisdiction of the Committee on Wdys and MeJfIS. Washing ton, D.C. : ~Government Printing Office, July, 199’1 and July,, 1993. Wiseman, Michael. WelfJbe Work incentives in Real Time. Madison, WI, October, 1993, unpub- lished mailuscript.

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