The Earned Income Tax Credit: A Proven Strategy for Boosting Economic Security

California’s improving fiscal outlook presents an opportunity for policymakers to begin tackling some of the state’s biggest challenges, including poverty, economic insecurity, and income inequality. Our recent report discussed how the federal Earned Income Tax Credit (EITC) – which allows low- and moderate-income workers to keep more of their earnings and afford the basics – is a proven strategy for addressing these issues and described options for designing a state credit. Today we begin a series of blog posts that will explore state EITCs further. In this first post, we highlight best practices for establishing a state credit by looking at how other states’ have designed their EITCs.

Creating a state Earned Income Tax Credit (EITC) would allow more Californians to share in the state’s economic gains. Created in 1975, the federal EITC has a proven track record of fostering economic security by encouraging and rewarding work among low- and moderate-income individuals and families. In fact, the federal credit is one of the nation’s most effective tools for reducing poverty (second only to Social Security), and because it overwhelmingly benefits families in the bottom half of the income distribution, it reduces after-tax income gaps, helping to mitigate inequality.

The federal EITC’s success in cutting poverty, economic insecurity, and inequality has prompted 25 states and the District of Columbia (DC) to create their own versions of the credit. The following sections summarize key features of these state policies and highlight issues state policymakers should consider in designing a credit in California.

What Do EITCs Look Like in Other States?

The vast majority of state EITCs are — like the federal credit — fully refundable, which is key to ensuring that the lowest-income families benefit. The table below shows that all but four of the states with EITCs offer credits that are fully refundable. Fully refundable tax credits benefit far more families than nonrefundable credits, because they allow families whose earnings are so low that they owe no state income tax to receive as a refund the entire credit for which they are eligible. Our analysis shows that a refundable state EITC would reach about one in five California families, while a nonrefundable state EITC would reach less than half of a percent of families. A refundable EITC would also provide a significantly larger credit to the lowest-income families — those in the bottom fifth of the income distribution — compared with a nonrefundable credit: $321, on average, versus $21, assuming the state EITC is set at 15 percent of the federal credit. In establishing a state EITC for California, policymakers should make the credit refundable, like it is in most states, so that it reaches the families who need it the most.

EITC Design Across the States 03.25.2015

Ten states and DC offer relatively large credits, which do more to reduce economic hardship. States typically set their EITCs at a percentage of the federal credit,  ranging from 3.5 percent in Louisiana to 40 percent in DC. (A 40 percent refundable state credit means that a family receiving $2,000 from the federal EITC would receive an additional $800 (0.40 x $2,000) from the state EITC.) Ten states provide credits equal to 15 percent or more of the federal credit. In addition to DC’s 40 percent credit, Vermont offers a 32 percent credit, Connecticut and New York offer 30 percent credits, and Maryland’s credit is scheduled to rise from 25.5 percent to 28 percent by 2018. These large credits translate into substantial income boosts for working families. A low-income working parent supporting two children in DC, for example, would be eligible for a maximum of $2,219 from the District’s EITC this year in addition to $5,548 from the federal credit. If California policymakers establish a state EITC, they should consider offering a credit equal to at least 15 percent of the federal credit, which would provide a parent with two children as much as $832 in 2015,  enough to pay for almost six weeks of groceries. A state EITC set at 30 percent of the federal credit would provide this family with as much as $1,664,  which would cover more than 11 weeks of groceries.

A few states offer nontraditional credits that target benefits to certain groups of workers. DC, for instance, allows low-income adults without dependent children to receive an EITC equal to as much as 100 percent of the federal credit. In contrast, the credit for families with children is set at 40 percent of the federal EITC. Like DC, California may wish to provide a larger credit to working adults without children, because they receive limited support from the federal EITC. So-called “childless” adults receive an average federal credit that is less than one-tenth the average credit received by families with children. California could consider targeting a state EITC to other groups, as well. For example, by limiting a state EITC to families with young children, California could make larger investments in children at a critical stage in their development. To learn more about alternative EITC designs and their tradeoffs, see our report.

Some states fund outreach efforts to encourage eligible workers to claim the state and federal EITC. There’s a significant gap in every state between the number of workers eligible for the federal EITC and the number who actually claim the credit. This means that many low- and moderate-income working families lose out on additional income that could help them financially, and states lose out on federal dollars that could help boost local economies. To address this problem, many states have devoted state dollars to public information campaigns, free tax-preparation services, and other strategies to boost the number of eligible workers who claim the state and federal credits. A future post in our series will look at options California might consider for boosting the take-up rate of the federal EITC.

— Alissa Anderson