Tax Filing and Inequality

The Earned Income Tax Credit (EITC) is America’s most successful poverty alleviation program, but too few families actually claim this benefit.

Many low-income families refer to tax season as “Second Christmas.” Although tax refunds are certainly not gifts that appear whether you’ve been naughty or nice, these refunds are often the salvation that millions of families look forward to every year.

The Earned Income Tax Credit (EITC) lifted 5.8 million people out of poverty in 2018, 3 million of those were children. The policy has been around since 1975 and has been expanded by both Republicans and Democrats alike — Obama expanded the EITC after the 2008 financial crisis to support families hurt by the economic downturn, and Trump expanded it in 2016 to focus on helping low-income families with children.

However, the EITC remains highly underutilized. More than 20% of people who are eligible for the EITC fail to claim it. The average family will get $3,191 in EITC benefits, effectively boosting wages by $266 per month. When families fail to claim, billions of dollars are left on the table every year which just get recycled back into the government’s budget.

While the chart above shows us where the most people in the US are filing for the EITC, it does not tell us where people should be filing.

Imperial County, California has the lowest rate of people claiming the EITC who should be, largely because many immigrant families are afraid how their information will be used. Imperial County is home to 150,000 residents, 84% are Latinx and the median income is $44,000. In 2017, ICE Director Thomas Homan told a House appropriations subcommittee, “And by me saying you should be worried, you should be afraid. If you lie on your taxes, you got to be worried, is the IRS going to audit me?” The IRS is not allowed to share any information with ICE, but Homan’s comments rippled through communities. 30% of eligible residents in Imperial don’t claim the EITC.

Source: Saez and Zucman

Despite everything you’ve been told, the US actually has a regressive tax system. In their book, The Triumph of Injustice, Emmanuel Saez and Gabriel Zucman show that the richest 400 Americans have an effective tax rate of 24%, which is the same tax rate that a middle-income family pays too. Instead of increasing the tax rate as people get wealthier, Saez and Zucman found the taxation curve actually slopes downward after a certain point. The inflection point has been steadily changing since Reagan’s 1981 tax cuts.

Not only is our tax system more regressive than people think, but the auditing system has also proven to be regressive. Pro Publica found that “last year, the top 1% of taxpayers by income were audited at a rate of 1.56%. EITC recipients, who typically have annual income under $20,000, were audited at a rate of 1.41%.” This means that the IRS cracks down on low-income families at the same rate that it does on millionaires.

Senator Ron Wyden (D-OR), the ranking member of the Senate Finance Committee, summed this up clearly — “We have two tax systems in this country and nothing illustrates that better than the IRS ignoring wealthy tax cheats while penalizing low-income workers over small mistakes.” IRS spokesman Dean Patterson acknowledged that the sharp decline in audits of the wealthy is due to budget cuts and the loss of IRS auditors. And he didn’t dispute that pursuing the poor is just easier.

Imperial County, CA stands in stark contrast to Rockwall County, TX where wealthy Americans pay few taxes. Not only does Texas have no income tax, but residents of Rockwall pay 0.38% in property taxes (San Francisco residents pay triple that), making it one of the lowest in the country. The median income in Rockwall is more than double that of Imperial. Residents of Rockwall are 72% White.

Even if we exclude the fact that wealth families can often pay accountants to find sophisticated tax loopholes, and even if we exclude the fact that

Taxes are complicated, but once you have a child, they get even trickier. If you are a single mother making $20,000 and just had your first child, you are eligible to receive $5,900 in EITC credits, or 30% of your total annual income. This means that tax-time can be a tremendous boost for low-income families.

Challenges to claiming the EITC

Why don’t more people claim the EITC if it is so helpful? The answer to this question is tied up in several factors.

First, researchers at Stanford Law School suggest that take-up of the EITC is actually higher amongst those families who have the most to gain from it. In other words, households that may only get a-few-hundred-dollars from the EITC are more likely to skip over it than those families who would be getting thousands-of-dollars.

Source: Congress

Second, the requirements are complicated. While the IRS has tried to outline the various qualifications, many families are unsure who qualifies as a ‘dependent’ for the EITC. If a teenage mom lives with her parents to help with childcare needs, is her baby the dependent or is she the dependent?

Third, many families lack proper tax support. Predatory tax filers often take advantage of low-income families who don’t know where to turn — a GAO study found that between 89%-94% of EITC tax returns filed with paid-prepares in 2015 had errors. Vulnerable communities need extra tax support and must be funneled toward the right resources.

The Path Forward

The 16th Amendment gave Congress the power to collect federal taxes in 1913 and since then people have been figuring out how taxes really work. While this article cannot go in depth on how to reduce tax code complexity, two possible solutions exist to reduce inequality in our tax filing system. First, automatic tax filing would be a more radical change to the system, which would entail sending out pre-filled-out 1040s to households with simple tax filing statuses based on information that the IRS already has. Second, free-filing information could be more easily provided so that low-income families in particular can avoid predatory filers and exorbitant fees.

Automatically prepare returns for people with simple taxes — The American system of tax filing can reduce the burden placed on individuals for filing their taxes. When the IRS checks if you have filed taxes correctly, they validate this information against the information that your employer, your bank, and other sources have already sent to them. If you say that you had $45,000 in income from your manufacturing job at Ford, the IRS checks the form that Ford also sent along to make sure this is correct. Instead of putting the burden on you to also send along the right information, the IRS can send you a pre-filled-out form based on the information they are already receiving and ask you to validate if it is accurate. While this would likely only work for people with simple tax situations, Austin Goolsbee at Brookings estimates that 40% of Americans would qualify for this ‘Simple Return’ process, saving 225 million hours each year, reducing $2 billion in tax fees, and improving tax collection by $36 million each year. This is already the practice in Spain, Sweden, and Denmark and California ran a pilot of this in 2005–2006 with great success, saving millions in auditing costs, reducing hours spent by citizens, and increasing tax revenue for the government. Unfortunately, Grover Norquist and tax lobbyists have made it nearly impossible to pass such legislation since it would disrupt the multi-billion dollar tax filing industry. Intuit spends more on lobbying each year than Apple or Amazon.

Increase access to tax volunteers — 70% of Americans qualify for free tax filing, but only 3% of them actually take advantage of this. The use of free tax preparers can actually be more accurate than paid prepares, with studies showing that paid preparers make errors 49% of the time, compared to volunteers which only make errors 11% of the time. The average cost of paying taxes is $242, but this can be far lower if more people took advantage of the paid options. Many Americans don’t know that free filing exists, and this is often done intentionally. In 2019, TurboTax hid its free file site by unindexing it from Google — this meant that if you searched for “TurboTax Free File” or similar, nothing would come up. Even fewer Americans know about the Volunteer Income Tax Assistance (VITA) program administered by the IRS. 5 million Americans relied on VITA last year to help them file tax their tax returns, but far more are eligible.

Fortunately, President Biden’s new tax changes will have incredible benefits for low-income families. The Child Tax Credit (CTC — which has a 98% filing correlation with the EITC) is increasing from $2,000 to $3,000 and filers can now use a “look-back” clause to help them claim the EITC, even if they had no earned income due to job losses related to the COVID-19 pandemic. This means that a single mother with two children earning $22,000 per year (which would be above minimum wage) can get $11,920 from the EITC + CTC, which is more than half her annual income.

We need to get Americans the credits they’ve earned. If the IRS will not send people ‘Simple Returns’ with their pre-filled-out tax returns, then they should at least do more to ensure that people can file their taxes for free. The IRS Free File page is a good place to start to learn more about options, the VITA locator is even better, but the best is going to Let’s Get Set to find the best match for you. Any household making less than 72,000 is eligible to file taxes for free. Tax software companies made over $1 billion in revenue in 2019 off of people who should have been filing taxes for free

While the US tax code may take decades to overhaul, we can take steps today to improve access to the EITC, to make it easier to avoid predatory tax preparers, and to get volunteer support that ensures every family gets their maximum refund.

MIT Grad Speaker 2020, now writing about inequality || follow along @ bit.ly/SubstackAmericanInequality