Lower the Investment Income Limit for the Earned Income Tax Credit and Extend That Limit to the Refundable Portion of the Child Tax Credit
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
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Low- and moderate-income people are eligible for certain refundable tax credits under the individual income tax if they meet specified criteria. Refundable tax credits differ from other tax preferences, such as deductions, in that their value may exceed the amount of income taxes that the person owes. Refundable tax credits thus can result in net payments from the government to a taxpayer: If the amount of a refundable tax credit exceeds a taxpayer's tax liability before that credit is applied, the government pays the excess to that person. Two refundable tax credits are available only to workers: the earned income tax credit (EITC) and the refundable portion of the child tax credit (referred to in the tax code as the additional child tax credit). In 2016, the number of taxpayers claiming the EITC and the refundable portion of the child tax credit were 27 million and 19 million, respectively.
To qualify for the EITC and the refundable portion of the child tax credit, people must meet several income requirements. First, they must have income from wages, salaries, or self-employment. Second, their adjusted gross income cannot exceed certain thresholds, which vary according to family characteristics. (Adjusted gross income is income from all sources not specifically excluded by the tax code, minus certain deductions. For purposes of determining eligibility for the child tax credit, adjusted gross income is modified by adding certain types of income excluded from taxable income.) For the EITC, the income thresholds for 2018 range from $15,270 for an unmarried worker who does not have a qualifying child to $54,884 for a married couple that files jointly and has three or more children. For the child tax credit, the income thresholds for taxpayers with one child in 2018 are $240,000 for an unmarried person and $440,000 for joint filers; the thresholds increase with the number of children in the family. (After 2025, those thresholds will revert to their amounts under pre-2018 law. For example, among those with one child, the thresholds will be $95,000 for unmarried workers and $130,000 for joint filers.) Finally, eligibility for the EITC is restricted to filers with investment income that is $3,500 or less in 2018. (Investment income comprises interest including tax-exempt interest, dividends, capital gains, royalties and rents from personal property, and returns from passive activities—that is, business pursuits in which the person is not actively involved.) For the EITC, the limitations on adjusted gross income and investment income are adjusted, or indexed, to include the effects of inflation. The income cutoff for the child tax credit, however, is not indexed.
According to the Internal Revenue Service (IRS), among taxpayers whose positive adjusted gross income was less than $50,000 and who also reported investment income in 2016, the most prevalent form was taxable interest: About 16 percent of those taxpayers reported, on average, about $110 in taxable interest income. (Some of those taxpayers probably had other forms of investment income, too.) That total, however, included the interest income of taxpayers over the age of 65. That age group contains the largest number of adult taxpayers reporting any interest income but also the smallest number claiming the two credits.
This option would lower the EITC threshold for investment income to $1,750. As under current law, that threshold would be indexed to include the effects of inflation. Moreover, the option would extend that requirement to the refundable portion of the child tax credit.
Effects on the Budget
If implemented, the option would raise $8 billion from 2019 through 2028, according to estimates by the staff of the Joint Committee on Taxation. The annual revenues raised by the option would begin to decline after certain provisions of the 2017 tax act expire at the end of 2025; however, those effects would not be fully observed until 2027, when taxpayers file their 2026 tax returns and claim the credits. The expiration of a temporary expansion of the refundable portion of the child tax credit will cause the maximum amount of the additional credit to fall from $1,400 to $1,000, and the expiration of other provisions will cause statutory tax rates to increase and the amount of the standard deduction to decline. As a result, there will be greater income tax liability for the nonrefundable portion of the child tax credit to offset, which will reduce the value of the refundable portion of the credit.
The budgetary effect of further reducing the threshold on investment income to less than $1,750 would depend on a number of factors, including the distribution of investment income among those receiving credits and the average size of the credits received by the affected population under current law. As the threshold declined, for example, both the number of EITC claimants affected by the limitation and the average reduction in the credit received by the affected population would increase rapidly, in the Congressional Budget Office's assessment. One consideration is how people would respond to changes in the investment-income threshold. Some people would respond to those adjustments by shifting their investments to assets (such as cars) that do not immediately generate income or by changing the timing of the return from their investments (for example, by retaining stocks for longer periods in order to avoid realizing capital gains in years that those realizations would affect their eligibility).
A key source of uncertainty in the estimate is that it depends on CBO's projections of various factors that determine the return on an investment. For example, in CBO's projections, personal interest income grows at an average annual rate of 8 percent from 2019 through 2023 and 4 percent for the remainder of the projection period. If interest rates were higher than CBO's current projections, then more taxpayers would be affected by the option.
The main argument for the option is that it would better target the credits to people without substantial means by denying them to people who have low earnings but have other resources to draw upon. Asset tests—requirements that recipients do not have savings in bank accounts, stocks, or other types of investments whose value is above a specified threshold—serve a similar role in some spending programs that provide benefits to lower-income populations. However, such tests would be difficult for the IRS to administer because the agency does not collect information on the amount of assets held by individuals. By contrast, the IRS does have extensive information on taxpayers' income from bank accounts and most other types of investments, and much of that information is accurate because it is reported independently to the agency by financial institutions as well as by taxpayers on their returns.
An argument against the option is that it would reduce people's incentive to save, especially if their income from investments was near the threshold amount and they could become (or remain) eligible for the credits under the option by making small reductions in their assets. The option would probably have little effect on people with very low income because they have little means to save and invest.