The earned-income tax credit is often said to encourage work, but it may do just the opposite.
This refundable federal income tax credit of a few thousand dollars a year is paid to families with positive but low earned income (that is, wages or salaries) for a calendar year.
The chart below shows the credit’s schedules for the 2011 tax year as a function of annual earned income for a given family situation (other family situations have the same basic shape). The schedule shown illustrates the mountain-plateau pattern described above: an increasing portion for the lowest incomes, a flat portion, a decreasing portion and then finally a flat portion of zero.
Along the increasing portion, the credit adds to the reward from working because a few more weeks or hours worked during the year tends to add marginally to the income from work, which adds to the amount of the credit.
Because of this pattern among the lowest incomes, the earned-income tax credit is often said to encourage work among low-income people. Indeed, studies have shown that the credit leads low-skill single mothers to work more and may be the most effective program at raising households out of poverty (the poverty line tends to be near the middle of the plateau portion of the earned-income tax credit schedule).
For the same reasons that the credit encourages more work among people who might otherwise earn close to zero during a year, it can also influence some people to work less — those with earnings at or slightly above the downward-sloping or “phase-out” portion of the schedule, where people lose about 20 cents of their credit for every additional dollar earned during a year.
In other words, for households on the downward-sloping portion of the earned-income tax credit schedule, the credit acts as an extra 20 percent tax on the income they earn in that range. The work-encouraging potential of the credit occurs only on the upward-sloping portion.
At first glance, it might appear that a lot of people might earn no income and might therefore be among those encouraged to work by the credit. After all, many people spend some time unemployed and earning no income.
But the credit applies to a household for a calendar year. It is uncommon for nonelderly heads of household to be out of work for 12 consecutive months and, even when they are, for those 12 months to coincide with a calendar year.
Someone unemployed from July 2010 to June 2011 but otherwise employed, for example, would have positive income in both calendar years 2010 and 2011. Even when someone is out of work for an entire calendar year, he or she may have a spouse who does work at least part of the year.
For these reasons, it is more common for families to be on the part of the earned-income tax credit where it acts as a tax, rather than a reward to additional work.