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Earned income credit veto: heartless, or good policy?

August 04, 2011

Governor Branstad's item-veto of an increase in Iowa's earned income credit -- from the current 7% of the federal credit to 10% -- has gone down poorly in some circles. The left-side tax policy group Citizens for Tax Justice calls the veto "one of the worst cases we’ve seen of kicking them while they’re down." The Iowa Fiscal Partnership says the veto "hurts working people and the economy." There is talk of a special legislative session to override the veto.

The Governor cited the $28 million estimated cost of the added credit in his veto message, adding:

It is my desire to approach tax policy in a comprehensive and holistic manner. As such, I urge members of the House and Senate to continue to work with my office on an overall tax reduction package that both fits within our sound budgeting principles while reducing those taxes that are impeding our state's ability to compete for new business and jobs

The Earned Income Credit is best understood as a welfare program. It applies when taxpayers have some income from wages and self employment income, but it phases out quickly as income rises. If the credit computed exceeds tax liability, the taxpayer gets a check for the difference. In effect, the Governor vetoed a 42% increase in a means-tested welfare program.

The Earned Income Credit, like other refundable credits, is a fraud magnet. The GAO estimates a 25% error rate in claiming the credit for 2010. Assuming that rate applies to Iowa's piggyback credit, that means $7 million of the $28 million would have been issued in error.

The way the credit phases out quickly as income rises also has the perverse effect of imposing a penalty on taxpayers who are rising out of low incomes. When combined with other means-tested phase-outs, you can get results like this, with marginal rates over 100%:

Source: Clifford F. Thies, "The Dead Zone: The Implicit Marginal Tax Rate." Click to enlarge

Increasing the piggyback Earned Income Credit would increase this perverse penalty rate, which can make getting a raise a money-loser.

Iowa's complex system, with its high rates and byzantine loopholes, is rated one of the worst for business in the country. While the Governor hasn't gotten behind real "holistic" tax reform -- like the Tax Update's Quick and Dirty Iowa Tax Reform Plan -- it's a good bet that a better Iowa tax system would do much more for Iowa's working poor than a boost in the EIC. It's too bad that Iowa's political leadership doesn't seem to be moving in that direction.

Tags: CTJ.Iowa Policy Project.Iowa tax policy.Quick and Dirty Iowa Tax Reform Plan.