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Utilizing Federal Credit Surrenders Policy Making

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By Lowell L. Kalapa

It appears that tax relief efforts will once more be the subject of the political football between a Republican administration and Democratically controlled legislature. And if this past session was any kind of a track record, the next legislature will probably leave tax relief on the cutting room floor.

The administration prefers raising the standard deduction and adopting an expanded tax credit to offset the regressive effects of the general excise tax. This has set off a volley from legislative Democrats who would prefer to see the state adopt the Earned Income Tax Credit (EITC) as a way to provide tax relief for the poor.

Lawmakers have politicized the issue by coloring the EITC as a proposal that was initiated by Republican President Ford and complimented by Republican President Reagan as “the best anti-poverty” measure to come out of Congress. And while these legislators refer to the expansion of the program under the first President Bush, they overlook the fact that current generous benefits were added in 1993 by Democratic President Clinton.

Enough of the politics. Let’s look at the credit and its genesis in order to understand why this would not be good tax policy for Hawaii. The Earned Income Tax Credit was established by Congress in 1975 for low and moderate-income workers to offset the burden of Social Security payroll taxes that might have otherwise been paid to them but were instead paid to the federal government by the employer. The credit was expanded three times during the 1980’s and 1990’s by the federal government to boost income earned by the working poor and lessen poverty among families with children. In other words, it became a tool by which the federal government undertook social policy beginning with the first expansion of the credit in 1986.

It is interesting to note the date of the first expansion because that was also the year that the federal Code was dramatically restructured, eliminating a number of tax benefits such as the deduction of consumer credit interest, deduction of state sales taxes, and institution of a minimum tax for those taxpayers receiving generally exempt income. It was also the year that rates were dramatically reduced, and together with the standard deduction and personal exemption, rates were indexed.

Thus, what started out as a mechanism to “refund” payroll taxes that might otherwise have been paid to low and moderate-income workers by the federal government has turned into a subsidy for these families. Amounts of the credit which are determined by income and number of dependent children often represents more than what was paid in Social Security, unemployment and withheld income taxes of these workers. The legislative proposals that have been considered in recent years would make the state credit amount a percentage of whatever the claimant gets under the federal program.

For years, the EITC was known for its complexity and abuse. Because of the definitions of the law, the credit was also rife with abuse. Advocates for the adoption of the credit argue that with recent changes that has all changed and more people are filing for the credit and it is helping them out of poverty.

But is that true? A study conducted by leading experts in the tax field found that the program continues to be plagued with persistent compliance problems with millions of claimants each year receiving benefits to which they are not entitled. Indeed, an IRS study of EITC claims on tax year 1999 returns published in 2002 reports excess claims of between $9.65 billion and $11.12 billion representing from 30.9% to 35.5 % of total claims of the EITC. As noted earlier, the tax credit often amounts to substantially more than the federal taxes – income, Social Security, and unemployment – taken from the worker. Thus, the EITC has become nothing more than a backdoor welfare payment system that has little oversight save but for an audit of the taxpayer’s return.

What local lawmakers seem to miss is the fact that Hawaii would be tying itself to a federal number by adopting a law that would allow a percentage of the federal credit amount. What is scary is not having control over what that amount will be. Thus, by picking a percentage of the federal credit amount, local lawmakers will surrender the policy making oversight to federal lawmakers. And once a part of state law, it will be difficult for legislators to change the rules of the game should the federal officials double or quadruple the amount of the federal credit. What is telling about this credit is that it is not about good tax policy but more about social engineering. Even more telling is that not one of the five Tax Review Commissions – all of whom were appointed by Democratic governors – that have been convened to date has made a recommendation to adopt the EITC.

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