Presidential candidate Mitt Romney's comment last month that 47% of Americans pay no income tax predictably drew strong reactions from both his supporters and his detractors. Thanks largely to the earned income tax credit, many low-income taxpayers are able to zero out their tax liability and even earn refunds despite having taxable income.
Regardless of whether you agree with Romney's conclusions about the 47%, it's important to understand the mechanism behind the earned income tax credit and how so many Americans manage to keep from having to write checks to the IRS every year. Only then can you make reasoned arguments about whether the tax policy behind these breaks makes sense. Let's take a closer look at how the credit works.
An easy way to boost take-home pay
The earned income tax credit is available to taxpayers earning as much as about $49,000, depending on the number of qualifying children you have and your filing status. Calculating your exact credit is complicated and typically requires consulting a special IRS credit table, but in general, here's how it works:
- The credit phases in at a rate of 7.65% for taxpayers with no children, 34% for one child, 40% for two children, and 45% for three or more children.
- At various points -- around $6,000 for those with no children, $9,100 for one child, and $12,750 for two or more children -- the credit amount maxes out. Additional earned income above those limits doesn't result in a bigger credit.
- At a higher income level, the credit starts phasing out. For every $100 of income earned above the appropriate limit, the credit is reduced by $21 for those with two or more children, $16 for one child, and 7.65% for no children.
The credit reduces any income tax liability on a dollar-for-dollar basis. If the earned income tax credit is enough to more than offset any outstanding tax due, then taxpayers are entitled to get the excess as a tax refund. That's unusual, as most other tax credits don't let you claim a refund if the credit would take your tax bill below zero.
If you're against using the tax system as a means of directly redistributing wealth, then there's pretty much no way to justify the earned income tax credit. Although the progressive tax policy of refunding payroll taxes withheld from low-income earners' paychecks is legitimate, it only explains a small portion of the credit for families with children. The rest is a targeted attempt to add to take-home pay for low-wage workers.
Yet the credit addresses concerns that many would support: If you don't work, you don't get the credit. That simple incentive helps push people toward working in a way that other programs focused on redistributing wealth toward low-income earners fail to accomplish.
You can even make the argument that the earned income tax credit subsidizes industries that pay low wages. A recent report from the National Employment Law Project (link opens PDF file) named the 50 largest low-wage employers, and among the top five were retailers Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and Sears Holdings (NASDAQ:SHLD). Restaurant stocks also made a big showing, with Yum! Brands (NYSE:YUM) coming in at No. 2 and McDonald's (NYSE:MCD) close on its heels at No. 3. Without the earned income tax credit, low-wage earners might not be able to make a living in these jobs, leaving employers either without an adequate supply of labor or having to increase compensation.
Give yourself some credit
In recent years, political battles have increasingly capitalized on the gulf between high-income and low-income workers in the U.S., and tax breaks aimed at both ends of the wealth spectrum have gotten a lot of scrutiny. Before you write off the earned income tax credit as bad policy, though, make sure you understand all of its impacts -- not just on the people who get it but on the overall economy as well.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend McDonald's, Wal-Mart, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.