FROM THE OFFICE OF PUBLIC AFFAIRS

I am pleased to havethe opportunity to discuss the Administration’s proposals toimprove the earned income tax credit (EITC) and look forward toworking with the Committee on this issue.

The Administrationis strongly committed to the goals of the EITC and will opposeany proposals which reduce the EITC and raise taxes on millionsof working families who play by the rules. The goals of the EITCare to make work pay and to lift workers out of poverty in themost efficient and administrable manner possible. With itsmessage of "work pays," the EITC helps reducedependency on welfare and increase reliance on jobs.

Economic Conditions Among Low-WageWorkers

To understand therole of the EITC, a couple of facts about the labor market forlow-skilled workers in the United States are useful.

There has been astriking drop in real wages for unskilled workers, beginning inthe 1970s and accelerating over the 1980s. Between 1979 and 1992,the earnings of full-time male workers who had not graduated fromhigh school declined by more than 23 percent in real terms. Amongfull-time male workers with a high school diploma, real earningsfell by 17 percent over the same period.

This decline in thereal wage for many unskilled workers has serious implications. Inthe United States, it is still possible for a family, containinga worker, to live in poverty. According to the Census Department,there were 2.4 million persons, over the age of 16, who lived inpoverty and had worked year-round at full-time jobs in 1995.

Effectiveness of EITC in Making Work Payand Reducing Poverty

The ETC makes workpay in two ways. Unlike many assistance programs for low-incomefamilies, the EITC is limited to working families. Moreover, thecredit amount initially increases -- rather than decreases -- foreach additional dollar of earnings. As a consequence, the EITC isdifferent from many low-income assistance programs that arecharacterized by a reduction in benefits for each additionaldollar of earnings. In my work prior to coming to Treasury, I --together with Stacy Dickert-Conlin and Scott Houser -- examinedthe net impact of the OBRA 1993 expansion of the EITC on laborsupply. We found that the EITC has a modest, positive effect onlabor supply by encouraging individuals to enter the workforce.The EITC also directly increases the disposable income of workingfamilies. According to the most recent Census data, the EITClifted 3.7 million persons out of poverty during 1995.

By making work pay,the EITC increases the probability that some parents may enterthe workforce and perhaps leave the welfare rolls. The EITC,then, plays a key role in our efforts to reform welfare.

Administering the EITC through the TaxSystem

The EITC achievesthe goals of making work pay and relieving poverty by reducingthe tax liabilities of low and moderate-income families. Thus, itis improper to characterize the EITC, as some have done recently,as a "non-tax function" of the IRS. The EITC wascreated and expanded to offset the overall tax burden of low andmoderate-income families and should not simply be measured as anoffset to income and SECA taxes. About 85 percent of EITC costswill offset the combined Federal tax burden of families receivingthe credit in 1998.

As these numberssuggest, EITC claimants are taxpayers. If the EITC did not exist,almost all EITC filers would still file an individual income taxreturn (in addition to paying payroll and excise taxes), and theIRS would still have to process their returns and verify much ofthe same information regarding their filing status, number ofchildren, and income. In 1998, about 69 percent of EITC claimantswill be required to file a tax return because they have anindividual income tax liability (before the EITC), owe specialtaxes, have self-employment income in excess of $400, or theirgross income will exceed the filing threshold. In addition, over25 percent of EITC claimants will file a tax return in order toobtain a refund for overwithheld taxes paid throughout the year.

Because most EITCclaimants would be filing a tax return even if the credit did notexist, the direct budgetary costs of administering the EITC aresignificantly lower than if the credit were provided throughanother means. The IRS cannot easily disentangle the costs ofadministering one line on the Form 1040 from other lines on thetax return, and we thus do not have estimates of the costs ofadministering this particular tax provision through the taxsystem. We can safely say, however, that the costs are lower thanthose associated with certain government expenditure programs.For example, in FY 1995, the food stamp program cost $3.7 billionto administer, while AFDC administrative costs were an additional$3.5 billion -- nearly 14 percent of the combined costs of thesetwo programs. For these administrative costs, the AFDC programserved, on average, about 4.9 million families in a given month,while over 10 million households received food stamps. By way ofcomparison, the entire IRS budget in FY 1995 was $7.6 billion,and the IRS served over 116 million individual taxpayers and 15million corporations.

Taxpayers alsobenefit from obtaining the EITC through the tax system. Manylow-income workers learn about the EITC when they file a taxreturn to obtain a refund. By claiming the credit on tax returns,EITC claimants do not have to take time off from work to applyfor the credit at a government office.

Not surprisingly,then, participation in the EITC tends to be higher than manyother assistance programs targeted to low-income families. In myresearch prior to joining Treasury, I found that 80 to 86 percentof those eligible received the credit in 1990. This highparticipation rate is striking when compared to the AFDCparticipation rate of 62 to 72 percent and the food stampparticipation rate of 54 to 66 percent. International comparisonsalso confirm this finding. The United Kingdom has an EITC-likeprogram called the Family Credit. It is administered through thetransfer system and directed toward families with children.Official estimates place the participation rate of the FamilyCredit at around 50 percent. Thus, both compared to cash andin-kind transfers in the United States and comparablework-related benefits in the United Kingdom, the EITC is muchbetter at reaching those who are eligible for the credit.

Notwithstandingthese benefits, there are costs associated with operating theEITC, as with other tax provisions, through the tax system. Asystem based largely on self-assessment will have loweradministrative costs than a more bureaucratic approach, but itwill also lead to higher noncompliance. Many of us were veryconcerned when EITC compliance data, from the 1980's, firstbecame available. The Taxpayer Compliance Measurement Program(TCMP), last conducted in 1988, showed that 35.4 percent of theEITC claimed ($2 billion) exceeded the amounts to which taxpayerswere eligible.

But the same TCMPalso places the problems of the EITC in perspective. Last April,the IRS released a study, based on the 1988 TCMP, showing thatthe gross individual income tax gap in 1992 was between $93.2 and$95.2 billion. The IRS estimated that the total "true"individual income tax liability was between $550.2 and $552.3billion for tax year 1992. Over 40 percent ($39.1 to $39.9billion) of the gross tax gap for 1992 was attributable to theunderreporting of business income (including self-employmentincome, partnership income and rents and royalties). About 20percent ($18.1 to $18.7 billion) of the gross tax gap was due tothe underreporting of non-business income. Over 14 percent ($13.5to $13.8 billion) of the gross tax gap was due to persons whofailed to file tax returns. These problems exceed anynoncompliance problems associated with the EITC.

Nonetheless, theAdministration and Congress have recognized that the EITC canbest meets its goals -- of making work pay and lifting familiesout of poverty -- by ensuring that only those who are eligibleand deserving receive the credit. Congress took a first step inthis direction during the consideration of OBRA 1990, when datafrom the 1985 TCMP became available. The TCMP data suggested thatEITC errors were linked to complicated and unverifiable supportand household maintenance tests. OBRA 1990 replaced the supportand household maintenance rules for EITC eligibility with simplerage, residency, and relationship tests, lowered the agerequirement for reporting a taxpayer identification number forEITC qualifying children, and created a separate schedule toclaim the EITC.

This Administration,with the support of Congress, has taken 17 additional legislativeand administrative actions to further improve the targeting andoperations of the credit. First, Congress has enacted stricterreporting requirements proposed by the Clinton Administration,and the IRS has tightened enforcement of these requirements.Since 1995, the IRS has transcribed the social security numbersof all EITC qualifying children and most dependents, andit has intensified its examination of returns with missing socialsecurity numbers. The Personal Responsibility and WorkOpportunity Reconciliation Act of 1996 (the welfare reform act)contains a Clinton Administration proposal which will enable theIRS to use the simpler and more cost-efficient mathematical errorprocedures to deny both the EITC and dependent exemptions totaxpayers who fail to provide valid social security numbers. As aconsequence of the Uruguay Round Agreement Act of 1994, taxpayerswill also be required to provide social security numbers for alldependents and EITC qualifying children without regard to theirage on their 1997 tax returns.

Other reportingrequirements have also been strengthened. The Uruguay RoundAgreement requires the Department of Defense to report to boththe IRS and military personnel nontaxable earned income used inthe computation of the EITC. The 1996 welfare reform act alsoauthorizes the IRS to treat the omission of self-employment taxesas a mathematical error, if the taxpayer claims eligibility forthe EITC on the basis of self-employment income.

The IRS, with thesupport of Congress, has also intensified scrutiny of"questionable" EITC claims and preparers. For the lastseveral years, the IRS has conducted studies of EITC complianceand has used this information to better identify questionablereturns. In addition, the IRS increased scrutiny of electronicreturn originators (EROs), instituted fingerprint and creditchecks on certain new ERO applicants, and eliminated the directdeposit indicator.

Finally, theAdministration has consistently supported provisions that wouldsimplify the EITC, opposed provisions that would add significantcomplexity to the EITC, and has striven to ensure that EITCreforms can be administered. In 1993, the Administration proposedthe repeal of two supplemental credits (for children under theage of one and for the purchase of health insurance forqualifying children), arguing that the IRS could not enforce theeligibility criteria for them, and these supplemental creditswere subsequently repealed. In 1995, the Administration opposed,on administrative grounds, proposals to base EITC eligibility onchild support payments and hours of work. TheAdministration’s proposal to deny the EITC to undocumentedworkers, included in the welfare reform act, was also designed ina manner which could be administered by the IRS.

Analysis of EITC Compliance Study for TaxYear 1994

The combined effectsof these efforts cannot be fully measured at this time, sinceseveral key steps did not take effect until the 1997 filingseason and another step -- the requirement that all children,regardless of their age, have a social security number -- willnot be fully implemented until the 1998 filing season.Today’s hearing, nonetheless, has been called in response tothe recent release of new IRS data on EITC noncompliance for taxyear 1994.

The CriminalInvestigation (CI) Division of the IRS conducted this study ofcompliance among 2,046 taxpayers who claimed the EITC on taxreturns filed and accepted by the IRS between January 15 andApril 21, 1995. CI Special Agents visited a random sample of EITCclaimants, shortly after they filed their paper or electronic taxreturns. Taxpayers (and often their employers, tax returnpreparers, family members, and neighbors) were interviewed atlength and asked to produce verification that they met the EITCeligibility criteria. While the Special Agents made initialjudgements about the legitimacy of the EITC claim, thesejudgements were reviewed -- and sometimes changed -- insubsequent review by Examination staff who had access to othersources of independent information (such as the Forms W-2 and1099 sent by employers and other payers).

The study found thatof the $17.2 billion claimed in EITC between January and April1995, $4.4 billion, or 25.8 percent of total EITC claimed,exceeded the amount to which taxpayers were eligible. Theoverclaim rate among EITC claimants was slightly higher amongpaper filers (26.1 percent) than for electronic returns acceptedby the IRS (25.3 percent). Noncompliance was found to be muchhigher among filers who claim EITC qualifying children than forthose EITC claimants without qualifying children. Among those whoclaimed EITC qualifying children, the overclaim rate was 26.1percent, while the overclaim rate was 15.7 percent for those whodid not reside with a qualifying child. IRS enforcementpractices, in place during the 1995 filing season, reduced theestimated net overclaim rate from 25.8 percent to 23.5 percent.If the IRS had been able to treat a taxpayer’s failure toprovide valid social security numbers for EITC qualifyingchildren over the age of one as a mathematical error on 1994 taxreturns, the net overclaim rate would have been reduced further,to an estimated 20.7 percent.

While EITCnoncompliance remains at unacceptably high levels, thestudy’s results do show significant improvement since thelate 1980s, the last time that the IRS examined a comparablegroup of taxpayers as part of the TCMP. The improvement in EITCcompliance since 1988 reflects the implementation of many, butnot all, of the steps described earlier.

To better understandthe remaining sources of noncompliance, we have conducted ananalysis of the data. We have found that the most common EITCerror is caused by taxpayers claiming qualifying children who donot reside with them for over half the year. Among taxpayers withchildren, such errors account for about 39 percent of overclaimedEITC amounts. Under current law, taxpayers are required to residewith their qualifying children for at least six months or a fullyear, depending on the relationship of the child. Taxpayers failthe residency test for many different types of reasons. Forexample, divorced parents who share the custody of their childrenmight both claim the EITC because they both feel the child livedwith them for over half the year. At the other extreme, ataxpayer may claim a child with whom he or she has never resided.

A second commonerror is due to misreporting of filing status among marriedtaxpayers. Filing status errors account for about 31 percent ofoverclaimed EITC amounts among taxpayers with children.Sometimes, separated couples do not understand that they muststill file as married persons if they have not yet obtained alegal separation. In other cases, married couples, who are stillliving together, do not file either a joint return or a"married filing separate" return.

The third mostcommon error results from complicated living arrangements. Insuch situations, a child lives with more than one adult whoappears qualified to claim him or her for EITC purposes. However,about 18 percent of overclaimed EITC amounts result when, in suchhouseholds, the caregiver with the lower AGI claims the child. Insome cases (although it is difficult to quantify), the othercaregiver was, in fact, qualified to claim the EITC but did not.The study does not account for the offsetting errors which occurbecause the taxpayer’s relative, with the higher AGI, didnot claim the EITC when he or she was eligible.

Even among EITCclaimants without qualifying children, many errors are caused bythe misreporting of family structure. Among these taxpayers,about 40 percent of overclaims are attributable to themisreporting of filing status among married taxpayers. However,most errors among EITC claimants without qualifying children aredue to the misreporting of income.

While we canidentify the sources of EITC errors in this study, we do not knowfrom the study the extent to which the EITC, itself, is the rootcause of the noncompliance on the part of the taxpayers. Bymisreporting filing status, child dependents, and income,taxpayers may be able to reduce their tax liability through otherprovisions in addition to the EITC. Because this study focusedonly on EITC claimants, it does not isolate the effect of theEITC on noncompliance, or the extent to which higher incometaxpayers are benefiting from misreporting their income or familycircumstances.

The study doesprovide evidence that the refundable nature of the credit doesnot induce ineligible individuals to enter the tax system simplyto claim the credit. As I have discussed, 95 percent of EITCclaimants have a reason other than the EITC to file a return. Theoverclaim rate among those with a positive pre-EITC tax liabilityis nearly three times larger than the rate among those who didnot have a tax liability. The data thus suggest that noncompliantEITC claimants do not enter the tax system merely to claim thecredit.

While the results ofthis study are not fully applicable to the current EITC, thestudy does point to the need for new approaches. Many types ofEITC errors are difficult to detect with the current IRSenforcement tools, such as matching of information reports andSocial Security Administration records to tax returns. Ourproposals are designed to provide the IRS with new tools toidentify erroneous EITC claims while minimizing additionaladministrative costs to the Federal government.

Legislative and Administrative Proposals

The TreasuryDepartment’s eight-point plan contains six legislativeproposals and two administrative actions. These proposals willhelp reduce EITC errors by increasing IRS’s ability todetect errors before EITC refunds are paid out, by imposing new,more effective penalties on EITC claimants, and by reducing therisk of unintentional errors by law-abiding taxpayers.

Proposals to Improve the Flow ofInformation Prior to Release of EITC Claims

Due diligencerequirements for preparers -- About half of earned income taxcredit (EITC) claimants use a paid preparer to complete theirincome tax returns. As a consequence, tax preparers can play akey role in helping working families file accurate tax returns.While there is little significant difference among returnsprepared by the taxpayer and those prepared by a paid preparer,the error rate does differ depending on the type of preparerconsulted by the taxpayer. Noncompliance was much lower amongtaxpayers who went to a preparer who was either a certifiedpublic accountant, lawyer, enrolled agent, or a representative ofone of the large nationally-recognized organizations. It washigher among those who sought other types of preparers.

Under our proposal,the responsibilities of paid preparers, with respect to potentialEITC claimants, would be clarified. Preparers who do not fulfillcertain due diligence requirements would be subject to cashpenalties ranging from $50 to the full amount of an EITCoverclaim. The proposed penalties would be in addition to thepenalties imposed on preparers and taxpayers under current law.The proposal would be effective for taxable years beginning afterDecember 31, 1997.

Recertification --When questions arise about EITC claims, the IRS generally mustfollow deficiency procedures to determine the accuracy of thetaxpayer’s return. While deficiency procedures protecttaxpayers’ rights, they can be time-consuming and relativelyexpensive when compared to the amount of tax at issue.

Under the proposal,a taxpayer who has been denied the EITC as a result of deficiencyprocedures would be ineligible to claim the credit in subsequentyears unless he or she provides evidence of his or hereligibility for the credit. To demonstrate current eligibility,the taxpayer would be required to meet evidentiary requirementsestablished by the Secretary of the Treasury. Failure to providethis information when claiming the EITC would be treated as amathematical or clerical error. If a taxpayer is recertified aseligible for the credit, he or she would not be required toprovide this information in the future unless the IRS againdenies the EITC as a result of a deficiency procedure.Ineligibility for the EITC under the proposal would be subject toreview by the courts. The proposal would be effective for taxableyears beginning after December 31, 1997.

DemonstrationProjects -- The Treasury Department is seeking legislationpermitting it to select four states to experiment withalternative ways of providing the EITC throughout the year. Underthe proposal, the four states could provide advance payments ofthe EITC to wage earners through state agencies rather thanemployers for a three year period. States would be required toverify eligibility for the EITC before paying out the credit.Effects on advance payment participation and compliance would bestudied by Treasury. Applications would be submitted by thestates to the Treasury Department during 1998 for demonstrationprojects to begin in January, 1999.

Earmarking of IRSResources -- Using information from the EITC compliance studiesand other ongoing pilot projects, the IRS will continue todevelop and use profiles of potentially erroneous EITC claimants.These profiles will be used to identify questionable EITC claimsduring the 1998 filing season. The IRS will expand the number ofquestionable EITC claims that it investigates during the 1998filing season. Refunds associated with these claims will bedelayed until the investigation is complete. Out of its currentappropriations request, the IRS is earmarking 550 full timeequivalent staff persons for this intensified effort during the1998 filing season.

Increasing the Penalties for IntentionalNoncompliance

New Penalties forIntentional and Fraudulent Errors -- Existing civil penaltieshave a limited deterrence effect against ineligible taxpayersrepeatedly claiming the EITC. Denying subsequent eligibility toclaim the EITC to taxpayers who have recklessly, intentionally,or fraudulently claimed the EITC in the past should help ensurethat only those who are eligible for the credit receive it.

Under the proposal,any person who fraudulently claims the EITC would be ineligibleto claim the EITC for a subsequent period of ten years. Inaddition, any person who erroneously claims the credit and sucherror is due to the reckless or intentional disregard of rules orregulations would be denied eligibility for the EITC for twosubsequent years. The sanction under the proposal would be inaddition to civil and criminal penalties imposed under currentlaw. In addition, the sanction would be subject to review by thecourts. The proposal would be effective for taxable yearsbeginning after December 31, 1997.

Continuing Levy --The IRS does not generally find it cost-effective to recoupoverpayments of the earned income tax credit (EITC) or imposemonetary penalties on noncompliant claimants. To some extent,these efforts are hindered by the exemption from levy of certaintypes of income prevalent among EITC claimants. By removing theseexemptions, this proposal would make it more likely that the IRSwould recapture overpayments.

In our FY 1998budget, the Administration proposed that certain exemptions bepartially lifted from the levy. Under the budget proposal,Federal workers’ compensation payments, annuity or pensionpayments under the Railroad Retirement Act, and benefits underthe Railroad Unemployment Insurance Act would no longer be fullyexempted from levy. The proposal would change the exempt amountof Federal wages, salaries, and other income to a flat 85 percentexemption. The proposal would provide for "continuous"levy on non-means tested, recurring Federal payments.

Under the EITCinitiative, unemployment benefits and means-tested publicassistance would no longer be fully exempted from levy for anypurpose. Up to 15 percent of these benefits would be subject tolevy. The proposal would also provide for the option of a"continuous" levy on these payments. Treasury wouldwork with affected Departments and state agencies to design themechanisms appropriate for each program. If necessary, conformingchanges would be made to the laws and regulations governingpublic assistance to ensure that there would not be offsettingchanges in these benefits to compensate for the levy. Theproposal would apply to levies issued after December 31, 1997.

As under currentlaw, taxpayers would be allowed to apply for relief from a levyif they can demonstrate that they are suffering significanthardship as a consequence.

Reduce Unintentional Errors

Simplification ofFoster Child Rule -- Under current law, a taxpayer is eligible toclaim the earned income tax credit (EITC) if he or she resideswith a son, daughter, or grandchild for over half the year. EITCqualifying children also include individuals who reside withtaxpayers for a full year and for whom the taxpayers "carefor as the taxpayers’ own children." All EITCqualifying children (including foster children) must either beunder the age of 19 (24 if a full-time student) or permanentlyand totally disabled.

The fosterchild" rule is confusing to both taxpayers and the IRS.Clarifying the definition would eliminate unintentional errors bytaxpayers and provide better guidance to the IRS. In addition,the definition of a foster child for EITC purposes would beconformed to the dependency exemption definition proposed as partof the Administration’s simplification package.

Under the proposal,a foster child would be defined as a child who (i) is under theage of 19 (24 if a full-time student), (ii) is cared for by thetaxpayer as if he or she were the taxpayer’s own child, and(iii) either is the taxpayer’s niece, nephew, or sibling orwas placed in the taxpayer’s home by an agency of a state orone of its political subdivisions or a tax-exempt child placementagency licensed by a state. The proposal would be effective fortaxable years beginning after December 31, 1997.

Improve Access toTaxpayer Assistance -- In 1996, 1.9 million low-income taxpayersreceive assistance preparing their tax returns from over 47,000volunteers in IRS-sponsored VITA (Volunteer Income TaxAssistance) facilities. The IRS provides training materials andtax forms to 8,300 sites. The IRS also provides software forelectronic filing and lends computer hardware to selected sites.These VITA efforts will be continued and strengthened as part ofthe Administration’s commitment to volunteerism. TheTreasury Department is contacting businesses and tax professionalorganizations to make sure that they are aware of the need forVITA volunteers, computers, facility sites, and outreachassistance. By improving access to free taxpayer assistance andelectronic filing, these efforts will help reduce the risk ofunintentional errors.

This concludes myremarks. We look forward to working with you toward the enactmentof these provisions. Thank you once again for providing me withthe opportunity to testify. I would be pleased to answer anyquestion that the Committee may have.