Exploring The Earned Income Credit

Well, its that time of year again.  Time to round up W2s and 1099-everythings.  Someday i hope to fill out a 1040 form by copying the one from last year, but every year as we do more grown-up things it seems there's a new mystery waiting for me.  Last year, after the birth of our son, i was expecting an extra deduction on taxable income.  That was easy.  I calculated our fairly modest bill and was almost at the bottom of the page when i hit this thing called Earned Income Credit.  Apparently, if you have a job that pays you, but doesn't pay very well, the government chips in some extra cash.  I'm thinking, great, we'll save a few hundred bucks.  Well...not exactly.  If you have children, the EIC can give back several thousand dollars.  When i finally found our entry in the lookup table, the EIC returned more than our tax burden.  Now i'm really excited.  I almost skipped the rest of the form and entered -0- in the Tax line.  Good thing i didn't, because the EIC is apparently the one place on the 1040 form where negative numbers don't round up to zero.

That's great and all, but now i'm really confused.  Grad student stipends are low, but they're not that low.  Lots of people make less than my family.  Are they all paying negative taxes?  Apparently they are.  I wrote a quick chart to calculate tax burden for the various family types recognized by the EIC (single/married, 0/1/2/3+ kids). In this, i assume the family takes only standard deductions and the EIC, if applicable.  Here is what i found.  (All data are for 2011).

If there are three or more people in your household, you're making more than $30k before you start paying positive taxes.  That describes 30% of the population!  Medium to large families are making $45k-50k before the credit runs out, a statistic which describes most such families.

Growing up, i always thought the goal of taxation was to raise enough money to run the government without causing undue hardship to any one citizen.  It seems Uncle Sam has taken a more pro-active approach.  The above graph makes a little more sense if converted into units of poverty threshold for each family type.  According to the Department of Health and Human Services, the household poverty threshold in 2011 was ($7070 + $3820/person)/year.

If you exclude childless households (who perhaps are less affected by shortages of food and shelter?), positive taxation cuts in at incomes of 1.5-1.9 times the poverty line.  We shouldn't tax people who are truly living in poverty, but i'm a bit puzzled that the IRS thinks one third of the wealthiest nation on earth is too poor to support their own government.  As someone living near that zero-taxes line i'm doing okay.  I can imagine how an illness in the family or some other catastrophe could put a family like mine over the edge.  But even so, i would think positive taxation should cut in at 1.0 times the poverty line.  Doesn't 'poverty line' mean 'barely able to afford the essentials'?  Once you have the essentials covered, shouldn't you be contributing something to the common good?

As weird as negative taxation is, it doesn't bother me too much at a gut level.  What did bother me was the change in my tax bill check when i declared a small amount of extra tutoring income.  Take a look at the $20k-$50k income range in the first graph.  Once a family starts making enough to support itself, the EIC starts to phase out at a rate of 16% (1 kid) or 21% (>1 kid).  This happens after incomes have reached the 10% or 15% tax bracket.  So even though their average tax rate is fairly low, about 30% of American families with kids have a marginal  tax rate above 30% due to this weird quirk of a disappearing gift.  I understand why the EIC should ramp up at low incomes; we want to encourage earning your own money.  If i can go by the income distribution chart on Wikipedia, only 15% of Americans experience the ramp up, while twice as many experience this bizarre ramp down.  Creating an artificial incentive for the lower middle class to under-report their income seems like a bad idea.  Policing that income bracket must be a nightmare for the IRS; high infraction rate combined with small gains per infraction caught must lead to lots of thankless poring over trivial 1040s.

Maybe i'm missing the point here.  The federal minimum wage in 2011 was $7.25/hr.  A full-time minimum-wage job (40 hrs/wk, 50 wks/yr) would pay $14,500/yr.  At that wage, the EIC is maxed out for everyone except the childless, who are already losing it.  So the part of this law that makes sense is aimed at people who only have a part-time job.  But you can't survive on a single part-time job and you certainly can't raise a family on one.  So the target audience of the EIC is on welfare?  Apparently there are 4.3 million people on welfare in this country and you can make up to $12,000/yr and still receive benefits.  Since welfare pays substantially more than minimum wage in most states, perhaps the EIC is needed to encourage welfare recipients with children to at least get a part-time job?  Again, this seems like a weird incentive structure to me.  If someone can't hold down a full-time job, they should be on disability.  If they can, then they don't need welfare beyond the safety net of unemployment insurance.  As is, we're encouraging companies to offer part-time jobs at low wages in the knowledge that the government will chip in an extra 35-45%.  This leaves otherwise full-time workers in a stable part-time limbo where adding hours results in a pay cut.

Am i missing something here?  Selfishly, raising a family in grad school is difficult and i'm glad to have the money, but this policy seems really strange to me.  What is it trying to accomplish?