Phasing out the Child Tax Credit at lower income levels may not be a good idea
By Kyle Pomerleau
The future of the Build Back Better (BBB) Act remains unclear. Some reports suggest that lawmakers continue to negotiate details while others throw the package’s prospects into doubt. According to reporting by Axios, Senator Joe Manchin (D-WV), a key vote for the Democrats, may still be open to a proposal that expands the Child Tax Credit (CTC) but scales back the credit for higher-income households. This trade would reduce the cost of the credit and target the benefits to low- and middle-income households but could worsen equity in the tax code.
In early 2021, lawmakers passed a one-year expansion of the CTC as part of the American Rescue Plan Act (ARPA). This expansion increased the credit from $2,000 to $3,000, provided a $600 additional credit for qualifying children under six years old, and made the credit fully refundable to all households. The $1,000 ($1,600 for young children) expansion of the credit phased out at $50 per $1,000 in adjusted gross income (AGI) for households earning $75,000 ($150,000 married filing jointly) in AGI. The remaining $2,000 credit phased out at $200,000 ($400,000 married filing jointly) in AGI. Half of the credit was also distributed to households over the last six months of 2021.
On January 1 of this year, the CTC reverted to pre-ARPA policy as enacted in 2017 as part of the Tax Cuts and Jobs Act (TCJA). As such, the CTC is once again $2,000 per child, with the refundable portion capped at $1,500 and phased in at 15 percent of earned income over $2,500. The full credit phases out at $200,000 ($400,000 married filing jointly) in AGI, and the monthly distributions have stopped.
Axios reporting suggests that Sen. Manchin is weighing an option to expand the CTC and reduce the phase-out threshold for the credit from $200,000 ($400,000 married filing jointly). This would be to further target the CTC to low-income households and reduce the cost of an expansion.
While phasing out the CTC at a lower income level better targets it at low-income households, this would worsen equity in the tax code, absent other changes.
An important principle in taxation is “horizontal equity,” which states that taxpayers in similar economic situations should face a similar tax burden. One way the tax code has traditionally maintained equity across households is to adjust tax burdens for differences in household size. A household with two members and $100,000 in income has higher living standards than a household with four members and the same level of income. As such, the household with more members should face a lower effective tax rate.
Prior to the passage of the TCJA in 2017, one way the tax code adjusted tax burdens for household size was with the personal and dependent exemption. The personal exemption allowed households to reduce taxable income by $4,050 per member, but the exemption phased out at $258,250 ($309,900 married filing jointly) in AGI. The TCJA expanded the CTC for households earning up to $200,000 ($400,000 married filing jointly) in AGI to offset the loss of the dependent exemption. This trade helped maintain the adjustment for households with children.
Phasing out the CTC at lower income levels would eliminate the adjustment for the number of child dependents for impacted households. For example, if the CTC were fully phased out by $150,000 in AGI for a married filer, households over $150,000 in AGI would receive no adjustment for child dependents. Holding all else constant, a household earning $150,000 with four children would face the same tax burden as a household with no children earning the same amount of income.
Lawmakers and analysts may think it is worthwhile to target the CTC to low-income households. This would allow for a larger tax credit at a lower cost. However, it is worth considering the role the CTC plays in the tax code. Targeting the CTC may be sensible in a more comprehensive reform, but without other changes, it would worsen equity in the tax code.
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