600 Income Security:Reduce Fraud in the Earned Income Tax Credit

Rationale:

The Earned Income Tax Credit is the nation’s largest means-tested cash welfare program. Although the EITC in some cases reduces federal income taxes owed, its major function is to provide “refundable” tax credits to low-income individuals. A “refundable tax credit” is simply a cash welfare grant to individuals who have no federal income tax liability. About 15 percent of the total expense of the EITC goes to tax reduction, while 85 percent goes to refundable cash credits.  In 2012, 24.3 million individuals received refundable EITC payments at a cost of $56.2 billion. (( Internal Revenue Service, “SOI Tax Stats–Individual Statistical Tables by Size of Adjusted Gross Income: Individual Income Tax Returns with Earned Income Credit,” (accessed December 12, 2014).))

Fraud is prevalent in this expensive welfare program. An IRS audit conducted from 2006 to 2008 found that 43 percent to 50 percent of tax returns claiming the EITC involved erroneous overclaims. These overclaims were not minor filing errors; the overwhelming majority of individuals making overclaims were not eligible for the credit at all. According to the IRS, the erroneous, often fraudulent, overclaims accounted for 28 percent to 39 percent of all EITC payments. The total overclaim amounts were estimated at $14 billion to $19.3 billion per year during the period. ((Internal Revenue Service, “Compliance Estimates for the Earned Income Tax Credit Claimed on 2006–2008 Returns,” Publication 5162(8-2014), August 2014, p. iv.))

The EITC differs favorably from other means-tested aid programs: Individuals must report earned income to receive cash aid. Thus, in certain income ranges, the EITC can encourage work effort. However, millions of individuals each year fraudulently report income to obtain EITC cash bonuses. These individuals invent fictitious income (or under-report earnings) to maximize their EITC welfare payments. According to the IRS, 30 percent of all EITC claims are based on false or erroneous income claims. In the 2006–2008 audit, 50 percent of the overclaim amount of $14 billion to $19.3 billion per year involved false income reporting. ((Ibid., p.16))

If the income misreporting ratios from the 2006–2008 audits are applied to 2012 EITC payments, an estimated 8 million households engaged in false income reporting in that year, yielding roughly $10 billion in overclaimed refundable EITC credits. We project that this fraud could be reduced by 80 percent by implementing these proposed anti-fraud measures.

The IRS has an effective capability to detect false income claims. But typically, the IRS scrutinizes claims only in a small number of cases. Audits generally occur after the EITC cash payments have already been made. There are apparently current legal restrictions on the IRS, which require it to make EITC refunds prior to proper income verification. The Department of the Treasury’s “Agency Financial Report” for FY 2013 states that 30 percent of EITC overpayments are the result of detectable income misreporting. The report adds:

• These [EITC payment] errors relate to improper income reporting which allows claimants to fall within the EITC income limitations and qualify for EITC. The errors include both underreporting and over-reporting of income by both wage earners and taxpayers who report that they are self-employed. Income reported through information returns such as Forms W-2, Forms 1099, etc., which can be used for verification of some income, becomes available only after tax returns are processed. Under law, the IRS must process income tax returns within 45 days of receipt or pay interest to taxpayers. (( Department of the Treasury, “Fiscal Year 2013 Agency Financial Report,” December 16, 2013, pp. 206–208, (accessed December 12, 2014). ))

Overclaims and overpayments can be significantly reduced by requiring the IRS to fully verify reported income before any refundable EITC payment is made.