NATIONAL CENTER FOR POLICY ANALYSIS HOME / DONATE / ONE LEVEL UP / ABOUT NCPA / CONTACT Child Care Tax Credits: A Supply-Side Success Story
REVENUE GAIN FROM THE TAX CREDIT Under current law, the tax credit applies to child care expenses up to $4,800 per year.5 Working families receive a tax credit equal to a percent of expenses incurred, and the maximum credit varies with family income. For families earning $28,000 per year or more, the maximum credit is equal to 20 percent of expenses, or $960. For families earning less than $10,000, the maximum credit is equal to 30 percent of expenses, or $1,440.6 Federal tax policy, then, lowers the cost of child care by as much as $960 for middle-income families and by as much as $1,440 for low-income families. To qualify for the tax credit, parents must work. Thus, in a two-adult family both parents must be working. Because of the child care tax credit, many women have entered the labor market.7 No one knows for certain how many women are working because of the child care credit, but a casual look at the evidence suggests the number is probably quite large. The tax reform act of 1981 (ERTA) created a more generous child care tax credit and other tax incentives for working mothers.8 Following these reforms, the number of families claiming the child care tax credit soared -- from 5 million in 1982 to 9 million in 1986.9 Increase in the number of Working Mothers. From studies cited in Appendix A, we can infer the impact of the tax credits and conclude that as many as 730 thousand working mothers have entered the labor market because of the credits. Increase in GNP and Work-Related Taxes. These working mothers increase our nation's output of goods and services and add to our GNP. In general, for each $1 of tax credit, we are getting at least $1.40 in additional production. Moreover, their income generates new tax revenue for government at all levels -- federal income tax and payroll tax, state and city income taxes and employment taxes. As a result, more than half of the revenues lost through the child care tax credit are repaid through other work-related taxes. 10 Overall, The $4 billion annual revenue loss associated with the child care tax credit leads to as much as $8.4 billion in additional output by working mothers. As much as $3.5 billion of the $4 billion revenue loss (or 89 percent of the total) is returned to government in the form of work-related taxes. These and other effects of the child care tax credit on the U.S. economy are presented in Table I, where both a low and a high estimate are given in each category. For reasons explained in Appendix A, the high estimate is more likely to be correct. TABLE I THE EFFECTS OF THE CHILD CARE TAX CREDIT ON THE U.S. ECONOMY Low Estimate High Estimate Total Tax Credit Dollars $4 billion $4 billion Increase in GNP: Total $5.6 billion $8.4 billion Per Dollar of Tax Credit $1.40 $2.10 Increase in Government Revenue: Total $2.4 billion $3.5 billion Per Dollar of Tax Credit $.59 $.89 Increase in Jobs 485 thousand 730 thousand Source: Appendix A FOR MIDDLE-INCOME FAMILIES A frequent complaint about the child care tax credit is that it amounts to a federal subsidy to higher-income families. Almost half of all child care credit dollars currently go to families in the top 30 percent of the income distribution while only 3 percent of these dollars go to families in the bottom 30 percent.11 Because of this, some child care proposals before Congress would eliminate even middle-income families from eligibility for the credit. One reason so few low-income families take advantage of the tax credit may be that many have been removed from the tax rolls by tax reform. 12 The tax credit is of little value to families who owe no federal income tax. To remedy this situation, several bills now in Congress would make the tax credit "refundable." Families who owe little or no income tax would be able to deduct the credit from any taxes owed and would be entitled to a negative income tax -- a refund from the IRS.13 That most child care tax credit dollars go to middle-income families does not mean, however, that the tax credit is unwise or undesirable. It is from middle-income families that the federal government currently gets its highest supply-side return. In fact, government is probably getting back more than a dollar for every dollar of tax credits given to middle-income families. The reason is that the income of a working mother in a middle-income family is taxed at a higher rate, even if her own job pays a low wage. As Table II shows, Among low-income families, the government gets as much as 77 cents in additional tax revenue for every $1 it loses through the child care tax credit for working parents. Among middle-income families in the 28 percent tax bracket, government revenues increase by as much as $1.04 for every $1 lost through the tax credit. Among high-income families in the 33 percent tax bracket, government gets as much as $1.14 in additional taxes for every $1 of tax credit. Table III shows that the higher a family's income, the more likely it is to take advantage of the child care tax credit. Amost half of the tax credits go to families with incomes of $32,050 or higher. But these families also generate the highest additional tax revenue per dollar of tax credit. In other words, the government's method of "investing" in child care is to rebate more dollars to those families that give it the highest return. The goal of tax policies is not necessarily to maximize government revenue based on supply-side responses. On the other hand, considering the size of the federal deficit, the supply-side response is not irrelevant. If anything, Table II makes a prima facie case for increasing child care credit at every level of family income and financing this policy by reducing other federal expenditures, such as income transfer programs that have a negative supply-side effect. TABLE II ADDITIONAL TAXES PAID BECAUSE THE CHILD CARE TAX CREDIT INDUCES MORE WOMEN TO WORK New Tax Revenue Family Tax Bracket Per Dollar of Tax Credit 15% Tax Bracket* $ .51 - $ .77 28% Tax Bracket $ .69 - $1.04 33% Tax Bracket $ .76 - $1.14 *Family income less than $10,000. Source: Appendix A TABLE III TAX SUBSIDIES AND REVENUE RETURNS FROM THE CHILD CARE TAX CREDIT Percent of Additional Taxes Family Percent of Total Credit Paid Per Dollar Income* Families* Dollars* of Tax Credit 0 - $12,000 30% 3.3% 51¢ - 77¢ $12,000 - $20,700 20% 20.3% 49¢ - 74¢ $20,700 - $32,050 20% 27.3% 49¢ - 74¢ $32,050 + 30% 49.3% 69¢ - 104¢ All families 100% 100.0% 59¢ - 89¢ *Based on 1985 dollars. Source: For columns 1, 2 and 3, Roberta Ott Barnes, "The Distributional Effects of Alternative Child Care Proposals," Urban Institute, October 1988. For Column 4, Appendix A. OTHER TAX BREAKS FOR CHILD CARE The child care tax credit is not the only way federal tax policy defrays child care costs. In fact, many working parents who would otherwise qualify do not even take advantage of the tax credit because Uncle Sam has provided more generous ways of getting income tax relief. One way is for employers to provide day-care for their employees' children. Clearly, this is an employee benefit -- fully comparable to the payment of wages. Under current law, however, the employer can deduct day-care services as a business expense and the benefit is not included in the employee's taxable income. Employers can also create flexible spending accounts (FSAs) which allow employees to allocate up to $5,000 in pre-tax wages for various purposes: pension funds, health insurance, day-care expenses. Currently,14 As many as 3,500 large companies provide child care benefits for their employees. As many as 1,500 employers offer flexible spending account options to their employees. To appreciate how valuable these tax-subsidized benefits are, consider the following options for middle-income working mothers: Under the child care tax credit, the maximum tax benefit is $960. Under the flexible spending account option the maximum tax benefit is $2,500. 15 If the employer provides day-care services directly, the tax benefit is unlimited. Through its tax policies the federal government is in effect willing to pay as much as $960 of day-care expenses through the tax credit, as much as $2,500 through the FSAs, and an unlimited amount through employer deductions for employer-provided day-care. The more generous provisions in the tax code, however, are employer-based and tend to benefit only employees of large companies. In general, only companies with many employees can justify the cost of directly providing day-care. Moreover, as a practical matter, only large and medium-size companies can afford to set up sophisticated FSAs. As a result, the benefits of these policies largely bypass small business -- the sector of the economy that is experiencing the fastest growth and creating most of the new jobs. THE ECONOMIC IMPORTANCE OF TAX BREAKS FOR WORKING MOTHERS An implicit goal of the Reagan Administration was to encourage wives and mothers to participate in the labor market. This goal was pursued by sharply lowering tax rates on the income of working wives 16 and by expanding tax subsidies for day-care. The dual incentive, perhaps combined with other social and economic forces, has had an enormous impact: In 1950, only 12 percent of married women with children under age 6 were in the labor market. By 1987, 57 percent of these women were in the labor market.17 This is a remarkable transformation of the American workplace. David Bloom, a Columbia University economist, has called it "the most dramatic labor market change that has ever taken place."18 From a purely economic perspective, the increase in working mothers is important for a number of reasons. By international standards, adult American women are a highly educated group -- a rich pool of talent and ability that can contribute to our national output and help us to stay competitive in international markets. Working mothers will become increasingly important in the future, as labor becomes more scarce.19 It is estimated that between now and the year 2000, two-thirds of all new employees will be women, and 85 percent of those will get pregnant.20 MAKING THE TAX CREDIT REFUNDABLE An alleged problem with the current policy is that the tax credit is reaching fewer and fewer low-income families. What is often ignored is that this has happened primarily because the Tax Reform Act of 1986 took millions of low-income people off the tax roles. Since the tax credit is valuable only to the extent that child care expenses can be subtracted from income taxes owed, it has no value to families with no tax liability. Table IV shows the maximum possible child care credit available to a working mother with two or more children in 1990. As the Table shows, In 1990, a single working mother with two children and an income of $10,000 will get no benefit from the child care tax credit. The actual benefit to a woman with an income of $14,000 will be only one-third of the theoretical tax credit. For these reasons, the leading bills being considered by Congress would make the tax credit refundable. Families with no tax liability would be entitled to an IRS refund. Because families receiving the refundable credit would have no income tax liability, however, the only additional tax revenue generated by a working mother would be from the Social Security payroll tax. Thus government's return for each dollar of refundable tax credit would be between 23 and 35 cents, much lower than the return from middle-income mothers. So far, Congress has paid almost no attention to the supply-side consequences of different child care proposals. Yet as Table V shows, proposals that look very similar on the surface can have markedly different effects on the federal budget. Because this issue is so important, we will briefly review some major types of proposals before Congress. TABLE IV THE INABILITY OF LOW-INCOME FAMILIES TO TAKE ADVANTAGE OF THE TAX CREDIT (1990) Theoretical Actual Family Maximum Maximum Income Tax Credit Credit* Credit* $10,000 30% $1,440 0 14,000 28% 1,344 $465 18,000 26% 1,248 1,065 22,000 24% 1,152 1,152 26,000 22% 1,056 1,056 30,000 20% 960 960 *Assumes single head of household with two or more children. Source: Background Material and Data on Programs Within the Jurisdiction of the Committee on Ways and Means, 1989 Edition, Committee on Ways and Means, U.S. House of Representatives, March 15, 1989, Table 18. Proposals to Make the Existing Credit Refundable. A number of bills before Congress would make the current tax credit either wholly or partly refundable. If the tax credit were made fully refundable, the number of new credit dollars going to families with incomes of $12,000 or less would increase by almost sevenfold. 21 Higher-income families would be unaffected by this change. As noted above, however, each new dollar of tax credit would generate only 23 to 35 cents of new government revenue, compared to the current 59 to 89 cents. Proposals to Finance Refundable Tax Credits by Reducing the Credits Available to Upper-Middle Income Families. An example is the bill introduced by Rudy Boschwitz (R-MN). This bill purports to be revenue neutral because for each dollar of refundable tax credits given to low-income families a dollar of tax credits would be taken from higher-income families.22 In other words, the bill intends to redistribute tax credits from the less poor to the more poor. When the supply-side response is taken into account, however, the bill would actually increase the federal deficit by more than $500 million. The reason is that the middle-class tax credits it eliminates currently return about 87 cents per dollar of tax credit, while the new refundable tax credits would return about 29 cents. Thus each tax credit dollar redistributed would cost the government 58 cents in in tax revenues. Proposals to Liberalize the Existing Credit and Make It Refundable. A number of proposals would both increase the amount of the current tax credit and make it partially refundable. For example, under the original proposal by Senator Robert Packwood (R-OR), the tax credit would be increased to 40 percent for low-income families and would be phased down to 20 percent at an income of $44,000 rather than the current level of $28,000. The credit would also be 70 percent refundable. As Table V shows, liberalization plus refundability gives the government a higher supply-side return than refundability alone. Proposals to Create Refundability and to Sever the Link Between the Tax Credit and Work. A number of proposals, popular among Republicans in Congress, would attempt to sever the link between the tax credit and work. For example, a bill proposed by Senator Malcolm Wallop (R-WY) and Representative Clyde Holloway (R-LA) contains many anti-supply-side features. The proposal, which is not depicted in Table V, would replace the existing credit with a new per-child credit containing the following features: (1) it would reduce the allowable maximum for most families who now claim the credit, (2) it would redistribute tax credit dollars from the less poor to the more poor, and (3) it would require that only one adult per family work -- thus providing a "child care" tax break to two-parent families in which a non-working wife remains in the home.23 TABLE V GOVERNMENT REVENUE PER NEW DOLLAR OF TAX CREDIT UNDER DIFFERENT PROPOSALS* New Tax Credits: Current Fully Boschwitz Packwood** Income Law Refundable Bill Bill 0 - 12,000 64¢ 29¢ 29¢ 30¢ 12,000 - 20,700 62¢ 28¢ 28¢ 44¢ 20,700 - 32,050 62¢ 28¢ 28¢ 52¢ 32,050 + 87¢ 0 -87¢ - All Families 74¢ 29¢ -58¢ 43¢ *Based on the mid-point between the high and low estimates in Table III. **Original Packwood proposal. Source: Prepared by the NCPA based on estimates of the static distribution of the credits in Roberta Barnes and Linda Giannarelli, "Briefing Memorandum," Urban Institute, December 12, 1988, and the dynamic estimates in Appendix A.