|Tax credits for child care expenses||The federal government and 23 states provide some form of tax relief for those who must pay for child or dependent care|
IT COST a Springfield family approximately $27.50 per week in 1978 for full-time day care for one child, or about $1,400 per year. In Chicago the weekly costs were about $34.50, for an annual expenditure of around $1,800.* When these child care expenses are added to other work-related costs such as food, clothing, laundry and commuting, it becomes difficult for many mothers with young children to join the labor force. For some, in fact, it simply does not pay to work.
Some of these mothers receive welfare of various kinds, and their reluctance to assume jobs that will not cover their expenses is understandable. To encourage those women to seek employment and to offer tax relief to many working women with pre-school children (over 20 percent of the women in the Illinois labor force had children under age six, according to the 1970 census), the state might consider a number of actions.
The state could operate day care centers, for example, or it could provide family allowances for such care. However, these alternatives are costly and complex. But there is another option: the establishment of tax credits on the state income tax for child care expenses. Such credits would provide tax relief for many women who work while not causing a major revenue loss for the state.
Models for such a provision are numerous. The federal government currently allows a credit on the federal income tax liability for child care expenses, and 23 states supplement the federal credit with a credit within their state tax codes. An examination of these models might help Illinois to estimate the potential costs and benefits of revising the state tax code to recognize employment-related child care expenses.
Federal income tax
Federal treatment of child care expenses has become increasingly generous over the past 25 years, moving from a deduction with highly restrictive eligibility criteria to a tax credit with more liberal application. By broadening and simplifying its policies, the federal government has simultaneously provided benefits to more citizens and created incentives for more people to join the work force.
Congress liberalized the deduction for child and dependent care in 1964 and later made even more significant changes in the deductions in the Revenue Act of 1971.
As of January 1, 1972, families were entitled to deduct up to $200 a month for one child under 15 years, $300 for two children and $400 for three or more children. The employment-related deduction was subject to an income limitation. If the adjusted gross income (AGI) exceeded $18,000, the deduction was reduced by 50 cents for every dollar over that figure. In effect, any AGI exceeding $27,600 would not be entitled to the deduction. The income figure was subsequently revised upward to $35,000 and $44,600, respectively, to cover the period March 29, 1975, to January 1, 1976. In order to qualify, both husband and wife had to be full-time members of the labor force or be looking for a job.
But even these changes did not alleviate the inequities in our current federal system of progressive taxation of income in two-earner families. In such families, the first dollar earned by a household's second income earner is taxed at the highest marginal tax rate of the other spouse. Taken alone, the second spouse bears a heavy tax burden, and no doubt this has acted as a disincentive for some people who might want to work. The child care deduction helped to eliminate some of the tax inequity existing between one- and two-earner families, although it obviously did not help childless couples.
The inequity and the complexity of the deduction led to provision in the Tax Reform Act of 1976 which changed the deduction to a credit, effective January 1, 1976. In brief, the new rules state that a household can take a credit against its tax liability equal to 20 percent of employment-related expenses. The maximum allowable expenses are $2,000 for one child, or $4,000 if there are two or more children underage 15, or any incapacitated individuals. Thus, the maximum credit is $400 for one child or $800 if there are two or more children.
*Based on a telephone survey in March 1978 of 12 randomly selected day care centers, six in each city. Costs are for a five-day week and include hot lunch and two daily snacks, but not transportation.
William Moskoff is associate professor of economics at Sangamon State University, Springfield.
23 / May 1979 / Illinois Issues
There are several reasons why the federal code went to a credit and dropped the itemized deduction. First, taxpayers who did not have enough deductions to itemize had been excluded from this tax subsidy. Specifically, renters in the low and middle income groups could rarely have enough deductions to qualify for anything more than the standard deduction, but homeowners typically benefited from the itemized deductions. Making child care expenses a credit enables lower income groups to enjoy this tax advantage. The complexity of the form associated with the deductions had also been a deterrent. The unduly complicated form had to be accounted for on a monthly basis, and many families found it annoying or intimidating. The new credit system is based on a flat percentage amount of the expenses and has been simplified in other ways to make life easier for the taxpayer.
A further consideration for the change to a credit was equity. With respect to deductions, as the marginal rate increases (i.e. family income rises), the tax value of an exempted dollar earned by the lower income earner rises accordingly. The deduction therefore gives couples earning high incomes a relatively larger tax break. Thus, a couple in a 25 percent marginal tax rate bracket saves $.25 if they are permitted to deduct one dollar from their taxable income, while a couple in the 50 percent bracket saves $.50. The credit avoids this built-in inequity because it is deducted after the tax liability has been computed and therefore treats a dollar of earned income in the same way for all income classes.
In addition, the liberalization of the law has spread the benefits to many more individuals. Formerly the deduction was applicable only if both marriage partners worked substantially full time. Now, if one spouse works part time or is a full-time student, the couple can still qualify for the credit. Moreover, while the amount of the credit is limited, there is no limit on the amount of income a taxpayer may earn. The incentive to work has been increased and the federal government has broadened its conception of which groups should justifiably receive the right to this tax break.
State tax codes
While the federal policy regarding child care provides uniformity, the states differ greatly in their policies. A questionnaire was sent to the head of the state agency responsible for tax concerns in each of the other 49 states to determine: (1) which states allowed a deduction or credit for employment-related child care expenses, (2) whether the terms are the same or different from federal regulations, (3) whether there are major problems administering the deduction or credit, and (4) the major costs and/or benefits resulting from this provision.
The survey results show that most states with an income tax have a child care provision within their tax code, and the majority have a credit similar to the federal law.
Twenty-three states of the 41 which have an income tax provide some form of income tax relief for taxpayers who incur child and dependent care expenses. Thirteen of these states grant a credit under terms identical to the federal law. The amount of the state credit varies among the states from a low of 10 percent of the federal credit in Arkansas and Georgia to a high of 50 percent of the federal credit in Minnesota. In between there are California and Maine at 15 percent; Alaska at 16 percent; Rhode Island at 17 percent; New York and Oklahoma at 20 percent; Hawaii, Iowa and Vermont at 25 percent, and Oregon at 40 percent. The average for the group is 22 percent. The other states allow a deduction either similar to or identical with the pre-1976 federal law. In five cases the allowable deduction is the pre-1976 $100, $200, $300 deduction for one, two and three or more children, respectively, and there is usually an income limit above which the deduction is reduced.
The other 18 states which have an income tax, including Illinois, do not allow deductions or a credit for child care expenses. Several of these states used to allow a deduction for child care (e.g. Colorado, Missouri, Utah and West Virginia), but they no longer do this because their own itemized deductions are determined by reference to the federal deductions, and since child care is now a credit, working taxpayers have lost that benefit within their own state. Two other states, Maryland and Mississippi, do not currently have an allowance for child care expenses but legislation is pending in both as of this writing. In the case of Maryland, the legislation would permit a tax credit of 7 percent of the federal tax credit, and in Mississippi the proposed legislation would allow a deduction on the state form.
The survey asked several questions in an effort to determine: (1) whether there were major administrative problems in implementing the credit or the deduction and (2) the main costs and benefits of the credit or deduction.
No state said it had any major administrative problems. In terms of costs, the most frequently mentioned was the loss of revenue. Eleven states cited this factor, three of them qualifying the loss as minimal and another four providing figures which, as will be shown below, indicate that the relative effect is small. Four states cited small administrative costs, apparently associated with auditing returns. One state said the cost of its deduction was the relative advantage afforded upper income families which itemized, and the absence of relief for low income earners. Seven states either did not list any costs or defined them as inconsequential.
A number of different benefits were listed, in particular those which related to the effect of the deduction or credit on employment. For example, about half of the states reported either that the tax relief provided incentives for mothers to work or incentives to low income families to work. Two states perceived a clear relationship between the credit and a decrease in welfare payments. The credit had apparently been an inducement to some people to find work.
24 / May 1979 / Illinois Issues
Similarly, another state reported that the credit would lead to an increase in the size of the labor force and therefore the state's tax base. Another major benefit cited by five states is the financial relief the subsidy provides for the affected individuals. Eight states mentioned the credit as being beneficial because it brings them into conformity with the federal code. Three states also said that the credit created taxpayer goodwill.
Should Illinois offer credit?
Illinois legislators will need to examine a number of issues before revising the tax code to account for child care expenses.
The first major issue involves the employment effects of tax relief. One argument in favor of a change is that there are always some individuals who will enter the labor force if it is made financially feasible. A credit on the state tax liability combined with the federal credit would presumably tip the scales for some individuals and persuade them to seek employment. There is no definitive evidence, however, that state action or even the more significant federal credit have really made a difference in providing an incentive for people to work. The argument is intuitive, although there is certainly ample evidence that pushing the appropriate financial levers in the past has caused people to respond as predicted. The long-run trend is for increasing numbers of women to enter the labor force, and the evidence is more persuasive that such variables as rising levels of education and increases in the demand for white-collar workers have accounted for the rise of married mothers in the labor force.
A second major consideration is the effects of a credit on welfare costs and the more general notion of public benefits. Because high costs and limited availability of child care services prevent some mothers of young children from working, tax credits for such costs may lead to a reduction in welfare payments as employment of the poor increases. In addition, the public benefits from the increased productivity of these newly employed women. If the inducements of such tax credits are not strong enough, however, the presumed savings in welfare costs will not materialize.
A third consideration is the discrimination faced by two-earner couples and the relief provided by a child care credit. If two couples earn $30,000, the couple with two workers has a lesser ability to pay taxes because the $30,000 income of the one-worker couple does not include the value of the services performed within the home by the unemployed spouse. Looked at another way, people who work outside the home are often obliged to pay for services otherwise done in the home. One of the major costs is child care, and the failure to allow a deduction or a credit provides a pecuniary disincentive to employment. Indeed, Congress justified the earlier deduction for child care in part on the basis that many individuals incur child care expenses so that they can earn a living, and in principle these expenditures can be compared to ordinary business expenses.
A fourth concern is the potential revenue loss to the state. While such losses might occur, the evidence from four states suggests that the loss would be extremely small. The revenue shortfall in Massachusetts, North Carolina, Oregon and Wisconsin constituted, respectively, 3/10, 1/10, 1/20, and 3/100 of 1 per cent of total revenues, based on 1974 revenue figures reported in Book of the States, 1976-77 edition. Moreover, part of the loss in revenues will be compensated for by a reduction in welfare payments and an increase in the tax base as more individuals find work. If Illinois suffers a revenue decline for allowing child care credit within the range found in other states, in fiscal 1977 it would have meant a revenue loss between $2.5 million and $25.0 million. Total revenue resources amounted to $8.3 billion. However, these losses do not take into account the possible decline in welfare payments or increase in the income tax revenues from higher employment.
Fifth, single parent households, particularly those headed by females, need relief from child care expenses. In 1970, 8.4 percent of white families and 28.8 percent of black families in Illinois had female heads. Almost half of all these families had related children under the age of six, and about 40 per cent of these households were below the poverty line. For this group the need for child care is extremely important, and tax relief makes these expenditures more feasible.
The economic problems of single parents, particularly those on welfare, have to be understood in a larger context. A good deal of effort has been devoted to get people off welfare and into the labor force through such mechanisms as training programs and job placement efforts. Yet, nationwide in 1973, only 16 percent of AFDC ( Aid to Families with Dependent Children) mothers worked.* In spite of the evidence which suggests that welfare mothers want to work, the low-paying jobs which they secure do not appear to compete with AFDC payments, plus in-kind benefits. The most important remedy is to get women into higher paying jobs. But reforms such as child care credits which reduce the implicit tax on earned income could be expected to bring more welfare recipients into the labor force and provide more women with higher incomes.
If the State of Illinois decides to provide tax relief for child care expenses, it must decide between a credit or a deduction. In terms of equity, the case seems very convincing that a credit is more effective than a deduction. Additionally, the state must consider whether to have an income limit. Overwhelmingly, the states have followed the federal pattern and have not set any income limit. It could be argued that those with the highest incomes do not need any tax relief, and there is little reason for the state to subsidize upper income groups. Moreover, an income limit on child care tax credits is not likely to deter women with high incomes from working because the cost of child care is much less than their potential earnings. California and Minnesota, which both offer tax credits, have income limits as do the states which still have deductions built into their tax structures under the pre-1976 federal terms.
If the General Assembly contemplates amending the tax code in this increasingly important area, it could affect the status of thousands of Illinois households. Given the incentives of meaningful tax credits, more mothers might join the labor force, thereby increasing the state's tax base. If the credits acted as an incentive for mothers on welfare to join the labor force, there would be a simultaneous effect of reducing welfare costs of the state.
*Cited in Isabel Sawhill, "Discrimination and Poverty Among Women Who Head Families," Signs. Vol. 1, No. 3. Part 2. Spring. I976, p. 206.
25 / May 1979 / Illinois Issues