Gaming the System

Despite the forest of laws that make up the Federal tax code, on a conceptual level the income tax system is pretty simple.

First, you total up your income. Next, you subtract deductions from income to arrive at your taxable income. Multiply that by the appropriate tax rate, and you arrive at your tax liability. Once you know your tax liability, you apply any applicable tax credits. Credits reduce your tax liability, dollar for dollar. The result of these calculations is the amount of income tax you owe the Federal government.

The last step in the process is to compare the amount of tax you have prepaid (aka withholding) to the amount of income tax you owe. If you had more withheld more than you owe, the IRS sends you a refund. If you withheld less than you owe, you get the pleasure of writing the IRS a check for the difference (cue the wailing and gnashing of teeth).

Clear as mud, right?

For wage slaves like me, and historically for most of us, it was difficult to beat the system. Your employer reported your wages directly to the IRS. For those of us who didn’t get the free use of a car and driver, there wasn’t much chance to under report income, aside from the odd garage sale now and then. You had to be unusually creative to come up with enough deductions to exceed the standard deductions, so that avenue for chicanery was also closed off to most of us.

So most of us were just resigned to paying taxes. Depending on your withholding you might get a big refund or you might have to pay in a little at the end of the year, but unless you owned a business with a lot of cash income, your opportunities for cheating on your taxes were pretty limited.

But with the Earned Income Credit, the opportunities have gotten much broader based. Remember, tax credits affect your tax liability on a dollar for dollar basis. This makes them six to ten times more powerful than hiding income or making up deductions, depending on your tax bracket. At the 15% tax bracket, you have to come up with $6.67 dollars of deductions to reduce your taxes by $1.00. One dollar of tax credit reduces your tax liability by $1.00.

But it gets better, because tax credits come in two flavors: non-refundable and refundable. With non-refundable credits, you can reduce your taxes to zero, but after that they don’t do much good. Once your tax liability is zero, you get your withholding refunded, but that’s all.

But the Earned Income Credit is a refundable credit. This means that even if you owe no taxes, you get the whole credit added to your refund. As an example, suppose an individual is a single parent with two children, and the individual earns $18500 per year. To make ends meet this person has the children enrolled in Medicaid, lives in government subsidized Section 8 housing, and receives food stamps (all non-taxable).

This person would file as head of household with three personal exemptions. With a standard deduction for head of household at $8000, and $10500 in personal exemptions, the taxable income in this case is $0. The individual gets all of their withholding back in the refund. But he also gets $4056 from the government in EIC.

The thing about these credits is that they provide huge incentives to game the system. So in the example I’ve just laid out, if the taxpayer was living with his girlfriend, and she also had earned income, his EIC would be reduced if they got married. If a single parent is living with a partner who pays more than half the household expenses, the parent is ineligible for the EIC. But all you have to do is fail to mention the partner when you do your taxes, and bang-zoom, you get that fat check of free government money.

Let’s say your niece lives with your mother, who is surviving off social security. For tax purposes, you claim that your mother and niece live with you, which makes you eligible to claim the niece for EIC. So what if you moved out of your mom’s house years ago. She doesn’t have earned income, so she can’t take advantage of the credit. Someone has got to take advantage of the government in that family.

The EIC can provide the equivalent of two or three months worth of wages for some low income earners. That’s a pretty strong incentive to cheat the system.

I used to think it was only the wealthy who cheated on their taxes. But anyone can play at being Tom Daschle these days.