New Tax Credit Research Offers Information for City Leaders

Alan Berube
Alan Berube Interim Vice President and Director - Brookings Metro

June 6, 2005

Traditionally, urban policy has conjured up visions of narrow spending programs targeted to cities and low-income neighborhoods in areas such as housing, jobs, transportation and security.

A growing number of city leaders have realized, however, that major federal budget decisions do even more to shape the health and wealth of urban areas, even if the dollars involved do not pass through city hall.

Increasingly, these investments do not take the form of traditional spending programs, but operate through the federal tax code.

In recognition of this, local elected officials across the country have mounted outreach campaigns to raise awareness of the Earned Income Tax Credit (EITC), a federal tax subsidy for lower-income workers and families.

Moreover, many are working to reduce the costs that city residents pay to access their credit dollars by promoting free and low-cost tax preparation for low-income filers. Their efforts are bringing millions of federal dollars back into communities and boosting the amount of money circulating in the local economy.

The Brookings Institution Metropolitan Policy Program recently published two reports concerning the EITC that should assist local leaders.

The reports describe opportunities for cities to harness the benefits of tax credits like the EITC and strategies to help working families keep more of their tax refund dollars.

Immigrant Communities and the EITC

Immigrants have contributed greatly to the population and economic revitalization of the nation’s cities in recent years.

In the nation’s 100 largest cities, three out of four residents gained in the 1990s were born outside the United States. The city neighborhoods that these immigrants inhabit are often vital centers of commerce and family life.

Still, working immigrant families often earn lower incomes than their native-born counterparts. Therefore, the EITC is an especially important investment in the neighborhoods where immigrants are most concentrated.

In 2000, roughly 50 percent of the nation’s foreign-born population lived in just 5 percent of its ZIP codes. In these communities, more than one in five workers and families claimed the EITC, compared to fewer than one in seven elsewhere.

The dollars that flowed to these neighborhoods as a result were impressive—their taxpayers claimed a combined $6.7 billion in EITC, more than 20 percent of all credit dollars claimed nationwide.

There are important differences in how immigrant-community families access the EITC, however.

Limited English proficiency and greater unease about the tax system mean that more file their taxes through a paid preparer—69 percent did in 2000, versus 65 percent elsewhere.

Unfortunately, they may relinquish significant sums for that service, even if their return is relatively straightforward (as many EITC returns are).

By contrast, in 2000, only 1 percent of EITC returns from immigrant communities were filed by a volunteer tax preparer.

This signals that added volunteer capacity, or more low-cost filing options, would bring important benefits to immigrant neighborhoods and their residents.

Moreover, many of these volunteer services also connect clients to additional federal benefits for which they may be eligible, such as nutritional supports, health insurance and energy assistance.

Even small investments by local elected officials in free tax preparation could help improve the economic stability of immigrant families and communities.

Refund Loans and the EITC

More troubling than the prices EITC earners pay for tax preparation is their frequent use of refund anticipation loans, or RALs.

RALs are short-term loans made by tax preparers that are secured by the taxpayer’s anticipated refund. For the convenience of receiving refund dollars only one to two weeks faster than the IRS could deliver them, RAL purchasers forfeit significant sums at interest rates generally exceeding 200 percent.

On this front, low-income taxpayers recently have taken a step in the right direction. In 2003, 38 percent of EITC recipients received their tax refund dollars via a RAL.

However, this was down from 43 percent the prior year. In nearly every state and big city across the country, the rate at which low-income workers and families purchased RALs at tax time fell between 2002 and 2003.

What accounted for this drop? No one factor seemed to wholly explain the pattern.

There was some evidence that RAL usage did not decline as much in cities in which commercial tax preparers were highly concentrated—perhaps because the product is promoted heavily in a highly competitive marketplace.

In addition, cities with a larger presence of volunteer tax preparers saw somewhat larger declines in RAL usage, consistent with the outreach messages delivered to low-income filers in those places. On this count, Milwaukee led the way with a 13 percentage-point drop in the proportion of EITC recipients getting RALs.

Probably most importantly, the way that major commercial tax preparation firms advertised RALs changed earlier this decade pursuant to major lawsuits—morphing from “rapid refunds” and “instant cash” to products with the word “loan” in their name.

However, throughout the South, more than half of all low-income families continue to receive their tax refunds via one of these high-cost loans. In cities such as Memphis, Tenn., Birmingham, Ala., Atlanta and Little Rock, Ark., upwards of 55 percent of EITC recipients spent significant sums on RALs in 2003.

Local officials may want to keep a close eye on products like RALs that negatively affect the financial health of their most economically vulnerable families.

In the meantime, continued support for low-income taxpayer outreach and volunteer tax preparation can spread important messages about the alternatives to high-price, low-value commercial tax products.