[Ed Rubenstein's complete report, The Earned Income Tax Credit and Illegal Immigration: A Study in Fraud, Abuse, and Liberal Activism, [PDF] is available courtesy of The Social Contract.]

The Earned Income Tax Credit is the largest anti-poverty program in the United States. In 2007 more than 23 million households received $47 billion EITC payments. That dwarfs traditional welfare and food stamp spending combined.

Yet unlike those programs, the EITC is virtually unknown outside of the policy wonks who study it and the low income individuals who receive it.

One reason for its relative anonymity: the credit is embedded in the tax code. The tax code is vast; its 80,000 plus pages are full of deductions, allowances and credits. The EITC is just one albeit perhaps the most lavish—and important.

Another reason for the low profile: the credit is widely regarded as a success. (Nothing succeeds like failure when it comes to making an impression on public opinion.) Politicians from Ronald Reagan to Michael Bloomberg, Bill Clinton to George W. Bush, have not only supported the credit but have moved to expand it over the years. They regard it as the one poverty program that works.

Their enthusiasm reflects the perception that—unlike welfare—the credit is available only to people who work: to the "working poor", especially families with children. Unlike welfare benefits, which decline as a recipient's earnings go up, EITC benefits go up as you earn more, thus actually increasing work incentives for low income individuals.

EITC is a very generous program. For a household with two  children, the credit is equal to 40% of earnings. In effect, taxpayers give these folks a 40% raise if their income is below a certain level. Even if recipients have not paid a single cent in taxes, they are eligible for the full tax credit amount—up to $4,800 in 2008. The credit does phase out—but only when income approaches the poverty level.

From a distance, the EITC looks like a winner. The devil is in the details.

For starters, the program is dominated by fraud.

Nearly one-third of all EITC claims are "improperly paid" according to the GAO. At $10.5 billion, fraudulent EITC payments in fiscal 2005 ranked second among the 57 federal programs reviewed by the agency—surpassed only by Medicare. As a percent of total program spending, however, EITC fraud far exceeds that of any other program:

Technically, only people authorized to work in the U.S. are eligible for the credit—you need a valid Social Security number. But identity theft, stolen Social Security numbers, and other scams effectively nullify the restriction. As a result, much of the fraud relates to immigrants.

Immigrants account for 13% of the U.S. population, but receive an estimated 26% of EITC benefits in 2008. Illegal aliens receive the EITC at even greater rates than legal immigrants:

Households headed by illegal Mexican immigrants are more than three times as likely to receive the credit as households headed by native-born Americans. In no other means-tested payment do illegal aliens receive such de facto preferential treatment.

Illegal aliens have very powerful enablers in this regard. Foremost among them:

• the IRS itself.

The agency does little to verify the validity of SSNs on tax returns, or the existence of immigrant children, or to ascertain that they've lived with the taxpayer for more than 6 months as required by law. Illegal alien husbands and wives often file separate returns in which both claim the same children.

The EITC, like most of the tax code, operates on the honor system. It relies on the taxpayer's self-assessment that he meets EITC eligibility criteria. This is very different from welfare and food stamps, where applicants are interviewed and required to present proof of eligibility.

• H.&R Block and other tax preparation services.

Nearly three-quarters of all EITC recipients hire commercial tax preparers to do their returns. (In 2005 almost 71% did so.) It not so much the tax preparation—it's the loans–the instant cash advance that attracts so many poor taxpayers to these companies. And for the H&R Blocks of the world, EITC means big money.  When you add up the interest payments, preparation costs, and other fees, the EITC recipient often spends more than 10% of his credit just to get his credit.

Liberal activists are naturally annoyed that for-profit companies have monopolized the EITC business. They want a piece of the action for ideological reasons, though it's also good for fund raising. So they have financed extensive EITC outreach efforts, including free tax help, for immigrants. The largest player in this group: the Center on Budget and Policy Priorities, a Washington-based think tank. Its EITC outreach kit has flyers in 21 languages—from English and Spanish to Tagalog and Hmong—all designed to hook immigrants into the EITC culture.

The overarching assumption of EITC activists is that the credit is underutilized. But this is simply not the case. As shown in more detail in my Social Contract study, EITC is one of the most accessible of all anti-poverty programs. Three-quarters of all households eligible for EITC receive EITC. That's a higher utilization rate than Food Stamps, Medicaid, and Supplemental Security Income (SSI).  

As an economist, I am particularly interested in the economic impact of EITC. The conventional wisdom is that it's more effective at reducing poverty than the minimum wage. And that is undoubtedly true. Any program that gives over $40 billion to the working poor is going to push many of them—perhaps most of them—above the poverty line.

But this begs the question: what would the labor market look like without EITC?

Let's do a thought experiment.

Let's suppose that no worker is willing to work for less than $10/hour. Even illegal immigrants with no education demand $10/hr.

If there is no EITC, employers would have to pay their workers at least $10/hour.

Now assume an EITC is in effect. Let's make it a 50% credit–so low income workers get a 50 cent credit for every dollar of wages. Other things being equal, the lowest paid worker now receives $15/ hour - $10 from the employer, and $5 from the federal government—the taxpayers.

But other things would not be equal. The EITC allows companies to cut wages below the minimum that workers required before the credit. If the companies were to cut wages to, let's say, $7/hour, the employees would get an EITC of $3.50/hr—or a total of $10.50/hour. That's a tremendous savings for the employer, and only a tiny bump up for the worker.

Bottom line: Under EITC, the incentive to cut wages is irresistible.

Low wage employers are the big winners. Walmart is a prime example. The company launched a massive campaign to promote the credit a few years ago. A company spokesman at the time said: "The momentum behind it is education—ways our employees can save money and live better." [US: Wal-Mart faces flack over EITC programme, JustFood.com, June 27, 2008]

He said this with a straight face. But we all know that his company is notorious for short-changing its employees. It is also the largest employer of illegal aliens in the U.S.

And low wages are not the only unintended consequence of EITC. 

The tax credit rises sharply with children. A family with no children received an annual maximum EITC payment of $438 in 2008; a family with one child received up to $2,917: two or more children bumps the maxim credit to $4,824.

Children thus trigger an 11-fold increase in EITC payment.

That's an irresistible windfall for low income workers, a big incentive to procreate—or at least claim to. The IRS estimates that roughly half of the incorrect filing claims under the EITC involve fraudulent child custodial claims. 

But most children claimed on EITC tax returns are real. And therein lies the problem. The decision to have children may often be influenced, at least in part, by the generous tax credit.

Parenthood incentives in the tax credit are far more acute for minority households and immigrants, for the simple reason that their incomes are lower and the credit represents a larger share of their total incomes.

It would be absurd to suggest that anyone has a child solely to get a larger tax credit. But still, the groups with the highest EITC eligibility rates do also have the highest fertility rates. Immigrant mothers from most countries have higher fertility rates in the U.S. than in their home countries. This result can reasonably be attributed, in part, to the EITC's parenthood incentives.

The net impact of EITC on childbearing may be small. But even a tiny increase in fertility rates, if maintained over the decades, will have enormous consequences.

The role of the EITC in the nation's demographic destiny cannot be denied.

What had started as a tax offset for low income workers is now simply another federal welfare program. A welfare program that subsidizes children in families least likely to afford them. A welfare program that benefits corporations more than the poor. A welfare program replete with fraud. A welfare program kinder to immigrants and even to people here illegally than to natives. Today, immigrants receive EITC at nearly twice the rate of natives, and nearly half (49.2%) Mexican immigrants receive it.

At one time EITC was part of the solution. Today it is part of the problem.

Edwin S. Rubenstein (email him) is President of ESR Research Economic Consultants in Indianapolis.