Avoiding disincentives in new affordability plan

from UH News, February 13, 2023

Problems may be on the horizon for low-income working families in Hawaiʻi, but a new recommendation by a University of Hawaiʻi Economic Research Organization (UHERO) expert may help to alleviate those issues.

Policy “cliffs” occur when a large benefit is suddenly withdrawn when income exceeds some threshold, even if by only $1. Cliffs may also reduce incentives to work and earn more. Under a new proposed tax reform plan, these cliffs could impact Hawaiʻi residents.

If passed, the recently announced Green Affordability Plan (GAP) would be the largest tax reform in the state’s recent history, providing tax relief to all Hawaiʻi residents. However, in its current form, the GAP (SB1347/HB1049) also exacerbates cliffs in Hawaiʻi’s tax code. A new blog by UHERO Assistant Professor Dylan Moore explains the problems these cliffs will create, and how the plan can be tweaked to eliminate them.

Issues related to policy “cliffs”

The GAP contains many provisions targeted to ALICE (Asset Limited, Income Constrained, Employed) households, particularly those with children. Under the GAP, a couple with two children earning $20,000/year who pays rent can receive $1,400 by claiming this credit (up from $200). Consistent with the governor’s focus on ALICE families, the expanded renters’ credit provides less money to higher income families.

The problem with this design is the way in which the credit is reduced: via cliffs. For example, this family will lose $400 worth of tax credits if they “fall off” a cliff by earning $60,000 instead of $59,999.

Experts said cliffs alter financial decisions. Researchers interviewing low-income families facing cliffs in Colorado and California found that many took steps to reduce their income to avoid losing a child care subsidy. Some worked fewer hours, or even turned down raises to avoid falling over a cliff. According to Moore, there is little doubt that some Hawaiʻi taxpayers would do so in response to the GAP’s cliffs.

Additional cliffs in GAP

The GAP—as currently proposed—creates many additional cliffs. Here are some examples:

• A single parent renter with two kids earning $60,000 instead of $59,999: It will cost this household $510–$300 from the renter’s credit and $210 from the food/excise credit.
• An elderly couple renting their home earning $60,000 instead of $59,999: It will cost this household $540–$400 from the renter’s credit and $140 from the food/excise credit.
• Taxpayers paying for care for two children under 13: For families with childcare costs, an expanded child and dependent care tax credit creates a series of cliffs at $150K, $165K, $180K, $195K, $210K and $225K. Going over these cliffs costs as much as $1,000.

Solution

According to Moore, this is not a difficult problem to solve. Cliffs are only one way to design tax credits targeting low-income residents. Alternatively, tax credit size can decline gradually as income increases. For example, an alternative version of the new credit for low-income household renters may provide reduced benefits at higher incomes, but the reduction happens gradually. For each additional dollar a household earns over $40,000, they lose only a fraction of the credit. Consequently, any increase in the household’s earnings will lead to an increase in their disposable income. This eliminates the significant fairness and disincentive effects the cliff approach creates.

“In response to feedback from UHERO, the governor’s office is considering amending the GAP to do exactly this,” Moore said. “This common sense approach would bring Hawaiʻi in line with the approach now taken at the federal level, where targeted policies like the earned income tax credit do not include any cliffs. But eliminating cliffs does not mean the GAP has no disincentive effects. Gradual credit reductions still decrease the extra disposable income generated by additional earnings.”

See UHERO’s website for the entire blog post.

SB1347: Text, Status

HB1049: Text, Status