Fixing the Child Care Penalty
Saturday, July 12, 2014
The current tax code denies families appropriate tax relief for work-related child care expenses. A new Senate bill would help correct this problem.
Earlier this week, five senators, Jeanne Shaheen (D-NH), Patty Murray (D-WA), Barbara Boxer (D-CA), Kirsten Gillibrand (D-NY), and Barbara Mikulski (D-MD), introduced S. 2565, the Helping Working Families Afford Child Care Act. The bill would take a big step towards neutral tax treatment of working single parents and two-earner couples by expanding the child care credit.
Under basic tax policy principles, workers should be allowed to deduct the expenses of earning the income on which they are taxed. Child care meets the economic definition of a work-related expense — parents are less likely to work when child care becomes more expensive. The link between child care costs and work decisions is supported by more than just common sense. It has also been consistently confirmed by a wide range of statistical studies, as I and my colleagues Aparna Mathur and Abby McCloskey have explained.
Unfortunately, the federal tax code does not provide proper treatment for child care costs. The payroll tax system fails to offer workers any child care tax relief at all. The income tax system includes a tax credit for child care costs, but it falls far short of what is needed.
The credit equals 20 percent (up to 35 percent for lower-income families) of some child care costs that single parents and two-earner couples incur in order to work. The percentage credit is less generous than a full deduction for many parents, but that is the least of its shortcomings.
This uneven treatment keeps parents, particularly women, out of the work force.
The big problem is the severe limit on the amount of child care costs for which the credit may be claimed each year – $3,000 for families with one child and $6,000 for those with more than one child. These caps, which are not automatically adjusted for inflation and are only 50 percent higher than in 1976, can be much smaller than parents’ actual costs. According to Child Care Aware of America, average annual costs for an infant and a four-year-old child in a child care center ranged from $9,000 in Mississippi to $28,000 in Massachusetts in 2012. The costs keep rising each year while the caps stay the same.
Taxing income without giving full relief for work-related expenses distorts people’s decisions. Consider two families deciding how to care for their children. In the first family, a parent sacrifices potential earnings in the labor market by staying home to look after the kids. In the second family, the parents work and hire a child care provider. The families’ child care costs get very different tax treatment.
It may look like the first family has no child care costs, because they do not pay anyone anything. But, that’s not right. Their child care costs – economists call them “opportunity costs” – are the potential earnings that they give up when the parent stays home. Both the income tax and payroll tax systems offer full built-in deductions for those costs – when the family gives up the potential earnings, they automatically escape the income and payroll taxes that they would have paid on the earnings. There’s no dollar limits on those built-in deductions.
The second family is less fortunate. No full income and payroll tax deduction for them. Instead, the income tax system gives them a credit with absurdly low dollar caps and the payroll tax system gives them nothing. So, the second family ends up paying higher taxes than the first family.
This uneven treatment keeps parents, particularly women, out of the work force. Families should be free to make their own child care choices, based on the options available to them, their understanding of their children’s needs, and their moral values, without interference from the tax system. Expanding the child care credit would help level the playing field.
Average annual costs for an infant and a four-year-old child in a child care center ranged from $9,000 in Mississippi to $28,000 in Massachusetts in 2012.
To be sure, the tax code offers no relief for many expenses that may be work-related to some extent. For example, there is no credit or deduction for purchases of frozen dinners, although, for some families, part of their time spent cooking may replace time that would otherwise be spent at work. The administrative challenges of providing frozen-dinner tax relief would be daunting, though, and only limited relief would be appropriate anyway, because more expensive frozen dinners probably don't make people significantly less likely to work. The tax code cannot address every minor expenditure with potential work effects, but it can and should provide adequate relief for child care costs, a large expense with a strong, statistically-confirmed impact on work decisions.
S. 2565 offers a clear path forward. The bill would raise the caps on creditable costs to $8,000 for one child and $16,000 for two or more children, restoring them to roughly their 1976 inflation-adjusted values, and automatically adjust them for future inflation. The bill would also make the credit refundable in cash for working families who are too poor to owe income tax, effectively giving them relief against their payroll taxes.
The bill is not perfect. It would phase out the credit for families with incomes above $200,000, a complication that increases effective marginal tax rates for some high-income families, raises little revenue, and violates the principle that everyone should get tax relief for work-related expenses. Also, the bill does not include any measures to offset its revenue loss – those will have to be added later. Nevertheless, the bill would be a big improvement over the status quo.
The current tax treatment of child care costs contradicts the basic economic logic of how tax systems should treat work-related expenses. S. 2565 would confront that problem head on, putting a big dent in the child care penalty that keeps too many parents out of the work force.
Alan D. Viard is a resident scholar at the American Enterprise Institute.
FURTHER READING: Viard also writes "When Setting Tax Policy, Don't Forget About Long-Run Growth" and "The Myth of the Limits on Itemized Deductions." Sita Nataraj Slavov contributes "How to Fairly Tax Families." Alex Brill considers "One Step Closer to Tax Reform." Matthew Jensen adds "An Honest Accounting of the Corporate Income Tax."
Image by Dianna Ingram / Bergman Group