Hot on the heels of the OECD saying what a good idea tax reduction for lower income earners is, the NBER has just released a major study of Earned Income Tax Credits, and to use an expression du jure jour it’s “all good” or almost all good.
So much for all those trade-offs we keep hearing about efficiency and equity. There are a hell of a lot of policies that promote both at once. Anyway, the (quite lenthy) abstract of the NBER research is over the fold – as well as at the link above.
THE EARNED INCOME TAX CREDIT RAISES EMPLOYMENT
This largest federal cash transfer program also successfully meets its explicit goal of encouraging low-income parents to go to work by, in effect, lowering their tax rate and providing a financial bonus for that work effort.
The Earned Income Tax Credit (EITC), a federal program that provided 22 million American families with children a total of $34 billion in cash assistance in 2003, accomplishes its stated goals. It not only provides low-income workers, including many who are poor, with extra income through tax refunds. This largest federal cash transfer program also successfully meets its explicit goal of encouraging low-income parents to go to work by, in effect, lowering their tax rate and providing a financial bonus for that work effort. It has been especially effective in encouraging single parents, particularly women, to obtain employment.
In Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply (NBER Working Paper No.11729), NBER researchers Nada Eissa and Hilary Hoynes review a large number of economic studies of the EITC and conclude that the main lesson from the accumulated evidence is that real responses to taxes are important. The second lesson is that, while the EITC stimulates people to join the work force, there is no evidence that it prompts them to work fewer hours. This difference, the authors write, “has several important implications for the design of tax-transfer programs and the welfare evaluation of taxation.”
The cost of the EITC is offset in part, they note, by a reduction in the number of single mothers receiving welfare. Moreover, the EITC now lifts more children out of poverty than any other government program. In 2002, it removed 4.9 million people, including 2.7 million children from poverty. Advocates see it as promoting the values of both family and work. Traditional welfare programs, according to their critics, do the opposite.
The EITC began in 1975 as a modest program aimed at offsetting the Social Security payroll tax for low-income families with children. The design of the credit was the result of a vigorous public debate around the disincentive effects of a Negative Income Tax (NIT) proposed by the Nixon Administration. The NIT would allow a transfer that is taxed away at a constant flat rate for all taxpayers. To offset the resulting disincentive effects, the EITC was made available only to workers; the maximum credit was earned, and the credit was phased out only after an untaxed region.
Eissa and Hoynes note that a taxpayer’s eligibility for the earned income tax credit depends on the taxpayer’s earned income (or in some cases, adjusted gross income) and the number of qualifying children who meet certain age, relationship, and residency tests. The taxpayer must have positive earned income, defined as wage and salary income, business self-employment income, and farm self-employment income. Also, the taxpayer must have adjusted gross income and earned income below a specified amount. In 2004, for example, the maximum allowable income for a taxpayer with two or more children was $34,458. Finally, the taxpayer must have a qualifying child under age 19, or 24 if a full-time student. Or, the child must be permanently disabled and residing with the taxpayer for more than half the year.
The tax credit is refundable, so that taxpayers with no federal tax liability, for example, would receive a tax refund from the government for the full amount of the credit after they file their tax forms. The refund can be spaced out in paychecks throughout the year. But in 2000, less than 5 percent of EITC recipients availed themselves of this provision.
In tax year 2004, the EITC maximum subsidy rate for the lowest-income families was 34 percent of allowable income for taxpayers with one child and 40 percent for taxpayers with two or more children. At a somewhat higher level of income, the maximum credit was $2,604 for families with one child and $4,300 for those with more than one child. At a still higher income level, the credit phases out at a rate of 16 and 21 percent. Most EITC tax returns are located in the phase-out region of the credit. Among full-time year-round workers, those earning the minimum wage receive the maximum credit, while those earning $15 an hour would be ineligible.
Over time, the EITC has been expanded, with the most significant changes arising from the Tax Reform Act of 1986 and the Omnibus Reconciliation Act of 1993. Between 1990 and 1996, the cost of the program more than doubled in real terms. The popularity of the program is shown by the fact that 18 states, as of 2004, have state EITCs that supplement the federal credit.
The largest group of EITC recipients is single mothers, typically in their early thirties with a high-school diploma, and with fewer than two children. Among this group, the EITC is expected to lead to higher rates of employment though fewer hours worked by those already working (through the cash transfer and the lower returns to work in the phase-out range).
The expansions in the credit have led to dramatic declines in average tax rates, from 14.5 percent in 1985 to a negative 4.1 percent in 2000; that is, the IRS provided a subsidy equivalent to 4.1 percent of income. The evidence consistently suggests that such EITC expansions raise employment rates. One study finds that 60 percent of the 8.7 percentage point increase in annual employment of single mothers between 1984 and 1996 is attributable to the EITC with its expansion. There is no evidence, however, that the credit leads to reduced hours worked for those already in the labor market. Eissa and Hoynes survey the various explanations for the different responses on participation and hours, including measurement error, the inability of workers to choose continuous hours of work, and the lack of knowledge of the structure of the EITC schedule.
In the case of married mothers, the EITC has indeed led to a small reduction in labor market participation – about 1 percentage point, according to another study by Eissa and Hoynes. This occurs because the credit is based on family earnings and income. If, for example, the husband is the primary earner, and these earnings place the family in the phase-out range of the EITC, then the family gets the credit even if the wife remains out of the labor force. And, if she goes to work, her earnings will decrease the credit. The real boost in family income may be much smaller than the nominal extra earnings and therefore may provide an incentive for the second earner to move out of the labor force. At $10 an hour, for example, the tax rate for married women could be 41 percent of her earnings. These are extremely large marginal tax rates for low- to moderate-income families.
David R. Francis
or ‘du jour‘, perhaps?
errr . . . yes. Du jour. Absolument.
Lest anyone get too excited about the case for introducing an EITC to Australia, it is worth bearing in mind that the primary function it performs in the US is the same as our means-tested Family Tax Benefit (FTB) – it is the primary vehicle for providing in-work assistance to low income working families with children in an attempt to ensure that work pays more than welfare. In terms of maximum assistance, it is considerably less generous than FTB (not least because it has no per child element, but simply three maximum rates, depending on whether you have no, one or two or more children. So if we were to contemplate the possibility of an EITC here, we would need to decide whether it should replace or complement FTB and if the latter it would need to be very carefully designed to ensure that it did not give rise to unintended (dis)incentive effects.
The other reason we may not want to go the whole EITC hog is that the rate of assistance phases in over a range of income before plateauing and then phasing out. By contrast, we pay the same maximum rate of FTB (the per-child part A, at least) to both families who are out of work and those in low paid work, only beginning to phase assistance out once parental income exceeds $40,000 a year. I dare say, many Australians would think it somewhat un-Australian to pay less in child-related assistance to a family on $20,000 than to a family on $40,000, but that is essentially what a US-style EITC does.
I have not seen any modelling of how the EITC actually interacts with means-tested welfare payments (and given that each US State has its own welfare system, this would require 50 different models), but it is not inconceivable that in some States at least this may lead to some odd effects on people’s budget constraints as income rose.
Thanks for that BG,
I’ve heard Prof Sue Richardson offer similar arguments.
The second part of BG’s comments – the different rates of assistance in respect of children – ceases to be an issue if the EITC is not tied to households with children. If it’s intended to reduce EMTRs for people moving from welfare to work, there’s no reason it can’t apply to everyone (cost aside).
An EITC tied to having kids would be silly.
Let’s not go overboard in thinking the FTB is an EITC in disguise. The key difference is that for very low wage workers (ie. those in the phase-in range), the EITC gets bigger as they work more hours, while FTB gets smaller. As the name suggests, an EITC is contingent on “earned income”. FTB ain’t.
The other critical thing about this paper is that Eissa & Hoynes are the authors of the main study used by EITC-critics (including our very own Patricia Apps). Yet here they say that even although an EITC can reduce married women’s labour supply, it is on balance a very good policy.
Yes, but:
1) very low wage workers (ie part timers) here will usually still get some income support.
2) we have a very high minimum wage which, with FTB, means that we have virtually no full-time working poor. The working poor were the principal target of the US EITC.
3) Our income tax threshold is much lower than the US’. Which means that we’d be pulling income tax during the year from these people and paying it back at the end of the year. Trying to pay the EITC during the year causes some really messy administrative and cashflow problems (which is why over 95% of EITC recipients in the US choose to get it at the end of the year).
Suffice to say that spog, backroom girl and muyself have all been involved at different times in trying to design a workable EITC for Australia and have concluded that it’s not a goer without some other large changes to our tax and welfare system. Arguably it’s worth making those changes – but you can’t just add a big EITC on to the surrent system and expect it to work.
Andrew
I’m not saying that the EITC is not a good policy for the US, but that is the point – it is designed for the US context and dare I say it for US prejudices, that don’t have a particular problem with assistance for children being phased in as earnings increase before being withdrawn further up the scale. I just don’t think that something like that would fly very well here, where there is more of a value that people should get the same level of (means-tested) assistance for their kids whether or not they have a job. And I agree with DD that it’s not clear that we have a real need here for an EITC per se, given the relative adequacy of minimum wages and the extent of income top-up that we provide through income support arrangements generally.
There might be an argument for restructuring what we have got and perhaps repackaging some part of current arrangements so that they resemble an EITC (for example, withdrawing income support more quickly than we do and phasing in an EITC at the same time so that overall EMTRs were either maintained at current levels or even reduced). But in the end if you couldn’t make it work on a fortnightly basis, it may not have a substantial effect on people’s work incentives or might even make them worse compared with what we have now.