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CHILD CARE TAX CREDITS: A SUPPLY-SIDE SUCCESS STORY by David R. Henderson NCPA Policy Report No. 140 July 1989 EXECUTIVE SUMMARY If the federal government is going to subsidize child care, which approach is better: tax credits for working families or another government spending program? The current system relies on tax credits and is producing an enormous supply-side response. Currently, families with working parents receive about $4 billion each year in income tax credits to offset partly child care expenses. Because these tax credits encourage women to enter the labor market, our annual GNP is as much as $8.4 billion higher than it otherwise would be. Because the additional income earned by working women is taxed, as much as $3.5 billion of the $4 billion in tax credits (89 percent) is returned to government in the form of work-related taxes. Almost all leading child care proposals before Congress show a hostility toward the tax credit for middle-income families -- those earning $28,000 a year or more. Some bills would even eliminate the credit for all but low-income families. Yet it is among middle-income families that the tax credit generates its greatest supply-side response. Middle-income working mothers return at least 69 cents in new taxes for each dollar they receive in child care tax credits. By some estimates, government makes a "profit" on middle-income families by receiving more than a dollar in new taxes for each dollar of tax credits. The ABC bill, recently passed by the U.S. Senate, is a grab bag of benefits designed to appease almost every constituency -- three types of refundable tax credits and $1.75 billion a year in spending subsidies that will empower state government bureaucracies rather than day-care customers. The ABC bill's spending may produce no supply side response -- no increase either in GNP or government revenue. Even if there is a supply-side response, the impact will be far less than the impact of using tax credits. Instead of the $1.75 billion in new spending, Congress could create $3.9 billion in new tax credits -- thereby doubling the credits now available to all working families -- and produce the same net impact on the federal deficit. The tax credits would produce six times as many jobs and add six times as much to GNP as spending under the ABC bill. The ABC bill also would require more government regulation at the state level, despite evidence that unnecessary regulations already diminish the supply of private day-care. Zoning laws, anti-homework laws, day-care licensing requirements, and many other city and state regulations prevent qualified caretakers from offering their services. The so-called shortage of day-care is caused by too much government. INTRODUCTION1 The child care tax credit is one of the most successful supply-side provisions of the tax code. This provision entitles working parents to a credit against income taxes of up to 30 percent of child care expenses for children under age 13.2 According to the conventional view, this program costs the federal government about $4 billion per year. This view, however, ignores the supply-side response of working mothers.3 As it turns out, the decision to work on the part of women with small children is highly sensitive to the cost of child care. Specifically, each 10 percent reduction in the cost of child care increases the number of mothers who work by almost 4 percent.4 Thus, If federal tax policy were to cut the child care cost by 50 percent, the number of working mothers would increase by 20 percent. If tax policy were to completely offset the cost of child care, about 87 percent of women with young children would participate in the labor market. REVENUE GAIN FROM THE TAX CREDIT LEADING PROPOSALS BEFORE CONGRESS TECHNICAL APPENDIX CONCLUSION The above analysis has strong implications for some child care proposals currently before Congress: 1. The total elimination of the tax credits for middle-income families, advanced in some Congressional proposals, is unwise. The reason: well over half, and possibly all, of the static revenue gain from abolishing the credit would be offset by a dynamic revenue loss. 2. President Bush's proposal, favored by many Congressional Republicans, would sever the link between work and tax credits for many low-income families. This would simply mean tax breaks for these families and would eliminate many of the work incentives of the current child care tax credit. It would tend to reduce the employment of women and lead to an even greater loss of tax revenue than is currently estimated. 3. The new spending program created under the ABC proposal, favored by many Congressional Democrats, is the worst of the alternatives. It would transfer more money from taxpayers to government. Far from empowering working mothers, it would give money and power to another layer of bureaucracy in ways that would not necessarily lead to any additional work, additional output, or additional government revenue. 4. If Congress wishes to increase current subsidies for child care, the ideal approach is to liberalize the existing child care tax credit -- leaving supply-side incentives intact and guaranteeing a high return on our child care tax credit investment. NOTE: Nothing written here is to be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder passage of any bill before Congress.