Overselling the Earned Income Tax Credit
September 24, 2014
The Earned Income Tax Credit (EITC) subsidizes the earnings of low-income workers, thus effectively raising their wages. The credit rewards those who work and helps keep them working, but it does little to get them to go to work in the first place, says Lawrence Mead of the American Enterprise Institute.
The subsidy that the EITC now provides is therefore quite substantial. In 2013, workers with children and with family incomes up to $51,567 could receive a credit amounting to as much as 45% of their earnings, up to $6,044, depending on income and the number of children in the family.
Under EITC's structure, as earnings rise, the subsidy builds to its maximum value, stays flat for an interval if earnings rise further, and then at still higher earnings is phased out until it disappears.
Twenty-seven million families received the credit in 2012. That year, the EITC cost $63 billion, or twice the cost of TANF and associated state programs.
A new consensus has formed that the credit promotes work while also subsidizing the poor, a rare combination not previously achieved in social policy. But this new consensus misses crucial parts of the story. The theory behind work incentives, the nation's actual experience with them, long-established patterns in the psychology of poverty, and on-the-ground testimony all suggest that the EITC in fact played a minor role in welfare reform and had only modest effects on decisions by welfare recipients to seek work.
It might seem obvious that subsidizing wages, as the EITC does, would tend to raise work levels, since the credit means that those not working will earn more by taking a job than they could before. But as economists have long known, the subsidy also raises the wages of those already working. They can now cover their needs with fewer working hours than before and may cut back work effort.
Some think that the EITC escapes this problem because the credit requires employment:
It subsidizes only low earnings, not low income in general, so only the substitution effect should operate.
But families receiving the EITC could nonetheless feel an income effect at the top end of the credit's income-eligibility range. That is, among the employed there could be a temptation to work less so as to remain eligible for the credit.
Since over three-quarters of EITC earners have incomes in the upper ranges of the credit, this income effect could be important. EITC does reduce work effort by wives in two-parent families, apparently due to income effects.
The Earned Income Tax Credit clearly does reduce poverty, but it raises work levels far less than some of the statistical studies of the past decade claim, and it appears to do so by encouraging working people to keep working, rather than driving the non-working poor toward jobs. We must add other suasions to promote and enforce work, including mandating participation in work programs and setting some threshold of working hours that claimants have to achieve to get benefits.
Source: Lawrence M. Mead, "Overselling the Earned Income Tax Credit," American Enterprise Institute, September 22, 2014.
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