"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 differe nt 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