Effect of Earned Income Tax Credit (EITC) on Labor Supply

• Michael Lederman

How does the EITC affect labor supply?

The Earned Income Tax Credit (EITC) provides a tax credit for those who qualify with positive earnings, low income, and minimal capital gains. It is more so directed at working families, whether it is 2 parents or a single mother. It is intended to push more people into the work force, especially low-income women. In fiscal year 1998 the EITC is expected to cost the federal government $24.5 billion, $7 billion of which will result from expansions incorporated in the 1993 Omnibus Budget Reconciliation Act (OBRA93) (Houser & Scholz, 2). It pushes for a “make-work pay” strategy of welfare reform so people do not rely as heavily on welfare programs. There are many articles that discuss what effect the Earned Income Tax Credit has on labor supply in America and the way the policy has affected so many.

In “The Impact of the Earned Income Tax Credit and Social Policy Reforms on Work, Marriage, and Living Arrangements” by Ellwood, he examines how changes in social reforms, such as the EITC, have impacted labor supply, marriage, and cohabitation. Ellwood acquired and used the current population survey from March 1995 of women ages 18-44 who worked at least 26 weeks, also separating between married or single, with children. Then he used a wage equation to predict a potential 1998 wage for the women. Then the predicted wage was used to place the women into predicted wage/skill quartiles after accounting for education level. The incentives were much higher for low skill single mothers to work. Differentiating the women between skill and wage levels is critical in determining which group of people receives benefits and which don’t get affected at all. In 1986, she could hope to earn just $2,800 more and her effective tax rate being 76 percent; but by 1998, the number had jumped to $7,600 with her effective tax rate falling to 31 percent (Ellwood). The lowest quartile showed the greatest amount of change, and the following quartiles showed change, but nothing too drastic. Employment rates were rising for unmarried mothers. For married women, incentives to work were sharply reduced for low-income women, with effective tax rates falling slightly for women in other quartiles. A large change in work by the lowest quartile occurred with employment rates shooting up from 34 percent in 1992 to 55 percent in 1999. In regard to married women, some cases led to them being discouraged to work. Roughly 54 percent of married women in the bottom quartile would have faced penalties up to $1,288 (had they been earning $10,000) whose husbands likely were earning less than the EITC maximum. Another 28 percent would have had no incentive to work because their husband’s income surpassed the EITC maximum. The EITC encouraged more work force participation by single mothers, but hadn’t had such an effect on married mothers. Overall, based on the number of mothers in each group affected, this article concluded the EITC results in a net increase of working women.

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In “The Earned Income Tax Credit and Transfer Programs: A study of Labor Market and Program Participation” by Dickert and Scholz, they focus on the degree to which welfare policies, like the EITC, that alter after-tax wages affect hours of work, labor market participation, and welfare program participation. They used the following empirical model to study the effect of wages, taxes, and program benefits on labor market and program participation; bivariate probit models of labor market and transfer program participation. They included variables for income, transfers, and demographic characteristics in both participation equations. Two models are estimated separately: one for one-parent families and the other for primary earners in two-parents families. Net wages are key in influencing participation when it comes to the EITC. The empirical results for the single parent model found that net wages positively affected labor market participation. A 10 percent increase in the after-tax wage raises the single parent’s probability of working by two percent (Dickert & Scholz). Two-parent families do not show any significant changes in labor market decisions for primary earners. Tax rates were also found to exert a strong negative effect on the probability of labor force participation. For single parents, the probability of working generally increases with predicted wage rates. In the bivariate probit model for single-parents families, a highly significant negative correlation is found between the labor market and transfer program participation. The article also examines the offset between the new participants in the labor force and the decrease in hours worked by those already working. The simulations show the EITC increases net wage of single parents by 15 percent, which in turn increases their probability of working by 3.3 percentage points. Assuming they work on average 20 hours a week for 20 weeks a year, this implies hours worked by single-parent families would increase by 72.8 million hour per year (Dickert & Scholz). Overall, the simulation results imply that greater labor market participation will lead to an increase of 74.4 million hours, compared to the 54.5 million hours less worked by those already in the work force, more than enough to offset. This article accounts for both the positive and negative effects EITC has on the labor force, and explains how the two cancel each other out with extra benefits to society.

In the article “Welfare, The EITC, and the Labor Supply of Single Mothers” by Meyer and Rosenbaum, they focus on the effect that tax and transfer program had on incentivizing single mothers to work. They use the Current Population Survey Outgoing Rotation Group Files and the March CPS files. Estimates from these specifications suggest that EITC and other tax changes account for 60 percent of the 1984-1996 increase in employment of single mothers (relative to single women without children). The article highlights the fact that the EITC credits increased from $1.6 billion in 1984 to $25.1 billion in 1996. A structural model was created, which accounts for taxes, welfare, Medicaid, welfare waivers and time limits, training and childcare, education, unemployment rate and macroeconomic conditions, and hours worked. These variables of empirical evidence are absolutely essential when making informed policy decisions. Every factor must be taken into account when making policy decisions, and the more evidence and information you get involved, the more solidified your conclusion. A one thousand dollar reduction in income taxes if a woman works increases employment last week by 2.7 percentage points and last year by 4.5 percentage points; labor supply of single mothers responds to taxes. A one thousand dollar reduction in annual welfare maximum benefit increases employment last week by 3.4 percentage points and increases employment by 3 percentage points. Also, a 10 percent cut in the maximum benefit increases both annual and weekly employment rate by 1 percentage point (Meyer & Rosenbaum). The period between 1984 and 1996 where tax and transfer policy was being pushed encouraged single mothers to work more. The one flaw I can find in this article is no discussion about the different phases that EITC entails. An individual experiences different incentives at different points of the EITC, and that is something that must be accounted for.

A matter in question I believe needs changing is a way to figure out how to get change the fact that two-thirds of recipients, and 84 percent of total earnings, are in the phase-out range of EITC (Browning). It must be more focused on the phase-in region, where the growth of labor supply is actually occurring. The favorable benefits and results happen during the phase-in region, but sadly this is a small proportion of the population of recipients. A policy recommendation I would suggest would be to somewhat change the structure of the EITC to prevent this waste of money from transpiring. Perhaps a brand new welfare program needs to be put into place instead of the EITC that focuses more on the increased net wages for those who truly need it. An possible option would be for a recipient entering the phase-out region to report their earnings so that it may be determined whether they still should qualify to receive these net wage increases.

In conclusion, these articles all feed off of one another to build up knowledge of the exact effects the EITC has on society. Single mothers experience higher incentives to join the work force, along with other low-income individuals. When structuring a model to research the effect of policy, it is crucial to take every variable into account. The EITC does cause decrease hours worked, but the increase in labor supply makes up for it. Increased net wages with the EITC is a big enough incentive to push people into work. It is important to doubt empirical methods and be suspicious of results. For example, some women with children may not be able to work to due the need to take care of their children, or any other possible factors as so. With the evidence stated here, we can claim EITC positively affected labor supply.

Reference List

Browning, E. K. (1995). EFFECTS OF THE EARNED INCOME TAX CREDIT ON INCOME AND WELFARE. National Tax Journal, 48(1), 23-43.

Dickert, S., Houser, S., & Scholz, J. K. (1995). The earned income tax credit and transfer programs: a study of labor market and program participation. In Tax Policy and the Economy, Volume 9(pp. 1-50). MIT Press.

Ellwood, David T. 2000. “The Impact of the Earned Income Tax Credit and Social Policy Reforms on Work, Marriage, and Living Arrangements.” National Tax Journal, no. 4: 1063-1105. Business Source Complete, EBSCOhost

Meyer, B. D., & Rosenbaum, D. T. (2001). Welfare, the earned income tax credit, and the labor supply of single mothers.The Quarterly Journal of Economics,116(3), 1063-1114.

• Michael Lederman