Dr Andrew Leigh. Earned Income Tax Credits: An Overview. Lecture I. Social Policy Evaluation, Analysis and Research Centre Economics Program, RSSS

Transcription

1 Earned Income Tax Credits: An Overview Lecture I Dr Andrew Leigh Social Policy Evaluation, Analysis and Research Centre Economics Program, RSSS Notes at

2 Overview Lecture 1: What is it, and where did it come from? What effect does it have on labor supply and welfare? Lecture 2: Alternative models of the EITC Critiques of the EITC Andrew Leigh - Earned Income Tax Credits I 2

3 History of the EITC In his 1962 book, Capitalism and Freedom, Milton Friedman proposed that one way of increasing labour force participation was a negative income tax. In the late-1960s and early-1970s, the negative income tax experiments in New Jersey found that EITCs increased labour force participation. In 1975, a small hybrid EITC was slipped into the US tax code by Senator Russell Long, and signed into law by President Gerald Ford. It was expanded by Ronald Reagan in his major 1986 tax reform, and boosted substantially by Clinton in the 1990s. Andrew Leigh - Earned Income Tax Credits I 3

4 History of the EITC Britain has had some form of benefit for families who worked over a given number of hours per week. This has been called the Family Income Supplement ( ), the Family Credit ( ), the Working Families Tax Credit ( ) and the Working Tax Credit (2003-) Several other countries have recently introduced EITCs Ireland, Belgium, Denmark, Finland. Since September 2003, Australia has had a very modest and temporary - form of EITC, which is known as the Working Credit. Andrew Leigh - Earned Income Tax Credits I 4

5 What is the EITC? The EITC is a subsidy to low-wage workers. Under an EITC, not only do these workers not pay taxes, but they receive money back from the tax office. This can amount to more than US$4000 per year. (By contrast, the best you can do out of the current Australian tax system is to pay zero tax.) There are three reasons for introducing an EITC: - to increase labour supply; - to transfer income to the poorest; and - to transfer resources to children. Andrew Leigh - Earned Income Tax Credits I 5

6 Why the EITC? The EITC has certain advantages over other policies. Alternative 1: Raising the minimum wage: - increase earnings for those in employment, but may cause firms to fire workers; - we know that the L D curve does slope down; - but the evidence is not clear-cut in the US, Card & Krueger 1995 find no effect, but Neumark & Wascher 2000 find an effect; in the UK, Stewart 2004 finds no effect; Machin & Wilson 2004 find an effect; - Neumark finds that the net effect for poor families is negative, and that the longer run effects are also detrimental, since higher minimum wages boost the high school dropout rate; - using a natural experiment from WA, I find that the elasticity of labor demand wrt the minimum wage in Australia is (Leigh 2003, 2004). Andrew Leigh - Earned Income Tax Credits I 6

7 Why the EITC? Alternative 2: A basic income guarantee - (In the Australian context, this might mean simply increasing the family payment) - causes a reduction in labor supply (income effect); - much more expensive than EITCs. Andrew Leigh - Earned Income Tax Credits I 7

8 Various countries have EITCs For simplicity, I ll focus on the one which has received most academic attention the US EITC. The US EITC has a phase-in, flat, and phase-out region. Andrew Leigh - Earned Income Tax Credits I 8

9 EITC schedule Figure 1: Federal EITC Schedule EITC payment ($) Two children One child No children Annual Family Income ($) Andrew Leigh - Earned Income Tax Credits I 9

10 EITC budget constraint Figure 2: Budget Constraint - Single Taxpayer with One Child in 2002 $40,000 $35,000 Without EITC With EITC dl L S S Annual earnings $30,000 $25,000 dw dτ dv slope = w = ηs $20,000 + ζ W τ V slope = w(1-phasein rate) $15,000 $10,000 $5,000 $ slope = w slope = w(1-phaseout rate) 1600 Annual hours Assumes a single taxpayer with one child and no investment income, earning $10 per hour. Calculations based on Taxsim, and ignore all other taxes and credits. Note that the phase-in rate is negative, and phase-out rate is positive. Andrew Leigh - Earned Income Tax Credits I 10

11 The basics of the US EITC No children: Phase-in rate: -7.65% Phase-out rate: 7.65% Max amount: $4000 One child: Phase-in rate: -34% Phase-out rate: 16% Max amount: $2500 Two or more children: Phase-in rate: -40% Phase-out rate: 21% Max amount: $400 Andrew Leigh - Earned Income Tax Credits I 11

12 A few more things to note... Families without children receive only a EITC payment (they received none prior to 1994). 99% of taxpayers receive it as a lump sum at the end of the tax year. Evidence suggests that many use it as a form of enforced savings. The EITC has received bipartisan support in the US, and has proved highly resilient to attempts to reduce it. Andrew Leigh - Earned Income Tax Credits I 12

13 Theoretical Predictions If the individual is EITCeligible and... Not working Working, and in the phase-in range Working, and in the flat region Working, and in the phaseout region Then the predicted effect on labour supply is... Income effect: Nil Substitution effect: Positive Income effect: Negative Substitution effect: Positive Income effect: Negative Substitution effect: Nil Income effect: Negative Substitution effect: Negative Andrew Leigh - Earned Income Tax Credits I 13

14 Theoretical Predictions Net effect on participation: - positive for single-earner households - potentially negative for the second earner in a twoearner household (since married couples file jointly in the US) Net effect on hours: -ambiguous Andrew Leigh - Earned Income Tax Credits I 14

15 Eissa & Liebman (1996) Question: What effect does the EITC have on labour supply? - theoretical predictions - the experiment TRA86 - methodology - treatment group - control group - results participation - results hours per year - alternative explanations labour market shifts for families with children, business cycle fluctuations, changes in AFDC benefits Andrew Leigh - Earned Income Tax Credits I 15

16 Meyer (2002) Question: How does the EITC affect labour supply on the extensive and intensive margins? - methodology - treatment group - control group - results participation - results weeks per year - results hours per week Andrew Leigh - Earned Income Tax Credits I 16

17 Other Research on the EITC Meyer & Rosenbaum (2001) attempt to parse out the effect of changes in welfare generosity from changes in the EITC. However, because welfare and EITC receipt are endogenous, they instrument for them by dividing single women into 50 ageskill categories, and assigning them the average welfare and tax benefits of their group. They find that most of the increase in participation can be attributed to the EITC. Neumark & Wascher (2001) look at the effect that the EITC has upon annual earnings and the probability that a poor family has one or more parents in the workforce. They use variation in state EITC supplements, and find a significant positive effect from the EITC. Andrew Leigh - Earned Income Tax Credits I 17

18 Other Research on the EITC Romich and Weisner (2000) surveyed low-wage households in Wisconsin. 36/40 knew of the EITC, but only two knew that they needed to earn a certain amount to maximize their credit amount. Berube et al (2002) find that 68% of EITC recipients use a tax preparer, which may contribute to a lack of knowledge. Andrew Leigh - Earned Income Tax Credits I 18