Threatening to “Reform” the EITC

August 7th, 2013 at 4:38 pm

Devoted OTEers know that I’m careful not to shoot everything that moves, but the more I hang around the DC tax debate, the more I’m exposed to deeply misguided thinking that seems largely motivated by the conviction that poor people—in this case, the working poor—have too much money and the wealthy have too little.

That’s the lesson from a report by the Tax Foundation on the “benefits” of getting rid of the Earned Income Tax Credit—a wage subsidy for low-income workers—and giving everybody else a tax break.

BTW, an interesting wrinkle here is that the Tax Foundation claims to “not advocate policy positions,” at least according to the Hill newspaper.  It’s just that they happen to mention that if we were to get rid of the EITC if would free up enough revenue to lower tax rates by almost 6%.  To paraphrase: “We’re not saying anyone should do that, of course…we’re just sayin’…and by the way, according to our BS dynamic scoring model, that would add a zillion jobs…but we’re not sayin’ anything…we’re just sayin’…”

As my CBPP colleagues show here, across-the-board rate cuts are highly regressive, ergo the “rich need more, poor need less” policy goal that this idea would promote, if the Tax Foundation promoted policies…which they don’t…really.

The EITC has historically been an extremely popular anti-poverty program, and not just among D’s.  Reagan viewed it as highly effective in no small part because, as much research has shown, it successfully incentivizes work.   How then, does the TF come up with the claim that it discourages work?

That’s because they’re emphasizing the “substitution effect” in the phase out range of the credit.  But of course the question is the net impact—the impact on work incentives across the full program, not just one piece of it (you don’t describe the results of a ball game by just telling us how many runs your team scored).*  And here the research has been clear that the EITC both promotes labor supply and makes sure that once you include the tax credit, low-wage work is much more likely to lift a family out of poverty.  (I will add the full employment/demand side piece here: it’s a great program but it won’t help if there aren’t enough job slots.)

Finally, a central theme here at OTE has been the extent to which inequality is dampening the upward economic mobility of kids stuck on the have-not side of that equation.  Well, we now have enough longitudinal data to examine the long-term impact on kids whose families benefited from the tax credit (or similar subsidies) versus those who didn’t get the extra income.  In fact, such research has uncovered long-lasting benefits including healthier babies, better school performance, and higher earnings and hours of work later in life.

I’ve held for a while now that this is an inauspicious moment to engage in tax reform—I just don’t think this Congress is up to meeting the necessary criteria of additional revenues and at least no lessening of progressivity.  Numerous developments thus far have reinforced this fear, threatening a “tax-reform trap” where policy makers want to pay for lower rates with a broader base, but seem to agree only on the lower rates, not the broader base.  This cooked research on the EITC provides another great example of the type of tax reform we’d be much better off without.


*That pro-work result on net is what I’d expect: on the up-slope of the credit both substitution and income effects incentivize more work.  On the down slope, the substitution effect flips but the income effect, while diminished, still points toward more work.  Interestingly, the research tends to find the work incentive has a much larger impact on the extensive versus the intensive margin.  That is, the tax credit is more likely to move non-workers into paid work than it is to lead workers to adjust their hours.  It’s a reminder that the microeconomic assumption that workers—especially low-wage workers—can seamlessly adjust their work hours in response to marginal changes in tax incentives is…um…fanciful.

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3 comments in reply to "Threatening to “Reform” the EITC"

  1. readerOfTeaLeaves says:

    Good to know that in an era where Wal-Mart is the largest employer in 25 of the 50 US states, the Tax Foundation claims that tweaking the EITC will somehow translate to ‘lower taxes’ for some of us.

    This idea, like so many others, seems to be part of the catechism of the Church of Finance, which is well explained by someone who studies innovation. The result of this sort of tax cut is going to create more ‘migratory capital’ seeking short-term results — irrespective of whether they are economically productive. In other words, not only is the idea of cutting EITC bad for policy, it’s probably bad over the long term for businesses as well.

    Don’t have a date for the Wal-Mart stats, but here is one link to facts that seems legit:

  2. Edward Lambert says:

    If a person defaults on their student loan, and falls into a low paying job, they might be eligible to receive an EITC tax refund.
    But they won’t receive their EITC tax refund. The IRS will keep the refund to pay the lender.

  3. Eugene Patrick Devany says:

    Since Mr. Bernstein is indeed one of the few economists that is, “careful not to shoot everything that moves” I will go out on a limb with combined safety net and tax reform.

    With a foot on the brake pedal it will be difficult to move forward no matter how much gas is applied with the accelerator pedal. The economic bus won’t go very far or very fast if the brakes are engaged.

    The payroll taxes are an effective brake to private sector domestic job creation. The business portion of the payroll taxes could be eliminated with a revenue neutral VAT of about 4%. No economist can provide a good economic reason for not adopting this win-win solution.

    Safety net programs may discourage work when only low paying jobs are available. Voluntary better paying full and part time jobs with public charities (at a little below private sector rates) could reduce safety net payments and provide transition to the private sector. As many as 2,000,000 new jobs could be created without new spending by simply allowing the $40 billion charitable deduction to be used only for charities that create decent new jobs. We do not need more minimum wage jobs because the U.S. already has the largest percentage of these jobs (about 25%) and they lock the workers into a welfare system.

    … and now for tax reform.

    Consider a taxpayer choice of paying a flat 26% income tax (plus capital gains, estate and gift taxes later) versus a low 8% income tax rate combined with a 2% tax on net wealth (excluding $15,000 cash and $500,000 retirement savings). Most of us would choose the wealth tax but a surprising number of wealthy taxpayers would also choose to have their net wealth taxed not just for the low 8% income tax rate but also to avoid large deferred payments on capital gains, gift and estate taxes.

    For business, a revenue neutral 4% VAT (the lowest rate in the world) could complement a C corporate income tax rate of 8% (also the lowest rate in the world). Pass-through business owners could elect the same 8% rate on their individual return or the 26% rate and avoid paying net wealth taxes. [A later change in election would incur a penalty].


    [Note that a previous proposal in the NY Times to replace the income tax with a progressive wealth tax still left the poor paying payroll taxes – why keep a job killer when it is not needed].