The EITC and the Extensive Margin: A Reappraisal
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Research by @HenrikKleven suggests the EITC’s employment effects on single mothers have been overstated due to covariance with welfare reform. The EITC’s role as a labor inducement is fragile, with limited impact on employment.
Kleven paper on the EITC you asked about, we had reviewed this when it came out. Also attached the WSJ editorial
Also though Scott Winship's thoughts on this paper were worth noting, "... I’ve come around on EITC employment effects being relatively small. I STILL think it plays a big role in poverty reduction, since it compensates for expenses single moms incur when they choose work instead of welfare. But yeah, needed welfare reform first & foremost..."
"....In this paper I have analyzed every EITC reform at the state and federal level within one modern empirical framework. From this comprehensive and long-run perspective, the EITC has not had any clear effects on labor supply at the extensive margin. Apart from the expansion enacted in 1993, EITC reforms are not associated with increases in the employment of single mothers relative to single women without children. The 1993 reform, on the other hand, is associated with very large employment increases, but these increases align closely with the confounding effects of welfare reform and a booming macroeconomy.Exploiting variation in these confounders across household type, space and time, I have shown that the effects are driven exactly by those affected most strongly by welfare reform and the business cycle. A stacked event study of all EITC reforms, controlling for welfare reform and the business cycle, produces a precisely estimated zero.There are two interpretations of this null result. One is that the extensive margin elasticity with respect to taxes is small, and perhaps especially the elasticity with respect to a highly nonlinear tax refund like the EITC. The other is that, even if the elasticity is not zero in general, the informational and psychological frictions specific to the EITC have reduced its impact. These frictions may be related to the complex nonlinear schedule or to the procedures for filing taxes and claiming the credit. As reviewed above, a number of studies have documented that most potential recipients are either unaware of the EITC or have a limited understanding of the schedule and eligibility requirements. Given these frictions, the EITC is not an a priori likely candidate for finding large labor supply impacts. While these frictions are widely acknowledged in the literature, they have been used mainly to explain the absence of intensive margin responses. The reasoning seems to be that extensive margin responses can be based solely on knowing about the existence of a tax refund without understanding the specifics of the schedule and eligibility rules. Even ignoring the fact that many potential recipients are unaware of the EITC, this argument is surprising. Economic theory predicts that intensive and extensive margin decisions are interdependent, and this interdependence is particularly strong for nonlinear incentives....The EITC is an incentive to enter the labor market around the refund-maximizing earnings range, which is relatively narrow and vary by family size. Without precise information about the location of the refund-maximizing earnings range and the size of the credit in that range, the extensive margin response is not very credible. By contrast, welfare reform is not subject to these concerns about salience and information. The debate about welfare reform and welfare culture was extremely prominent in the nineties, as exemplified by Bill Clinton’s famous campaign pledge to “end welfare as we know it.” State waivers and national TANF reform imposed drastic changes on existing program participants, so information was essentially automatic. What is more, the changes to welfare were mechanical and brute-force. They included lifetime limits on welfare receipt (down to two years in a number of states), work requirements, community service and training. Those who did not satisfy these requirements were kicked off the welfare rolls. These initiatives stand in sharp contrast to the complex tax refund incentives introduced by the relatively unknown EITC program. These findings do not necessarily imply that the EITC is a bad policy. Absent labor supply responses at either the extensive or intensive margins, the EITC is a non-distortionary transfer to the working poor. The optimality of such a transfer depends on the social welfare function and on who pays for it. For example, if the EITC is financed by a lump-sum tax on all individuals and if the government puts a larger weight on the working poor than on the average individual, then the policy is socially optimal. This is the reasoning underlying the results in Saez (2002). Conversely, if transfers to the working poor are financed by reducing welfare benefits to the poor, then the equity effect is negative under standard social preferences. In this case, the desirability of the EITC requires social preferences that put more weight on the working poor than on the non-working poor, even if the latter are worse off. Leaving aside these optimal tax considerations, the political argument for the EITC has relied heavily on its supposed employment effects. The empirical findings presented here do not lend support to this argument..."
Henrik Kleven, "The EITC and the Extensive Margin: A Reappraisal," National Bureau of Economic Research, September 2019, https://www.henrikkleven.com/uploads/3/7/3/1/37310663/kleven_eitc_sep2019.pdf
Type of Info: Theory and Quote
Characterization:
Importance: High
Point of View: Conservative
Ed's Agreement: Neutral
Timelessness: High
Trustworthiness: High An Overhyped Tax Credit The earned-income tax credit is one of those bipartisan policy idols that everybody worships but nobody examines closely for results. Now comes A study showing that its employment benefits are grossly overstated. Congress created the EITC in 1975 as temporary assistance to increase the marginal incentive to work. The idea, inspired in part by Milton Friedman’s negative income tax, was that tax benefits would increase as workers earned more and phase out after they hit a certain threshold (initially $4,000). We supported the credit as an alternative to raising the minimum wage because it doesn’t reduce incentives to hire low-skilled workers. But politicians expanded the credit and have kept raising the minimum wage. (Memo to those who want a carbon tax to replace some other tax.) One in five households now claims the credit, and government payments exceed cash welfare by six times. Complicated rules on eligibility and credit size have encouraged fraud. According to the IRS, a quarter of the $69 billion in EITC payments last year were “improper.” Yet politicians from both parties continue to pump it as a labor inducement. As Princeton economist Henrik Kleven shows, there’s scant evidence it boosts employment. The biggest EITC expansion occurred in 1993 when Congress doubled the maximum to about $2,152 for taxpayers with one child and tripled it for those with two or more. Most economists have attributed the subsequent spike in labor participation and employment among single mothers to the credit. But Mr. Kleven concludes that the real labor stimulator was welfare reform aided by a booming economy. It’s odd, he notes, that none of the other four EITC expansions in history has been linked to higher labor participation among single mothers. So what was special about the 1993 expansion? Some economists have posited that the 1993 expansion was simply larger than the others, though this doesn’t explain why employment increased most among women with more children. Following the 1993 expansion, employment increased by 10 percentage points among single mothers with one child, 15 points among those with two, 20 among those with three and 30 points among those with four or more. Mr. Kleven says this pattern is more consistent with state and federal welfare reforms in the early 1990s that reduced government cash benefits most among women with more children. Before Congress passed welfare reform in 1996, 113 state and county waivers were approved to establish work requirements and family size caps and time limits on benefits. A 2016 study found Connecticut’s welfare waiver induced many women to work. Yet Mr. Kleven finds in his study that state EITC expansions have not produced a similar effect. “Overall and contrary to consensus, the case for sizable extensive margin effects of the EITC is fragile,” Mr. Kleven concludes. His study adds to the economic research finding that the EITC phase-out causes steep infra-marginal tax rates as workers make more money. None of this may bother Republicans or Democrats who want to redistribute more income, but they shouldn’t claim these welfare tax payments are an incentive to work.
