New evidence on the benefits and costs of an expanded child tax credit

Scott Winship on Bruce Meyer's Research (attached), "...But in an explosive new working paper from the University of Chicago’s Becker Friedman Institute, Kevin Corinth, Bruce Meyer, Matthew Stadnicki, and Derek Wu (henceforth, CMSW) demonstrate that the behavioral effects of the expanded CTC are a much bigger issue than previously documented. They do so using new, improved data and correcting inconsistencies in the modeling conducted by the NAS committee. CMSW find that the work disincentives created by the expanded CTC are larger than previous researchers have claimed — perhaps sizable enough to reverse the employment gains caused by welfare reform and the EITC in the 1990s — and primarily impact single parent families.As a result, existing studies have overstated the short-term poverty-reduction impact of the policy by a third. Notably, the NAS committee failed to model the primary behavioral response to the new CTC that would be expected to reduce employment. In contrast, the committee did include such a response in its modeling of an Earned Income Tax Credit (EITC) expansion, when the financial incentives involved would be expected to increase employment....But by demonstrating the importance of short-term work disincentives (and the blind spot that many researchers have regarding behavioral effects), CMSW have strengthened the case that child allowances might have precisely the unintended consequences that conservative critics fear...."

Scott Winship, "New evidence on the benefits and costs of an expanded child tax credit," American Enterprise Institute, October 7, 2021, https://www.aei.org/poverty-studies/new-evidence-on-the-benefits-and-costs-of-an-expanded-child-tax-credit/

New evidence on the benefits and costs of an expanded child tax credit

Good intentions cannot be the measure of a policy’s merit. The case for expanding the child tax credit (CTC) has always been disarmingly simple: Giving parents money will reduce hardship among children. The American Rescue Plan Act (ARPA) temporarily made the CTC more generous for all but the richest families — especially to those with little to no earnings. Unlike the old CTC, the newly expanded version — which Democrats are trying to extend via the budget reconciliation bill — provides the full credit amount to families even if they owe no income tax or have no earnings. Estimates of the effect of the expansion have ranged from a drop in poverty of one-third to 46 percent. These estimates simply add the new CTC benefits to families’ incomes and re-calculate whether they are poor. Unsurprisingly, when poverty is defined as having too little income, giving more income to more families means that fewer fall below the poverty threshold.

Critics of the CTC expansion have offered a number of objections, including its $1.6 trillion cost over a decade.

An important criticism stems from concerns that the larger CTC will lead some parents to behave in ways that will counter the immediate (mechanical) poverty-reducing effect of the benefits. For example, if some parents react to having more purchasing power by working fewer hours, leaving the workforce, or not entering it in the first place, that will negate (at least partly) the short-term effects on poverty of the more generous CTC.

Advocates of the CTC expansion have downplayed the importance of such behavioral effects, pointing to (among other studies) the work of a recent National Academies of Sciences, Engineering, and Medicine (NAS) committee examining strategies to reduce child poverty. But in an explosive new working paper from the University of Chicago’s Becker Friedman Institute, Kevin Corinth, Bruce Meyer, Matthew Stadnicki, and Derek Wu (henceforth, CMSW) demonstrate that the behavioral effects of the expanded CTC are a much bigger issue than previously documented. They do so using new, improved data and correcting inconsistencies in the modeling conducted by the NAS committee.

CMSW find that the work disincentives created by the expanded CTC are larger than previous researchers have claimed — perhaps sizable enough to reverse the employment gains caused by welfare reform and the EITC in the 1990s — and primarily impact single parent families. As a result, existing studies have overstated the short-term poverty-reduction impact of the policy by a third. Notably, the NAS committee failed to model the primary behavioral response to the new CTC that would be expected to reduce employment. In contrast, the committee did include such a response in its modeling of an Earned Income Tax Credit (EITC) expansion, when the financial incentives involved would be expected to increase employment.

The CMSW paper does not model all of the potential short-term work disincentives embedded in the new CTC, nor does it model short-term incentives that would be expected to increase the share of children living with single parents, nor any long-term incentives on work, living arrangements, marriage, or fertility that might be expected to work against poverty reduction even more. It does not examine the potentially negative impact of the expanded CTC on other outcomes, such as intergenerational mobility. But by demonstrating the importance of short-term work disincentives (and the blind spot that many researchers have regarding behavioral effects), CMSW have strengthened the case that child allowances might have precisely the unintended consequences that conservative critics fear.

Policy Incentives, Work, and Poverty

CMSW rely on a restricted-use dataset that combines data from the widely used Current Population Survey with administrative data on earnings, retirement income, federal benefit programs, and taxes. The merger of the two datasets allows the authors to correct for substantial underreporting of income.

The Chicago team first analyzes the effect of the expanded CTC using the same conventions as previous researchers, ignoring potential behavioral responses. It finds that the expanded CTC reduces child poverty by 34 percent. In fact, the expansion of the CTC — the new part alone — reduces child poverty more than any other existing antipoverty program.

CMSW then consider how the work-reducing incentives embedded in the CTC expansion might change that conclusion. Specifically, they consider how those incentives might cause some adults who would have been employed without the expanded CTC to decide not to work. CMSW find that with an expanded CTC, the return to working falls by about 7 percent among families earning under $10,000, by about 10 percent among families earning between $10,000 and $40,000, and by between 7 and 9 percent among those earning between $40,000 and $60,000.

To illustrate how sizable this reduction in the return to work is, CMSW compare it with what would happen if the EITC were eliminated. The EITC is one of the largest antipoverty programs, and it is explicitly designed to incentivize work. For families with under $10,000, eliminating the EITC would reduce the payoff to working by nearly 30 percent. Thus, the work disincentive from expanding the CTC is about one-fourth as large for these earners as the work disincentive that would be created by eliminating the EITC.

However, there are nearly twice as many earners in families making $30,000 to $40,000 as there are in families making less than $10,000. For them, the expanded CTC reduces the incentive to work by more than eliminating the EITC would.

CMSW take the percent changes in the return to work for families in their data and multiply them by labor supply elasticities drawn from the literature, which give the percentage decline in employment for a 1 percent change in the return to work. They also multiply the percent changes in income represented by the expanded CTC for families in their data by income elasticities from the literature, which provide the percentage decline in employment for a 1 percent increase in income. (Additional income affords more people the ability not to work.) Together, and applied across families, these calculations yield an estimate of the decline in employment due to the CTC expansion, through its reduction of the return to work and its increase in income. Finally, CMSW model the change in the child poverty rate resulting from not only the more generous CTC benefits enacted in ARPA, but the reduced earnings that those benefits produce.

Incorporating the work-reducing incentives embedded in the CTC expansion, CMSW find that child poverty is reduced not by 34 percent, but by just 22 percent. More dramatically, while conventional estimates suggest the expanded CTC would lower deep child poverty — being under half the poverty line — by 39 percent, with behavioral effects modeled there is no impact whatsoever on deep child poverty. (The authors suggest that this probably understates somewhat the true impact on deep child poverty due to the way they implement their modeling.)

Revisiting the National Academies Study

The impact on poverty that CMSW report is lower than that found by the widely-cited NAS committee, which modeled the impact on child poverty of an expanded CTC similar to the one that was included in ARPA. The committee included behavioral effects on work in their modeling and found that an expanded CTC would lower child poverty by 41 percent.

In large part, the NAS estimate was higher than CMSW’s because the committee found that just 149,000 people would be induced to stop working by an expanded CTC. CMSW find that the work-reducing effects of the expanded CTC are ten times as large — 1.5 million would leave the workforce. What accounts for the difference?

The NAS committee modeled two “income effects” on labor supply — two ways that the increased income provided by an expanded CTC might cause people to work less. It modeled an income effect on the participation margin (the decision to work or not work) and an income effect on the hours margin (whether to work more or less, conditional on working at all). Its modeling assumed relatively small income effects. The Chicago researchers model effects very similar to NAS’s on the participation margin, as their assumptions are explicitly informed by the NAS study.

However, the NAS committee did not model any “substitution effects” on labor supply — changes in work due to the return to work declining. In a report from earlier in the year, I noted this issue, but I highlighted the less important hours margin. Since the old CTC phased in, it incentivized additional work by increasing the CTC amount as earnings rose until it reached the maximum of $2,000 per child. The expanded CTC is available to even non-workers, so it eliminates the pro-work phase-in, and this would be expected to reduce labor supply by lowering the return to working additional hours. CMSW do not model this effect either.

But as the Chicago researchers note, substitution effects are not confined to workers whose earnings put them on the old CTC phase-in, nor to the hours margin. The expanded CTC reduces the return to work across nearly the entire income distribution and therefore affects participation decisions across the distribution. This effect is the focus of the CMSW study. The NAS committee’s omission of any substitution effect on the participation margin in its CTC modeling has more serious consequences than ignoring substitution along the hours margin.

The omission is also curious because the committee’s modeling of an EITC expansion did include such substitution effects. The primary difference between the two policy modeling cases is that the substitution response when expanding the EITC would be expected to increase employment and thereby reduce poverty, while the response in moving from the old phased-in CTC to a child allowance would be expected to reduce employment and thereby increase poverty.

One worries that the NAS committee — even if subconsciously — might have been “rooting” for a more favorable CTC modeling result. At least three of the 15 members of the committee wrote in support of expanding the CTC to resemble a child allowance prior to the NAS report being published. Another committee member recently co-led the development and circulation of an open letter to policymakers for economists to sign supporting a permanent extension of the new CTC. Of the six economists on the NAS committee, five signed the letter. Ironically, that letter cited the NAS committee’s finding that the expansion would not reduce work significantly, which may have contributed to their subsequent advocacy. The modeling oversight uncovered by CMSW should remind us of the importance of including diverse perspectives on government panels examining important policy questions.

Reversing Welfare Reform

The CMSW study should give policymakers pause as they contemplate extending the newly expanded CTC. It identifies significant short-term effects on employment, even without looking at how the expanded CTC might cause some workers to reduce their hours while still remaining employed. Nor does it look at the effect on non-workers’ likelihood of choosing to enter work. So it only partly gets at the labor supply response to an expanded CTC.

The negative effects on work that the study does estimate would be heavily concentrated among low-earning families, who are disproportionately headed by a single parent. Roughly half of the families leaving employment in the CMSW modeling would come from families earning under $30,000. Over 80 percent of families leaving employment in their model switch from one worker to no workers (rather than from two workers to no workers — their model does not allow for two-worker-to-one-worker switches). In other words, the paper’s results are not driven by married mothers (or fathers) leaving the workforce to have a single-breadwinner family.

Neither does the paper look at the response to the expanded CTC in terms of marriage, living arrangements, and fertility. In the same way that safety net benefits make it possible to work less, additional income from the CTC makes it more feasible to raise children outside of marriage. In response to more income and declining returns to having earnings, some parents (disproportionately mothers) will choose to leave their marriage and take their children with them, while some (disproportionately fathers) will choose to leave and to leave the parenting to their ex. Other couples will find out-of-wedlock childbearing marginally easier: Either the mother, the father, or both may feel the mother has less need of the father’s support. More couples will find themselves with nonmarital, often unplanned, pregnancies and choose not to marry in the first place.

Finally, the CMSW paper is unable to consider whether the long-term effects of the policy might be understated by these short-term effects. Most narrowly, the longer-term effects on work might be understated. In the negative income tax experiments of the 1970s, one group of single mothers was assigned to receive a UBI-like benefit (but taxed away as earnings rose) for 20 years. After receiving benefits for three years, the decline in hours worked was twice as large as it was after receiving benefits for one year. (The experiment prematurely ended soon thereafter.) Thus, the long-term impact on child poverty of an expanded CTC might be significantly smaller than CMSW estimate.

More broadly, an expanded CTC might have other negative consequences over the long-run. As I wrote in my March report: "Child allowances run a very real risk of encouraging more single parenthood and more no-worker families, both of which could worsen entrenched poverty in the long run — an overreliance on government transfers, poverty over longer stretches of childhood, intergenerational poverty, and geographically concentrated poverty. And the concern is about not only material poverty but also the social poverty that comes from growing up in non-intact families or communities with limited social capital and a dearth of meaningful roles for members to fill."

Advocates of the CTC expansion point to research suggesting that safety net expansions have improved various long-term outcomes. This research is often non-experimental and ill-equipped to rigorously answer the policy questions of interest. It often comes from older expansions of a relatively threadbare safety net, calling into question its relevance for new safety net expansions when child poverty is at an all-time low. It is also often ambiguous in another way; if transfer income improves outcomes, it stands to reason that income from employment or from marrying someone with earnings might as well. Indeed, many results cited by advocates come from EITC research, which involves not just additional federal benefits but additional work.

To the extent that working increases parents’ skills and social capital, it would be expected to raise their future earning potential, and thus have a bigger impact on lifetime income. Working may also provide beneficial role-modeling for children. While greater work might mean less time for parents to invest in their children, providing better child care opportunities while parents work might improve the cognitive and socioemotional environments of many children, especially those whose parents struggle to provide healthy environments. Growing up with both biological parents is also associated with a variety of improved outcomes. Perhaps it is for these and other reasons that, in the past three months alone, two studies found that welfare reform improved living standards among single-mother families and reduced the adulthood poverty of children affected by it. (Meyer was a coauthor of the former.)

In truth, almost everyone involved in anti-poverty debates has good intentions. No one favors increasing child poverty as a policy goal. We should all rely on evidence as best we can to guide our policy positions, but evidence is almost always more ambiguous than the staunchest advocates of safety net expansions believe. Ambiguity calls for caution and for the kind of experimentation that informed welfare reform. Jumping hastily into a dramatic transformation of the safety net without worrying about unintended consequences may be soft-hearted, but researchers and policymakers must take care to be hard-headed as well — because we are trying to help today’s and tomorrow’s children.