Archive - Earned Income Credit

The Earned Income Credit: Does it Work?

The Maryland General Assembly is considering legislation that would increase the state's refundable earned income credit (EIC) for low-income workers with children. This analysis seeks to inform the debate on the EIC by reporting on the academic literature on the effects of the EIC on poverty, work, and participation in welfare programs.

Summary of Findings

The EIC is an effective anti-poverty policy tool. In 1998, the federal EIC lifted 4.8 million people in working poor families above the poverty thresholds. More than half of the people lifted above poverty were children. A state EIC lifts additional families out of poverty.

The EIC encourages work. Several studies have found that, after accounting for other factors, the federal EIC has been a major inducement to single parents to enter the labor force. States that offer EICs have been shown to have particularly high labor force participation.

The EIC leads to reduced participation in welfare programs. One study of the impact of the EIC on participation in welfare programs concluded that the 1993 expansions in the federal EIC would lead to more than 500,000 families being removed from either the AFDC or Food Stamp Programs. Further, the impact of the entire EIC program--not just the marginal changes in 1993--would be expected to have a much greater impact on welfare participation.

The EIC contributes to long-term well-being. Many families use their EICs to make the kinds of investments -- paying off debt, investing in education, obtaining decent housing -- that enhance economic security and promote economic opportunity.

The EIC does not lead people to substantially reduce their hours of work. Economic theory suggests that the EIC would cause some workers--those in the middle and upper ranges of credit eligibility--to work less. However, studies have shown this negative effect to be negligible.

Research Findings on the Impact of the Earned Income Credit on Poverty, Work, and Welfare Program Participation

Poverty

Recent research findings indicate that the EIC substantially reduces poverty. In 1998 the EIC helped 4.8 million people in low-income, working families lift themselves above the poverty line. More than half of those removed from poverty--2.6 million--were children.(1) The Census data also show that more than one out of every six children who would have been poor in the absence of the EIC were lifted out of poverty by the credit.

Among government programs, only social insurance programs--largely social security--lift more people out of poverty than the EIC. No program or category of programs lifts more children out of poverty.

Work

Several recent studies conclude that the EIC induces single parents to go to work.(2)

Harvard economist Jeffrey Liebman has published a series of articles on the impact of the EIC on the decision to work. He notes that the labor force participation of single women with children increased from 72.7 percent in 1984 to 82.1 percent in 1996. His research concludes that the EIC was responsible for nearly 60 percent of this increase in labor force participation.(3) That is, the EIC induced 20 percent of single women with children who were not in the labor force to begin working or looking for work.

Research by Liebman and University of California economist Nada Eissa similarly found that the EIC caused single women with children to enter the labor force.(4) They compared changes in the labor force participation of single women with and without children in the mid-1980s. The labor force participation of those with children increased, while the proportion who worked among those without children remained unchanged. After conducting several statistical tests and accounting for other potential factors, they concluded that the EIC expansion and federal tax changes of 1986 were most likely responsible for the increase in work among women with children.

Similarly, University of Wisconsin economists Stacy Dickert, Scott Hauser and John Karl Scholz estimated that the EIC expansions of 1993 would increase the labor force participation of single parent families by 3.3 percentage points.(5) They found that this increase was due to the EIC's impact on net wages; the EIC expansion in 1993 increased the net wage of low-income, single parents by 15 percent.

State EICs, although usually smaller than the federal EIC, are likely to contribute further to workforce participation. States have been slower to enact EICs than the federal government, and so the track record is less extensive. However, a recent study by Bruce Meyer of Northwestern University and Dan Rosenbaum of UNC-Greensboro found clear evidence that state EICs also increase work participation. Meyer and Rosenbaum found that from 1993 to 1996, a time of growth for several state EITCs, states that offered their own EICs had higher growth in workforce participation than other states.(6)

Among people who are already working and earning above the "subsidy" range of the EIC, the impact of the credit on work is slightly more ambiguous. Economic theory asserts that the EIC would reduce the number of hours of work for people in this range for two reasons: First, recipients would work less because the credit provides them with higher income (thus reducing the need to work); second, in the phaseout range of the credit, reducing the amount of the credit as earnings increase amounts to an additional "tax" on earnings, thus discouraging work.

Few studies have examined actual behavioral responses to the EIC among those who are already working. Eissa and Liebman found that the EIC expansions of 1986 had no negative effect on the hours of work of single women with children who were already in the labor force. Similarly, as Liebman notes in his previously cited paper, "While there is only limited evidence so far, the evidence that does exist suggests that the phase-out of the EITC has little or no impact on hours of work." Alternatively, Dickert, Hauser and Scholz found a modest, negative effect on the number of hours worked by those already in the labor market.

Welfare

Historically, welfare programs have been designed in a manner that discourages work. For example, in Maryland's Temporary Cash Assistance program, benefits are reduced by 74 percent when a participant has an increase in earned income. This is marginally better than prior federal law, which reduced benefits dollar for dollar for some recipients. Combined with work-related costs, child care, and reductions in food stamp benefits, an increase in earned income often made recipients worse off economically. Numerous studies have been conducted on the impact of benefit reductions on work, and there is a consensus on the findings: high benefit reduction (referred to as "tax") rates on the earnings of welfare recipients discourage work.

The earned income credit partially mitigates the high tax rates faced by welfare recipients and increases the net wages earned. At the lowest levels of earnings, the federal EIC provides an additional subsidy of 40 cents for every dollar earned. Several studies by Johns Hopkins University economist Robert Moffitt conclude that net wages matter in the work decisions of welfare recipients.(7)

Dickert, Hauser and Scholz estimated the effect of the EIC on participation in the food stamp and AFDC programs. They concluded that the 1993 expansions in the federal EIC would decrease participation in these programs by 7.2 percentage points. Overall, the 1993 expansions were estimated to induce more than 500,000 families to leave welfare.

This finding is based on the impact of the 1993 expansions alone. The impact of the EIC--not just the marginal changes in 1993--on welfare participation (or nonparticipation) would be expected to be substantially higher.

The EIC may be expected to reduce welfare receipt in the long run as well. Emerging research shows that many EITC recipients use their EITC refunds not only to meet day-to-day expenses but also to make the kinds of investments — paying off debt, investing in education, obtaining decent housing — that enhance economic security and promote economic opportunity.(8)

Summary

Many factors will influence the Maryland General Assembly's decision to expand or not expand Maryland's current refundable earned income credit. These factors may include cost, an assessment of need among lower-income, working families, issues of tax burdens, and the effectiveness of the credit.

The conclusion is clear: The EIC works. The EIC reduces poverty, encourages work, and reduces participation in welfare programs.

This Research Note was written by Steve Bartolomei-Hill. Please contact him with any questions or feedback you may have.

Notes.

1. Tabulations from the March 1999 Current Population Survey. Data are reported for 1998 because it is the most recent year for which data are available.

2. The economic literature provides consistent evidence that the labor supply of working-age men is fairly insensitive to changes in wages and income. As a result of this and the fact that men already have high rates of labor force participation, most studies focus on the impact of the EIC on women.

3. Jeffrey B. Liebman, "The Impact of the Earned Income Credit on Incentives and Income Distribution," October 1997.

4. Nada Eissa and Jeffrey B. Liebman, "Labor Supply Response to the Earned Income Tax Credit," Quarterly Journal of Economics, May 1996, 112(2), pp. 605-637.

5. Stacy Dickert, Scott Hauser, and John Karl Scholz, "The Earned Income Credit and Transfer Programs: A Study of Labor Market and Program Participation," in James M. Poterba, ed., Tax Policy and the Economy, Vol. 9, MIT Press, 1995.

6. Bruce D. Meyer and Dan T. Rosenbaum, "Making Single Mothers Work: Recent Tax and Welfare Policy and its Effects," Joint Center for Poverty Research, JCPR Working Paper 152, 1999.

7. See for example, Fraker, Thomas and Robert Moffitt, "The Effect of Food Stamps on Labor Supply," The Journal of Public Economics, Volume 35, 1988, or Robert Moffitt, " Incentive Effects of the U.S. Welfare System: A Review," Journal of Economic Literature, March 1992.

8. Michael O'Connor, Katherin Ross, Michael Simon, and Tim Smeeding, "The Economic Impact of the Earned Income Tax Credit," JCPR Working Paper 139, Joint Center for Poverty Research, 1999.