Economy & Business

How to Fix the Earned-Income Tax Credit

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There is a great deal of support for the earned-income tax credit (EITC) among conservative policy thinkers, yet there is also a fair bit of skepticism among conservative lawmakers and activists. Is it possible to bridge this divide? Conservative fans of the EITC like it because it encourages labor-force participation. Conservative critics dislike it for a variety of reasons, ranging from a mostly false suspicion that it subsidizes low-wage employers rather than low-wage employees to a belief that because the EITC is refundable, it is essentially a handout that breeds dependency.

Do the critics have a point? Recently, Britain’s Conservative government has moved to cut tax credits that supplement the earnings of the working poor, like our EITC, and instead they’ve embraced steep increases in Britain’s national minimum wage. One can imagine at least some American conservatives wanting to move in the same direction. To the extent conservatives want to restrain federal spending, there is a certain logic to forcing employers to pay higher hourly wages to their lowest-paid employees while zeroing out wage subsidies. Wage subsidies are paid for by all taxpayers, and they swell the size of government. Wages are paid by employers, who pass on the cost of higher wages to their customers.

The trouble, of course, is that above any given wage threshold, there will be some number of workers who are no longer employable. Moreover, the higher consumer prices that flow from higher wages in service sector jobs will be borne by poor customers as well as affluent ones. And while wage subsidies like the EITC are targeted to individuals in low-income households, minimum-wage regulations apply to all comers. Indeed, some believe that higher wage floors can lead to a shift in the composition of the employed population: people with limited skills get priced out of the labor force, while people with higher skill levels enter the labor force or choose to work longer hours.

The case for the EITC is, in my view at least, pretty clear. As Hilary W. Hoynes and Ankur J. Patel observe in a new working paper, the EITC doesn’t just raise incomes by giving workers in low-income households a cash transfer. It also does so by drawing these workers into formal employment and increasing their market incomes. Once an individual is employed, she is in a better position to gain work experience and the skills that come with it, which will over time put her in a position to command higher wages.

Why is this so important? The Census Bureau found that for adults who work full-time, year-round, the SPM poverty rate (a relatively new poverty measure that offers a more realistic assessment of the resources available to households than the official poverty rate) was 5.4 percent in 2013. For those who worked less than full-time, year-round, the SPM poverty rate shot up to 19.6 percent. And for those who worked less than one week, the SPM poverty rate was a staggering 32.2 percent. Increasing work hours is an extremely effective tool for fighting poverty, and no one really doubts that the EITC tends to increase work hours. Far from breeding dependency, the EITC puts families on the path to economic independence. Granted, many low-wage workers will draw EITC benefits for years. But this is due to larger forces that are suppressing wage growth among less-skilled workers, not because the EITC is somehow sapping the work ethic of the working poor.

Streamlining the EITC might be the best way to unite its fans and its critics on the right.

This isn’t to say that the EITC is flawless. The EITC is enormously complex, with different workers eligible for different amounts depending on how much they earn and on the composition of their families. Childless workers get much less than workers with children, two low-wage workers might lose some of their EITC benefits if they get married, and so on. Most beneficiaries have to hire tax preparers to navigate the EITC’s complexity. The EITC’s critics often point to the program’s high rate of improper payments. What they often fail to appreciate is that improper payments are an almost inevitable byproduct of the program’s complexity. The flipside of the improper payment problem is that many people who are eligible for the EITC don’t actually access it, because they’re simply not aware that they are eligible.

Streamlining the EITC might be the best way to unite its fans and its critics on the right. One of the perennial debates over the EITC is whether the incentive effect of its phase-in outweighs the disincentive effect of its phase-out. At very low levels of income, the EITC makes work more attractive. But as household income passes a certain threshold, the value of the EITC is steadily reduced, and this creates an implicit marginal tax that might actually reduce work effort. Some believe that this latter effect is fairly unimportant, and the main thing that matters is whether an individual is in the workforce or not. Others think that this effect is so important that we ought to replace the EITC. If nothing else, the sliding-scale nature of the EITC certainly makes it more difficult for low-income households to navigate.

The Bipartisan Policy Center (BPC) has offered a novel approach to wage subsidies. To deal with the disincentive created by the EITC phase-out, the BPC proposes replacing the EITC outright with a refundable earnings credit equal to 17.5 percent of the first $20,000 in earnings that would apply to each worker, with or without children, regardless of filing status. This reform would do away with the EITC’s role in the marriage penalty and it would remove the disincentive to earn more money. And while the EITC varies by the number of children in the household, the BPC has instead augmented the refundable per-child tax credit. Overall, the BPC reform is somewhat less generous to the lowest-income households while being somewhat more generous as households climb from low- to lower-middle-income status. I can see a case for making the BPC’s refundable earnings credit somewhat more generous. But the BPC deserves praise for crafting a new approach to wage subsidies that addresses some of the EITC’s biggest flaws.

— Reihan Salam is executive editor of National Review.


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