Why the Earned Income Tax Credit Cannot Become the Silver Bullet of Poverty Reduction

The Great Recession and this stagnant recovery have shed some light on the issues of income inequality and poverty reduction. One particular debate that has recently arisen is the "Earned Income Tax Credit versus Minimum Wage." I started wondering about this after reading commentary from the Center on Budget and Policy Priorities (CBPP) regarding the Earned Income Tax Credit (EITC). Is one policy preferable over the other? Should we be implementing both, or for that matter, neither one? As for minimum wage, it should be no surprise that I do not consider it to be wise public policy. But what about the earned income tax credit? If Milton Friedman, one of the greatest libertarian economists in history, advocated for the earned income tax credit in the form of a negative income tax, shouldn't I find it to be sound policy? As much respect as I have for Milton Friedman, I have a mind of my own where I would like to take a look at the evidence and come to my own conclusions.

What was initially a small tax subsidy back during the EITC's inception in 1975 has transformed into a poverty relief program. The earned income tax credit acts as a form of a negative income tax that is supposed to assist low-income households with poverty relief. For individuals that make below a certain amount, rather than have to pay on the income tax, ones receives money in the form of a tax credit. Looking at the chart below (courtesy of the Tax Policy Center), there are three phases of the EITC. The first is the in-phase, which means that each added dollar of earned income receives a matching credit. The second level is the plateau, in which the additional income does not affect the size of the credit. The final phase is the out-phase, in which an increase in income translates to a smaller EITC. The credit continues to decline during the out-phase until one's income reaches the break-even point, which is when an individual no longer qualifies for the EITC.

Determining the net benefit can be tricky with something like the EITC. The first obvious cost is the decrease in tax revenue. The funds have to come from somewhere, and in this case, it would be the revenue collected from income tax. Furthermore, a Princeton University study (Rothstein, 2008) suggests that the EITC depreciates wages of low-skilled workers while harming non-EITC low-skilled workers, which is to say there is a distinct possibility that the EITC is actually trapping low-skilled workers in poverty. The Federal Reserve Bank of Chicago shows that when individuals receive their payments, they purchase healthier food (McGranahan and Schanzenbach, 2013). The downside to this benefit is that the EITC is one lump-sum, as opposed to spread out throughout the year, which means that the purchase of healthier food is more erratic because of mismanagement of money.

The EITC also comes with its benefits. The primary benefit of the EITC is that in increases employment (Meyer, 2010, p. 164-167), and the predominant research in the past 15 years illustrates that. Research also shows that it has a predominant, positive effect on single parents, which is great because single parenthood is shown to be the single largest factor in income inequality. The reason why the EITC incentivizes work is because one has to work to receive the tax credit. In theory, the phase-out of the EITC is supposed to discourage individuals to work because the EITC decreases with increased income. However, due to an inability of workers to freely schedule their hours and an imperfect perception of marginal tax rates, the concerns around phase-out are merely theoretical (Meyer, p. 168). Moreover, the EITC is shown to improve upon infant health (Hoynes et al, 2012), not to mention give a boost to K-12 scholastic achievement. The Congressional Budget Office also shows how the EITC can positively affect Social Security retirement benefits, which also erroneously assumes that Social Security is indefinitely solvent.

Furthermore, the EITC is a better tool for fighting poverty than the minimum wage, which is something economist David Neumark illustrates. Since most minimum wage earners are not in poverty, the EITC does a better job at targeting poorer households because the EITC is based on family income, and not the wage rate. The costs of minimum wage are squarely put on the employer, whereas the tax burden of the EITC is diffusely spread throughout the income tax base. More diffuse costs means that it is easier for employers to higher low-skilled labor than it would be when one implements a higher minimum wage. The EITC primarily focuses on households with children, which leaves single, childless individuals out to dry. The Brookings Institution just published a paper (Kneebone and Williams, 2014) showing how an expansion of the program would further aid childless workers and could rectify the situation.

For those of us who would like to shrink the size of government in a more incremental fashion, the EITC has some allure. Replacing the EITC or a basic income grant with the current welfare system would mean less government intervention. I understand that a direct cash transfer is still the government depriving individuals of a certain percent of their income, but at least with a direct cash transfer, the government doesn't tell the recipients of the cash transfer what they can or cannot spend the money, such as is observed in programs like the Supplemental Nutritional Assistance Program, aka the food stamp program. The other advantage of replacing the EITC with a welfare system is that it would reduce welfare caseloads (Meyer, p. 169), reduce administrative effort, and eliminate duplicative work, which would save taxpayer dollars. In theory, the EITC is supposed to be more clear-cut and targeted. However, the current implementation of the EITC is most bothersome.

The Mercatus Center points out that the government program with the highest improper payment rate is the EITC, which comes in at a whopping 22.7%. The high error rate is something both the Department of Treasury and the Government Accountability Office confirm. This might have something to do with the complexity of the EITC, which not only makes it difficult for qualifying recipients to navigate the application process, but also makes it difficult to enforce and detect fraud.

Until the improper payment rate is well in the realm of single digits, I could not possibly endorse that the EITC replace the current welfare system. Much like with the rest of the tax code, simplification of the EITC is a necessary first step so that a) low-income households are able to file for the credit without significant hassle, and b) payments are better applied. As previously mentioned, increasing the credit towards childless households could help with the perception that the government is punishing individuals for choosing to be single or childless. The EITC for those with children can be combined with other tax breaks to combine it into a single family tax credit.

Even with reform, I'm still skeptical. Much like the CBPP, I have my doubts about the EITC's overall efficacy, but for different reasons. I'm still worried about it being implemented without a high improper payment rate. I'm also worried about the political unfeasibility of removing the current welfare system because many of the programs are too popular to gut. I also think that a silver bullet policy is as rare as common courtesy these days. Although there will inevitably be other policies to help increase employment and reduce poverty, I foresee the EITC playing a more integral role in the "War on Poverty."


10-18-2015 Addendum: This policy brief from the Cato Institute highlights the work disincentives, the fraud, and costs to the taxpayer that might not make the EITC so alluring.