The Earned Income Tax Credit

1
The Earned Income Tax Credit

• Jennifer Karavanic
• April 15, 2004
• University of Oklahoma

2
Facts about the EITC

• Benefits only individuals who are in the labor
  force.
• Goal is to increase labor force participation.
• For some individuals, the going wage is less than
  the costs they incur from working.
• These individuals may therefore choose not to
  work (or to work less).
• The EITC subsidizes wages to so that the benefit
  from working is increased.
• This creates an incentive for these individuals
  to work.
• Source Married Couples, work and the EITC.
  www.jcpr.org/98summer/article2.html/

3
EITC Statistics

• Largest Cash transfer program for lower-income
  families with children among the most expensive
  federal transfer programs.
• Amount is 3,656 for 2 children, 2210 for one
  child.
• Individuals with children making less than
  29,666/ year receive a credit on their income
  tax return.
• Individuals without children must make less than
  11,230/year.
• Refundable tax credit if credit exceeds amount
  of taxes paid out, the full amount of the credit
  is still dispersed, so individuals can get more
  back than they paid out.
• Source EITC Overview. Internal Revenue
  Service, U.S. Dept. of the Treasury.
  http//www.irs.gov/individuals/article/0,,id9640
  6,00.html/

4
Policy Goals

• Three reasons for the EITC
• Equity
• Negative externalities of poverty
• Maximizing social welfare

5
Policy Goals Equity

• Equity
• Equity is a policy goal for our society.
• Many people believe more equal income
  distribution is one way to achieve equity.
• The EITC is a progressive tax
• The poorer the individual, the more he or she
  benefits income distribution is more equal.
• Sources Nonparametric Labor Supply Estimation
  under the Earned Income Tax Credit and Welfare
  Programs. Ximing Wu, 2002. UC Berkeley.
• Holcomb, Randall. Public Finance. 1999.

6
Market Failure

• Charitable giving is a collective consumption
  good
• There is an incentive to free-ride.
• Assistance to poor people is under-provided by
  the market.
• The government must intervene to correct this
  market failure.

7
Effects on Equity

• By allowing individuals to get more back than
  what they paid in, the EITC redistributes income
  from the rich to the poor, with a special focus
  on children.
• EITC eases the burden on working families who are
  struggling to make ends meet and provide for the
  basic necessities of their children.
• Source Facts about the Earned Income Credit.
  Center on Budget and Policy Priorities.
  http//www.cbpp.org/eic2004/eic04-factbook.pdf

8
Policy Goals Externalities of Poverty

• Negative Externalities of Poverty
• Poverty may increase crime.
• Individuals affected by these negative results
  may be willing to pay to reduce poverty.
• This willingness to pay is not reflected in the
  market wage.

9
Mrozeks framework
Labor Market
Wage()
MSC
DWL
W WM
Marginal External Cost
MSB
MPB
Q of Labor
LM L
10
Explanation of Diagram

• The wage is the MPB that workers receive from
  supplying an additional unit (hour) of labor.
• MPB is less than MSB because there is a marginal
  external benefit that is not captured by the
  market.
• Because of this, the market wage, WM, is lower
  than the most efficient wage, W.
• Because WM is less than W, labor is
  undersupplied, so that LM is less than L.
• Size of the inefficiency (DWL) ½ MEC (L -
  LM)

11
Effects on Externalities

• Economic Efficiency
• Welfare policies like AFDC created a disincentive
  to work, distorting labor supply but by giving
  the EITC only to families who are working, this
  distortion is reduced.
• An incentive to enter the labor force is created
  EITC rewards people who find and keep a job by
  adding to the wages they earn. ---Center for
  Budget
• and Policy Priorities.
• This incentive may reduce the externalities of
  poverty without distorting labor supply as much
  as policies like AFDC did.

12
Results of the EITC
Wage()
Labor Market
MSC
It should be noted that, in reality, the
effects of the EITC are much more complex. The
new segment of the MPB curve is non-linear, and
there are other more complex changes as well.
For purposes of illustrating basic course
concepts, the entire project analysis is
simplified significantly.
W1
WEITC
Amt. of subsidy (EITC) at this wage level
WM
Wb
Wa
MPB EITC
MPB
QM
QEITC
Q of Labor
13
Explanation of Diagram

• The EITC is a wage subsidy.
• At any wage below W1, the worker receives the
  EITC.
• The lower the wage, the greater the amount of
  EITC the worker receives for example, at Wa,
  the worker will receive a subsidy amount of (Wb-
  Wa) in addition to their wage Wa.
• The effect of the EITC is to create a new
  equilibrium wage (WEITC) and quantity of labor
  (QEITC).
• This subsidy ensures that the benefit workers
  receive from working is more equal to the benefit
  society receives from having them work.
• Subsidizing the wage is reflected by the shift in
  MB.

14
Policy Goals Maximizing Social Welfare

• Increasing the overall welfare of society may be
  a policy goal.
• Even if a few people are made worse off, if
  society overall benefits, it may be worthwhile.
• If the gains to the winners from a particular
  policy exceed the losses to the losers, the
  losers can be compensated and society is made
  better off.
• Source Holcomb, Randall. Public Finance. 1999.

15
Policy Goals Maximizing Social Welfare

• One way to measure (or at least attempt to
  measure) the welfare of society is through a
  social welfare function.
• In theory, this function incorporates the
  preferences of all individuals.
• A utility possibilities frontier (UPF) shows the
  utility that one person can have given the
  utility of another.
• The marginal utility that a poor person derives
  from an additional unit of income may be greater
  than the MU a rich person gains, so
  redistributing income may increase overall social
  welfare.
• Suppose 3000 is taken from a richer taxpayer to
  give to a working poor person
• Source Holcome, Randall. Public Finance. 1999.

16
The Social Welfare Function
Utility of Rich Person
Again, an accurate analysis would be much more
complex. The shapes of the curves will affect
the respective increases and decreases in
utility. Also, a more accurate analysis would
account for things like the excess burden that is
created by taxation, and administrative costs
(fairly low for the EITC).
Utility lost by not having 3000
U2
U1
UPF
Utility of Poor Person
Utility gained by having 3000
17
Explanation of Diagram

• The 3000 dollars represents the amount of the
  EITC that is redistributed from the rich to the
  poor.
• Clearly, there is more utility gained by the poor
  individual than is lost by the rich.
• By redistributing the money to the poor person,
  society moves from U1 to U2, a higher level of
  utility.

18
Conclusion

• The EITC encourages labor force participation by
  subsidizing the wage.
• Because there are winners (the working poor) and
  losers (wealthier taxpayers) that result from it,
  the EITC is not a Pareto-optimal policy.
• The EITC may increase social welfare.
• The EITC redistributes income from the rich to
  the working poor.
• This can be a way to increase equality and
  equity.
• This reduces poverty and the externalities
  associated with it.
• The EITC is a beneficial policy that may increase
  equity without giving up too much efficiency.