Paul L. Caron
Dean





Thursday, February 18, 2021

The Earned Income Tax Credit: Targeting The Poor But Crowding Out Wealth

Maren Froemel (Bank of England) & Charles Gottlieb (University of St. Gallen; Google Scholar), The Earned Income Tax Credit: Targeting the Poor but Crowding out Wealth:

This paper quantifies the individual, aggregate and welfare effects of the Earned Income Tax Credit (EITC) in the United States. In particular, we analyse the labour supply and saving responses to changes in tax credit generosity and their implications for prices and welfare. Our results show that the EITC is a subsidy on labour income and a tax on savings. An increase in EITC generosity raises labour force participation, reduces savings for many and provides insurance to working poor households. The EITC reduces earnings inequality but increases the skill premium and wealth inequality. A 10% increase in tax credit generosity increases welfare by 0.31% and benefits the majority of the population.

Conclusion
This paper bridges the empirical literature on the EITC and the literature on taxation with household heterogeneity and conducts a positive analysis of the EITC. While the research on tax credit is dense, we know little about its effect on individuals’ savings decision, and on its redistributive impact, in particular towards individuals that are not directly affected by tax credit policies. We quantify the labor supply, wage and savings responses of a once and for all EITC extension across stationary equilibria and on the transition path.

Our results show that the EITC successfully redistributes income towards the poor working population without distorting incentives to work. However, the tax credit reduces the incentive to save for a large part of the targeted population. Both effects of the tax credit have non trivial distributional effects: the increase in labor supply contributes to an increase of the skill premium, and the crowding out of savings leads to an increase in wealth inequality. Our analysis is more nuanced and shows that the EITC might contribute to a widening the wage gap, but that for the eligible population, these adverse wage effects are dominated by the direct transfer effect of tax credits. As for the population that is only indirectly affected via wage effects, we show that when we take into account transitional dynamics, a large part of the wage drop is compensated by a short run increase in wages and higher consumption in the long term due to the depletion of savings along the transition path. Our welfare analysis shows that a majority of the population benefits from tax credit policies, except for the high income households within the low skilled population. Once we take into account transitional dynamics, these welfare losses disappear.

we take into account transitional dynamics, a large part of the wage drop is compensated by a short run increase in wages and higher consumption in the long term due to the depletion of savings along the transition path. Our welfare analysis shows that a majority of the population benefits from tax credit policies, except for the high income households within the low skilled population. Once we take into account transitional dynamics, these welfare losses disappear.

https://taxprof.typepad.com/taxprof_blog/2021/02/the-earned-income-tax-credit-targeting-the-poor-but-crowding-out-wealth.html

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