The Low-Wage Labor Market: Challenges and Opportunities for Economic Self-Sufficiency. Job Creation for Low-Wage Workers: An Assessment of Public Service Jobs, Tax Credits, and Empowerment Zones. Tax Incentive Programs

02/03/2004

In this section the literature on the job creation potential of tax credits is reviewed. As noted above, the focus of the paper is on direct job creation programs, so the review presented here is brief.

Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is a wage subsidy program that began modestly in 1975, but has increased in recent years to be the largest cash­transfer program for nonelderly low­income families.(27)  The program seeks to encourage labor force participation by "making work pay" for potential low­wage workers. The program has increased in generosity since 1975, with the maximum benefit increasing from $400 in 1975 to $3,656 in 1997 for a family with two children. The size of the benefit varies by the number of children, but the benefits are quite small for families without children. Attention in this paper is restricted to EITC's job creation potential, but the program also plays a significant role in reducing poverty.

The structure of the EITC is straightforward. In 1997, for a family with two children, the first $9,140 of earnings entitles the family to a refundable tax credit of 40 percent of earnings for a maximum credit of $3,656. The credit remains at $3,656 until earnings reach $11,950. The credit is then reduced by 21 percent of all earnings above $11,950 until the credit is phased out entirely at earnings of $29,290.

The EITC has no direct effect on the number of jobs available in the economy. Instead, it can create employment by inducing individuals to work who would have remained out of the labor force in the absence of the EITC. For a single­parent family, the labor supply effects of the EITC vary depending on how much the person would have earned without the EITC. For individuals out of the labor force or in the phase-in range (where the wage rate is increased), the higher post­EITC wage rate provides an incentive to work, but the extra income generated by the credit could reduce hours of work; thus, the overall effect of the credit for those with very low earnings is ambiguous. For individuals who would receive the maximum credit, there is no wage increase for additional hours worked and economic theory predicts that the extra income from the tax credit would lead to a reduction in hours. For individuals in the phase­out range, where the credit is reduced for each dollar earned, the EITC actually reduces the after­tax wage even though the family still receives some income from the credit; for families in this range, economic theory predicts a decrease in labor supply. Overall, for a single­parent family, economic theory suggests that some individuals would enter the labor market, but some of those already working would be expected to reduce their hours. The situation is more complex for two­parent families, and it is difficult to make predictions on how labor supply will be affected by the EITC.

Caution must be exercised in interpreting the findings. Evaluations of the EITC require strong assumptions about what factors lead to changes in labor market behavior over an extended period where the EITC changes. Studies generally make use of families without children as a "control group" to purge time trends of factors that affect all potential workers. In addition, comparing findings across studies is difficult because the studies vary in terms of the time period studied, the aspects of the EITC studied, and the estimating methods. Nonetheless, many of the recent studies show a consistent pattern of EITC effects.

A study which conducted simulations to estimate the impact of the 1993 round of EITC increases on labor supply concluded that the 1993 expansion of the EITC would lead to an increase of 3.3 percentage points in the proportion of single parents working. For married couples, they projected that primary earners would increase labor supply by .7 percentage points and that secondary earners would decrease their labor supply, but they could not accurately project by how much.(28) 

Another study examined the effects of the 1987 EITC expansion of the EITC on the labor supply of single women with children in 1991.(29)  The authors used several years of Current Population Survey (CPS) data before and after the change and data on single women without children as a control group to eliminate other factors that may have affected labor supply. They concluded that the 1987 changes in the EITC increased labor force participation for single women with children by 2.8 percentage points, from 73.0 to 75.8 percent. The authors also analyzed the impact of the 1987 changes on hours worked for those already in the labor force and, contrary to what theory predicts, they found no impact on hours worked by single women with children.

An evaluation of the impact of the EITC on married couples found that because married couples tend to have more income than single­parent families, 70 percent of the EITC recipients have pre­tax income that puts them in the range where the EITC is at its maximum or is declining and the incentive is for less work.(30)  The researchers discuss the complexities involved in modeling the labor force behavior of two­adult units, and they analyze the data several ways to account for the difficulties. In one analysis, they find that the EITC increases labor force participation by .9 percentage points for men and decreases participation by 3.1 points for women in married couples with children. They also perform some simulations, and in those analyses they find smaller effects — an increase of .1 percentage points for men and a decrease of .5 points for women.

A complex study examined the impact of EITC, along with changes in the Aid to Families with Dependent Children (AFDC) program, Medicaid, child care, and job training on the labor supply of single mothers over the 1984 to 1996 period and the 1992 to 1996 period.(31)  They conclude that the EITC accounts for 52 percent of the increase in weekly labor force participation between 1984 and 1996 and 70 percent of the increase in annual labor force participation over this period. To put these figures in perspective, the labor force participation rate for single mothers increased by 8 percentage points between 1984 and 1996, from 73 to 81 percent. Since the EITC was responsible for 70 percent of this increase, the EITC is estimated to have increased the labor force participation rate by 5.6 percentage points over this period.

In summary, the EITC appears to have been effective in increasing labor market participation among single mothers. In addition to increasing labor force participation among the poor, the EITC helps provide income to poor children, and the program is extremely popular across the political spectrum.(32)  The major problems with the EITC are that it provides work disincentives to married couples and to some single parents. In addition, the refundable nature of the credit creates potential for fraud.(33)  Finally, it is important to recognize that unlike public service jobs, EITC cannot create new jobs. Thus, it is not an appropriate tool to use if the underlying problem is too little aggregate demand.