How to Improve the Earned Income Tax Credit

This year is the 40th anniversary of the passage of the Earned Income Tax Credit (EITC). Signed into law by President Ford in 1975, the EITC was originally intended to give temporary tax relief to low-income workers to offset food and energy prices. The credit was made into a permanent program in 1978, and has been expanded several times since.

According to a 2014 report by the Brookings Institution and the Urban Institute, the EITC has been responsible for lifting millions of Americans out of poverty. In 2012 alone, the tax credit lifted the incomes of 6.5 million Americans above the official poverty measure. The report credits the EITC expansions that took place between 1984 and 1996 for more than half of the increase in employment among single mothers during that period.

The findings of the report are backed up by a new National Bureau of Economic Research (NBER) working paper by Hilary W. Hoynes (University of California, Berkeley) and Ankur J. Patel (Department of the Treasury). Their research demonstrates that a $1,000 increase in the EITC leads to a 7.3 percent increase in employment for families below the poverty line. The same increase leads to a 9.4 percent reduction in the share of families below 100 percent poverty. The EITC rewards poor families—especially single mothers—for finding work, which increases their employment rate. The program raises their income—directly from the EITC, and indirectly from increased employment.

Despite its empirical success, the EITC is far from a perfect program. One of the leading criticisms of the tax credit is that the eligibility requirements are too complex and ambiguous. The requirements lead to fraud—those who do not deserve the benefits receive them—and create confusion for those who do deserve them. Eligibility is determined by income, family size, filing status, and a few other criteria. For example, if a family files “married filing separately,” they are ineligible for the credit.

If eligibility is acquired, the amount a family can receive from the EITC varies based on circumstances. The most telling factor is the number of children in the family. A family with zero children receives up to $464, while a family with three children receives up to $5,751, a difference of over $900 per person. Single mothers benefit the most, which discourages marriage. The EITC should be revamped, as suggested by Manhattan Institute senior fellow Scott Winship, to benefit all qualified workers equally, to promote planned and marital childbearing.

Even the positive effects of the EITC are limited by regulations, such as the minimum wage. Recipients of the tax credit must be employed to receive the benefit, but minimum wage laws may prevent them from being hired in the first place. Using the EITC or a similar program to subsidize wages is preferable to minimum wage laws because the tax credit does not ban low-skilled workers from entering the job market. Instead of forcing businesses to pay employees more than they are worth, subsidizing wages attempts to provide a living wage without an increase in unemployment. In fact, the EITC encourages employment, making society more productive overall.

Free-market economists such as Milton Friedman supported the EITC, or something similar to it. Friedman’s version was called the Negative Income Tax (NIT), which guaranteed income for everyone, whether they had earned income or not. The NIT would provide a certain percentage of the living wage, depending on the income of the recipient. For example, with a rate of 50 percent, workers receive half of the difference between their income and the poverty line. If they make $10,000, and the poverty line is $15,000, they receive a wage subsidy of $2,500.

Critics of wage subsidies such as the NIT say that they will incentivize employers to push wages down, since the government will make up for it. This concern may be valid for the most low-skilled workers, but in most cases, employers pay their workers what they are worth. If an employer is willing to offer a higher wage, workers will change jobs. As people’s skills improve, their labor is worth more, and their base wage will rise, with or without a wage subsidy.

Some form of guaranteed basic income is preferable to means-tested welfare programs for several reasons. First, it encourages employment. The EITC does this directly, since the beneficiary must work to receive the credit. A wage subsidy such as the NIT also encourages employment, since workers only lose part of their subsidy by increasing their pre-tax income. Second, the implementation of a basic income program is much less costly than welfare programs. Far less bureaucracy is required to administer to a cash transfer than means-tested programs. Third, a tax credit or wage subsidy allows families to allocate resources more efficiently, rather than the government wasting money on programs families do not want or need.

The tax plans of presidential candidates and Senators Marco Rubio (R-FL) and Rand Paul (R-KY) both support the tax credit. They recognize the importance of the EITC to both supplement the incomes of and encourage employment for low-income families. Both plans not only cut tax rates, but also retain the EITC and the Child Tax Credit, further helping low-income families.

The Earned Income Tax Credit has been successful, but could be improved. The eligibility requirements should be reformed to reduce fraud, or simply overhauled and made universal. A system such as the Negative Income Tax could be a suitable replacement, but it should go hand-in-hand with reforming our welfare and entitlement programs.