 levels of other, mean-tested, benefits discourage other social groups, notably single women with children, from participating in the labor market. A number of OECD governments have developed schemes of in-work benefits with the express intention of encouraging low income families to participate in paid work, and the objective of reducing rising unemployment and/or rising welfare rolls. A number of studies, particularly in the United States and the United Kingdom, have attempted to evaluate the success of these policies in bringing families with children into work.
The major welfare policy of this type in the United States is the Earned Income Tax Credit (EITC), first introduced in 1975. The EITC is a credit against income tax liability paid to low income families with children (since 1994 there is a very small credit for childless taxpayers). When the credit exceeds the tax liability, the difference is refunded as a cash sum. Reforms in 1986 and 1993 made this the most generous form of in-work benefit provision to low-income households in the United States (Scholz, 1996). The EITC raises the net-of-tax (or credit) wage relative to out-of-work income and by doing so reduces the incentive to stay out of the labor force. However since the credit is reduced as the family’s earned income increases, the EITC, like all such programs, serves to flatten the budget constraint relative to the original pretax income. There should be a positive effect on the labor force participation of single parents, but, with both income and substitution effects, the impact on hours of low income families with children who are already working, cannot be predicted. The labor supply response is also more complicated in families with more than one potential wage earner.
The United States is not the only country to have such a program. The United Kingdom has, since 1971, provided money to low income working families. Originally paid as a cash payment and termed Family Income Supplement, the program was renamed Family Credit. Family Credit was paid to the woman of the family (if a married couple) above a 16 hours a week threshold as a cash sum, reduced at a rate of 70p in the £ as earnings increased (Walker and Wiseman, 1997). In 1999, the program was replaced by Working Family Tax Credit, which, although similar to Family Credit was conceptually closer to the EITC in being a tax credit against tax liability paid to the worker in the family. Other countries with similar schemes include Ireland, which has a scheme of Family Credit, Canada, which introduced a modest income tax credit in 1993 (with however a high weekly hours threshold at 30 hours a week), and several European countries that offer mixtures of deductions for work-related expenses, child-care costs and other general forms of tax credits (Whitehouse, 1996).
There is an important trade-off in tax policies designed to help low income working families. At one extreme, intervention can be targeted at the very lowest income families with either generous initial levels of credit and/or sharp “tapers” (phase-outs): that is, the rate at which the credit is withdrawn as the earned income increases. This is both more equitable and targets the program efficiently. But it produces a substantial disincentive to increase hours conditional on participation (the “poverty trap”). Alternatively, if the program is less generous in the size of the credit and phases-out the credit at a reduced (slower) rate, it improves the incentives to work more hours conditional on participation, but reduces the positive effect on participation. Moreover, reducing the rate at which the benefit is phased-out incorporates more, relatively higher earners, into the program. For these families, access to the credit acts as a disincentive to work, since the income and substitution effects both induce lower hours of labor supply (Moffitt, 1992). There is no clear-cut answer to program design, and governments have tended to change the generosity and phase-outs frequently. This temporal variation permits researchers to estimate program effects.
How should we think about the impact of these tax and welfare policies on participation and hours supplied? In the EITC, there are three segments: a “phase-in” segment where, as the level of earnings is higher, the credit is added to earnings at a rate of 40 percent (in 1996) for every $ of earnings. There is then an earnings interval where the family retains the maximum credit. The credit is then “phased-out,” at a rate of 21.1 percent (in 1996) for every $, so that, ultimately the family is back on the pre-credit budget constraint. The United Kingdom’s Family Working Tax Credit is very similar, except that there is no “phase-in” segment; instead there is a minimum hours constraint (16 hours a week) and a further increase in the rate of the credit at 30 hours a week.
There are further complications. First, the credit may affect the wage level, if employers use the existence of the credit as a means of reducing pretax pay. Second, the actual budget constraint is complicated by the presence of other income-tested benefits such as housing benefit, and, in the United States, AFDC and food stamps. Third, there is interstate variation in the local generosity of EITC in the United States (Neumark and Wascher, 2000). Finally, the response must be considered as a family supply response. For a single parent, estimation of the effect is more predictable, as in the work of Eissa and Liebman (1996) and Meyer and Rosenbaum (1999). For families with more than one actual or potential worker, the increase in hours or participation of one member may be offset by reduced labor supply of another member, if the family can thereby maximize its utility over income (combining earned income and the tax credit) and leisure. This is the scenario explored by Eissa and Hoynes (1998), and Blundell and others (2000) for the United Kingdom.
Figure 2, Panels A and B illustrate recent policy changes for the U.S. and the United Kingdom respectively. In each case, there is a regime I, where we might expect the change to induce greater participation but uncertain effects on labor supply of those already participating; a regime II where the taper has been extended to a level of earnings that were previously above the “breakeven” point at which the EITC/WFTC was fully phased out, and where the labor supply response should be unequivocably a reduction in hours; and regime III where the worker is unaffected.
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Table 6 describes the main methods and findings used by the various authors to analyze the impact of EITC and other in-work benefits on labor supply. Despite a variety of data sources, time periods and estimation methods, the studies seem to contain a degree of unanimity. First, the Earned Income Tax Credit increases the labor force participation of single parents, relative to other groups, as modeled by improvements in its generosity over time. Second, EITC changes have an equivocal impact on the working hours of single parents. This not surprising, given the impact on the budget constraint of EITC reforms (Figure 2, Panel A). Third, the EITC increases labor supply of primary wage earners among low income married couples with children, but this is almost wholly offset by a reduction in labor supply or participation of the secondary earner. Fourth, the levels and withdrawal structures of other welfare benefits generate labor supply responses that are predictable from theory.
Impact of Earned Income Tax Credit and Other Welfare Benefits on Labor Supply: Results of Selected Studies
Impact of Earned Income Tax Credit and Other Welfare Benefits on Labor Supply: Results of Selected Studies
Impact of Earned Income Tax Credit and Other Welfare Benefits on Labor Supply: Results of Selected Studies
These results are confirmed by the studies of the impact of Family Credit, and simulations of the transition to the Family Working Tax Credit, in the United Kingdom. The implied reform arising from the shift from Family Credit is depicted in Figure 2, panel B. Blundell and others (2000) use data from the Family Resources Survey and tax micro simulation models to simulate the reform. Labor supply responses are estimated from a discrete choice structural model of family labor supply. Their findings are that, with 100 percent take-up, the participation rate of single parents increases by 2.2 percent and the average hours of workers by 0.2 percent from the switch from Family Credit to FWTC. For married men, there is a small increase in participation (+0.1 percent) and for married women with working partners, a decline (−0.6 percent). For women married to unemployed men, there is a gain in participation (+0.5 percent) and also in hours. These results are in line with those of the U.S. studies of changes in the generosity of EITC.3
Gregg, Johnson and Reed (1999) estimate a reduced-form model of individual transitions into work for the United Kingdom. The probability of entering work is determined by the predicted difference between incomes in and out of work and a variety of controls, using the Labour Force Survey. Then tax-benefit simulation based on the Family Resources Survey is used to simulate income gains from various policy experiments, including the replacement of Family Credit by WFTC. The impact of these policy changes on entry to work (participation) can then be calibrated using the reduced form entry to work model. The overall impact of this particular reform (FC to FWTC) is to increase the work entry probability by 0.26 percent for men and 0.09 percent for women. There are no effects for singles without children, a negative impact on married women with working partners (−0.4 percent), but significant positive effects for married men (+0.6 percent), for lone mothers (+1.1 percent) and for married women with partners who are not working (+0.5 percent). Again, this is exactly what theory, and the comparison with