I like the Earned Income Tax Credit (EITC) a lot. I also really like brownies with gobs of vanilla ice cream and hot fudge. But I don't have them for breakfast, lunch, and dinner.
The EITC--a refundable tax credit that subsidizes the wages of low-income workers--is everyone's darling. New Democrats love it. President Clinton expanded it significantly in his first budget and recently proposed another expansion. Almost every economist willing to use tax policy to help low-income families supports it. Even the right is on board. When congressional Republicans wanted to delay EITC payments to help make their budget numbers add up, candidate George W. Bush (still in compassionate mode) went after them with vigor for trying to balance the budget "on the backs of the poor." And in recent testimony around a proposed minimum wage increase, House Republicans were falling all over each other to heap praise on the EITC as a far better alternative (though none was proposing to increase it).
But is it possible, as with brownies and ice cream, to have too much of this good thing? Are there unintended effects of the EITC that might be worth considering?
The EITC is clearly raising the living standards of low-income working families. Furthermore, the fact that it is tied to work has largely insulated it from partisan attack and has even allowed for its expansion in this era when social welfare spending is so highly scrutinized. Yet the EITC is not perfect. Some of its benefits surely end up subsidizing employers, who would likely have to raise their wage offers in the absence of the program. More important (since this wage effect is probably small), relying solely on tax policy to raise the incomes of low-wage workers is a serious mistake. We also need policies that focus directly on raising pretax wages. Otherwise, we face the likelihood of a perpetually expanding low-end labor market, with jobs that fail to pay a living wage and thus require ever-increasing taxpayer subsidy.
The EITC dates to 1975. The original idea was to offset the bite of payroll taxes on low-wage workers in low-income families. Since then, the credit has been expanded considerably. There are now three different schedules: a small credit for single-person households and childless couples, a much larger credit for families with one child, and a still larger credit for families with two or more kids. And since eligibility is keyed to family income, the subsidy is quite finely targeted (rich kids with after-school jobs need not apply). As family income rises, EITC benefits initially grow, then level off, and then begin to phase out. A working parent with two children gets 40 cents in tax credit for each dollar earned up to an income level of $9,720. (These figures are for the year 2000.) The maximum annual benefit is thus $3,888. Then, starting at $12,690 in annual income for this type of family, the tax credit declines by 21 cents for each dollar earned, phasing out altogether at an annual income of $31,152. For a family with one child, the peak benefit is $2,353, and for a single person, it's $353.
The key to the program is that the tax credit is refundable. Low-income families (those in the bottom 20 percent or so of the income distribution) owe no federal income tax and thus have no liability against which to deduct a tax benefit. But since the EITC is refundable, these workers receive a check from the IRS.
In 1997 the IRS paid out $30.6 billion in EITC claims to about 18.5 million persons. That's up from $6.6 billion in 1989 and $1.3 billion in 1975 (in nominal dollars). And we've gotten a lot for the money. As the Center on Budget and Policy Priorities has shown, in 1998 the EITC was responsible for lifting nearly 5 million persons out of poverty. A memo circulated by the Council of Economic Advisers at the time of the last minimum wage increase made the important point that by itself the minimum wage would not lift a full-time working parent with two kids above the poverty line, but it would with the EITC. Moreover, as a wage subsidy, the EITC has avoided the political fate of welfare benefits. Progressives encounter little resistance when they argue that if Congress wants people to work, it needs to make work pay.
But there are two questions worth asking about this laudable program. First, is it possible that the EITC is subsidizing employers as opposed to low-wage workers? Second, does it make sense to depend so thoroughly on the tax system to "make work pay"?
Tax subsidies invariably leak. They almost always subsidize, at least in part, something that would have happened anyway, and they thus create a windfall for whomever would have paid for it. The structure of the EITC probably mitigates this problem considerably, but there are certainly some employers of low-wage workers who would have offered a higher wage in the absence of the tax credit.
Imagine a tight labor market where workers will not accept a job that produces take-home pay lower than, say, $300 per week. If employers know that the taxpayer will make up the difference through the EITC, then they can get away with a lower wage offer. Thus, the EITC partially transfers income from taxpayers to employers, whose labor costs for low-wage workers are artificially suppressed by the tax credit. The transfer can only be partial because the credit has to leave the worker better off--otherwise, she has no incentive to participate.
No one has figured out the extent to which this is occurring, but tax and labor economists generally agree that the credit is partially subsidizing employers--and that the effect is probably small. One reason is the design of the tax credit. Employers do not necessarily know who's covered by the EITC since nearly everyone elects to take it in a lump sum from the IRS, not as a paycheck benefit. Nor do employers know a job applicant's income or family structure, both of which determine the amount of the credit. So it is hard for employers to gauge how low a wage they can offer.
Still, by inducing an increase in the supply of low-wage labor, the EITC probably lowers market wage offers slightly across the board. When work is more financially attractive, more people want to work, which can lead to lower wages. And the EITC, in tandem with welfare reform, has significantly increased the supply of low-wage labor. Since 1989 the employment rate of single mothers has increased from 58 percent to 71 percent. (There is some evidence of reduced employment among those on the down slope of the subsidy schedule, where the subsidy falls as earnings rise. But on a net basis, the credit has been found to raise labor supply--as, indeed, it was meant to do--especially among the lowest-wage workers.)
These supply effects have been more than offset, however, during the recent highly touted economic recovery, by a much more important determinant of wages: a low unemployment rate. In fact, low wages did not budge until two things happened, both circa 1996: The minimum wage was raised, and the unemployment rate began its downward trek from 5.7 percent in January of 1996 to 4 percent four years later. In the earlier years of the recovery, between 1989 and 1996, the real pretax wage at the 20th percentile fell 2.4 percent; since 1996 it has risen 8.1 percent. But these wage gains should not be taken to mean that increased labor supply--stemming from the expanded EITC, welfare reform, and the higher minimum wage--hasn't had an impact on the low-wage sector and won't in the future. It's just that the demand for low-wage workers has recently grown even faster.
More troubling are the effects of relying on the EITC--as many progressives and all New Democrats do--as our sole near-term wage policy.
To be sure, it is largely due to the increase in the EITC in the first Clinton budget that the federal tax system has become more progressive. (Taxes also rose for those at the very top.) According to Congressional Budget Office tabulations, between 1989 and 1999, the average income of the bottom 40 percent of households fell by 3 percent on a pretax basis, but was unchanged in the post-tax distribution. Most of this difference is due to the EITC, which has helped not only to offset the regressive payroll tax, as originally intended, but also to make up for some of the earnings decline experienced by these families.
So what's wrong with that? Well, for one thing, we cannot depend on the tax system--or, more precisely, on the taxpayers--to keep repairing the damage caused by market outcomes. Except for the past few years, when tight job markets and the minimum wage increase did begin to lift the earnings of the lowest-paid workers, pretax wages have been falling for two decades. Even with the recent gains, the 20th percentile male wage, adjusted for inflation, is still 13 percent below its 1979 level. Low-wage women workers have not done as badly: Their 20th percentile wage in 1999 was only 1 percent below where it was in 1979, but their 10th percentile wage, which is more closely tied to the minimum wage, was 9 percent lower.
These negative trends in pretax wages have nothing to do with the tax system. As my colleague Larry Mishel likes to say, "It's not what the government's been taking out. It's what employers have failed to put in." It is market forces that have led to persistent increases in wage and income inequality since the late 1970s, and while progressive tax shifts (like the EITC expansion) have helped to slow the process, this approach cannot go on indefinitely. Even if conservative politicians would agree to such an agenda, it would be bad economic policy.
No matter how much we like the EITC, progressives mustn't punt on the pretax distribution, leaving it to the tax system to clean up the mess. The tax credit should be seen as part of a package that involves both pretax and post-tax interventions in the low-wage labor market.
The low-wage labor market is very much a part of the American economic landscape. Various silly reports that try to argue that the new jobs of the past decades are mostly good jobs are patently false (though it's equally false to argue that all the new jobs are for hamburger-flippers). We have a booming low-wage sector, driven by both the increase in demand for low-wage services and the fact that these jobs are relatively cheap to create. In The State of Working America, which I co-authored with Larry Mishel and John Schmitt, we show that the share of the work force earning low wages has actually expanded slightly since the late 1970s, growing from 24 percent in 1979 to 26 percent in 1998. (We define a low wage as any wage up to the amount needed to lift a family of four to the poverty line with full-year work, which was $8.26 an hour in 1999.) In fact, among the 10 occupations that the Bureau of Labor Statistics predicts will add the most jobs over the next 10 years, five are low-wage, including retail salespersons, cashiers, and home health aides.
Whether this strikes you as a good or bad thing depends on your perspective. For a welfare reformer or for someone who believes that all you need is a start, an expanding low-wage sector is a blessing. For someone who appreciates the generally low mobility in low-wage jobs--how infrequently they are stepping stones to better jobs--the blessing is much more mixed. However, in either case, what's clear is that most low-wage workers are not likely to earn enough to meet their basic needs for safe housing, food, reliable child care, health insurance, and transportation. That is why the vast majority of analysts who examine the economic opportunities facing low-income working families advocate the use of subsidies such as the EITC. But what led us to a situation where we have such a large low-wage labor market in need of such extensive subsidies?
You might think to blame a decline in the skill level of low-wage workers. But in fact, as Heidi Hartmann and I show in a recent paper, the average level of education in the low-wage labor market is considerably higher now than in earlier periods. We only go back to 1979 in our work, but we show that the share of workers in the low-wage sector with at least some college education has risen by 13.5 percent since then. This is, of course, simply the outcome of long-term educational upgrading of the labor market, but so what? The fact is that we now have a more skilled (at least in terms of years of education) yet lower-paid low-wage worker.
A number of factors have contributed: the well-known shift from manufacturing to services, hastened by years of trade imbalances in manufactured goods; the related decline in unions and their slow (though accelerating) inroads into low-paying sectors; the long-term decline in the real value of the minimum wage, which, even with recent increases, remains 27 percent below its late 1960s peak; the inflow of large numbers of low-skilled immigrants; the fact that throughout the 1980s and early 1990s, the monetary authorities mistakenly believed that the noninflationary unemployment rate (the so-called NAIRU) was 6 to 6.5 percent (a mistake that led to a looser labor market than was necessary and thus made low-wage jobs cheaper).
And the increase in economic inequality has reinforced these changes. In our economy, people want more and more cheap services. Those of us who work many hours want dry cleaning, takeout, videos, child care (which has no business being a low-wage job), and 24-hour markets. And as long as low-wage labor is cheap and plentiful, we'll probably keep getting them.
On the other hand, let me tell you about my shoelaces. If you run into me and I'm wearing my black shoes (I also have brown ones--the full D.C. footwear complement), take a look at my shoelaces. You will notice that the right one is a shorter version of the left, threaded through every other hole. The reason is that while I was at a recent conference in Germany, my shoelace broke. Each day, as the conference wound down around 5:00 p.m., I went out to buy new shoelaces. And each day, I confronted a bunch of closed shops. For the lack of low-end services available after work, I had the very un-American experience of not being able to buy what I wanted when I wanted it.
There simply isn't a comparable low-wage service sector in much of Europe because higher wages (both pretax and post-tax), more union coverage, and more social protections mean it costs much more to create a low-wage job there. Europeans also have regulations about when shops must close. (And they have more unemployment and less job growth, about which more in a moment.) But the point is, we have set up our economy in such a way as to encourage the creation of millions of low-wage jobs. The signs here point to the low road. The Europeans tend to block that route.
If we made low-wage jobs more expensive, we might create fewer jobs, but they would be of higher quality. If the American minimum wage were significantly increased, and then indexed to prices or productivity, it could have this effect. Our current minimum wage does not because it remains at a level that neither discourages low-wage job formation nor provides low-wage workers with enough income to meet their basic needs, and also because its value begins to erode the minute it's introduced. Back in 1968, full-time work at the minimum wage put a worker with two children about $1,300 (in 1999 dollars) above the poverty line. Today, she would be $2,700 below the line. Of course, once you add in the EITC--which didn't exist in the late 1960s--her family's income once again surpasses the poverty line, in this case by a few hundred dollars. Over the past three decades, the cost of maintaining an antipoverty wage has been shifted from employers to taxpayers.
Increasing union power in the low-wage sector would also raise low wages, and recent rumblings suggest this sector is ripe for organizing [see Harold Meyerson, "A Clean Sweep," page 24], while the labor movement has recently made it clear that it will be making an effort to organize low-wage immigrants.
Mandating employer-provided health care is another idea along the same route. And, of course, the education and training of our low-wage work force is a key to raising wages. I de-emphasize this not because I think it's less important than the other ideas noted above, but because it already has a plethora of defenders.
But does this path not guarantee the high rates of unemployment and low rates of job growth facing Europe? In fact, no. The case that Europe's labor market problems stem from its labor market protections is a very weak one. Numerous studies, including work by the ideologically middle-of-the-road Organisation of Economic Co-operation and Development, show that the pattern of unemployment in Europe is inconsistent with this hypothesis, while other studies show that macroeconomic factors, such as unnecessarily tight monetary policy, go much further in explaining the differences between our labor market outcomes and theirs.
This is not to say that raising the cost of low-wage jobs would have no effect on job creation. While I guarantee you that the low-wage job market is a far cry from the competitive job market we learned about in grad school, it's still the case that significantly increasing the pretax wage does engender the possibility of less low-wage job creation. But it just as certainly engenders the possibility of creating better jobs.
We cannot and should not regulate our labor market to the extent of some European economies, but by raising pretax wages, we could go some way toward blocking the low road.
We have a low-wage labor market problem in this country, and the EITC is an essential part of the solution. But it cannot be the sole solution. Unless we rely on other strategies for improving pretax earnings in the low-wage sector, the living standards of low-income families will be largely dependent on the tax system. And when the current tight market for low-wage labor unwinds, and real wages start to head south, we will be stuck trying to ratchet up the EITC year after year. That can only work for so long. ¤