Should we subsidize work? Welfare reform, the earned income tax credit and optimal transfers

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This paper was published online in International Tax and Public Finance, Policy Watch category, September 29, 2006 by Springer Publishing. Used with permission.

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1 Introduction

This paper examines factors that should be considered in deciding whether income transfer programs should subsidize work effort of beneficiaries. If the goal of programs were simply to raise incomes of the poor, the most direct way to do so would be to pay benefits that vary inversely with economic status. In contrast, by their design, work subsidies, within a certain range, provide larger transfers to some poor families as their incomes increase. This paper briefly reviews the theory of optimal transfers and discusses conditions in which subsidies to work may be economically efficient. We then review evidence on the effects of subsidizing work effort of low-income families in the United States on work effort, incomes of the poor, and other considerations, including long-term human capital development of beneficiaries and the well-being of their children.

Kaplow (2006) reviews the literature on optimal transfers in detail and concludes that there is a substantial gap between the existing literature on optimal transfers and the design of transfer programs. Although the optimal transfer literature is highly abstract and its results are sensitive to various assumptions, much of the analysis that Kaplow reviews supports high marginal tax rates on the working poor rather than earnings subsidies. In contrast, the thrust of reforms in the United States in recent years, both welfare reform and the expansion of the earned income credit, has been to reduce work disincentives and, in some income ranges for some people, to provide a net positive inducement to work. As Kaplow notes, one possible rationale for this policy shift is a perception that there are large external benefits to work that the optimal tax literature does not capture. This paper explores in more detail what is known about these external benefits.

1.1 The theory of optimal transfers

In standard neo-classical economic theory, the wellbeing or utility of individual economic agents depends on the quantities of goods and services consumed and available non-work time in different time periods. (Non-work time includes all time not spent in working for pay, including "home production" activities, such as cooking and childcare.) Individuals allocate their time between work and non-work time and allocate their income from work among consumption goods in the present and future so as to maximize their utility. Under certain conditions (no externalities in production and consumption, perfect competition, and no distorting taxes), agents' maximizing behavior leads to efficient outcomes in the sense that it is not possible to improve the welfare of one individual without reducing the welfare of someone else.

Free markets do not necessarily produce a socially attractive income distribution, however, so there is a role in the neo-classical system for income transfers from better off people (those with larger endowments of skills or inherited wealth) to those less fortunate. Re-distribution of resources necessarily entails some loss of economic efficiency because it is not feasible to impose taxes and transfers based on perfect measures of people's endowments. Instead, measures of economic wellbeing must be based on observed market outcomes such as income or consumption that do not consider non-work time. But income taxes and consumption taxes distort choices between market work and leisure (and income taxes also distort the choice between current and future consumption). An extensive economic literature has explored the design of optimal tax structures, given the need to finance public goods, the existence of a social welfare function that values a less unequal income distribution, and the inability to tax non-market production. (Atkinson and Stiglitz, 1976; Mirrlees, 1976; for a review and critique, see Slemrod, 1990). This literature has examined both the choice between income and consumption as a tax base and the optimal structure of marginal tax rates, given distributional objectives. Transfer payments introduce economic distortions because they must be financed by taxes on labor and/or the return to saving. If transfer payments were universal and were financed by labor income taxes, everyone with earnings above the tax-paying threshold would face a positive marginal tax rate on an additional hour of work. Low-wage earners would receive net fiscal transfers, while high-wage earners would pay net positive taxes. Limiting transfers to low earners only, by reducing them as earnings rise, reduces their budgetary cost and thereby lowers marginal rates on high earners, but at the cost of subjecting beneficiaries to very high marginal rates as their benefits phase-out with higher earnings. The question for optimal tax design is to determine the marginal tax rate structure that minimizes the efficiency loss in terms of reduced work incentives and other distortions, for any given net transfer of resources to the poor.

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The authors thank Pamela Loprest, George Zodow, and an anonymous referee for helpful comments.

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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