Wednesday, January 10, 2007

Why Increased EITC is Not a Good Idea

After the Democratic victory in last year's congressional elections, a minimum wage increase looks certain to pass the U.S. Congress. While Bush have suggested he might only agree to it if it were combined with tax cuts for small businesses (a combination Democrats reject), I doubt he would actually veto a clean bill (although I hope I'm wrong about that).

Some opponents of an increase in the minimum wage -for example Greg Mankiw- have argued that one should instead help low income workers by raising the so-called "Earned Income Tax Credit(EITC)". The EITC may sound like a form of tax relief, but it is actually a pure government handout (welfare), modeled after Milton Friedman's classic "negative income tax".

While it is true that at least some (but certainly not all) of the recipients of it pay enough of other taxes , like payroll taxes and state and local taxes, to currently be net tax payers, they will certainly be net tax receivers during their entire life, as the payroll taxes the EITC compensates them for gives them social security, plus various othe government hand-outs and services.

While Max Sawicky is a leftist who makes this argument in order to promote the minimum wage increase, he nevertheless makes a lot of good points about the problems of fighting poverty through the EITC.

As he points out, an increased EITC must mean a higher level of received maximum payments from the system. This must imply either that the rate of phase-out (which in effect works as a marginal taxation in terms of effect on incentives) is unchanged and that the final level when the EITC is completely phased out is raised from $38,348 to $58,291, which would be very costly. Or you could increase the phase-out rate dramatically , which would have a disastrous effect on incentives, with the effective marginal taxation raised to 100% in some income spans.

The EITC is thus not the kind of brilliant, super-effective, side-effectless solution to (relative) poverty in America that Greg Mankiw delude themselves into thinking it is. Just like government interventions typically do, the EITC creates negative side effects that arguably is as bad or worse than the problems they allegedly solve.


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