"How Do EITC Recipients Spend Their Refunds?"

Most people know about the Earned Income Tax Credit (EITC). Under this program, payments to qualifying individuals are made once a year. There is also something called the Advance Earned Income Tax Credit (AEITC) that allows qualifying individuals to receive the credit with each paycheck. But even though this program exists, most of the payments are made under the EITC and come around the time tax returns are filed.

I've often thought this was a potential disadvantage relative to the minimum wage for people living close to the margin. With a minimum wage, the extra income comes with every paycheck and helps with monthly bills, etc., but with the EITC, it comes as one large payment leaving families to struggle each month in return for a feast once a year. [Why more people don't enroll in the monthly payment plan I'm not sure, that seems like the better option (you can always save a bit of each monthly check and mimic the EITC plus interest), but I suspect it is partly the administrative hassles with getting the AEITC put into place, and the restrictions on who qualifies.]

But maybe this is a feature, not a bug, at least that's the argument below, i.e. that the once a year payment allows households to buy needed durable goods such as cars they wouldn't otherwise be able to purchase. Is it a feature? In essence, this is like forced saving (even under the AEITC only part of the credit is paid), requiring households to give up monthly consumption for one large annual payment. The fact that they are able to buy more durable goods - cars - with the one time payment is nice, and the argument is that this helps them find employment, but we need to know what they gave up each month before we can conclude they are better off.

In some cases, there are market failure arguments that provide the foundation to force people to participate in particular programs (e.g. adverse selection in health care or insurance for drivers), and there are arguments that can be made here, but the particular argument ought to be made explicit. Why is it better to force people to save (we do this with Social Security)? Unless there's some good reason for the government to step in and make choices for people, I'd rather not have the government get in the habit of thinking it knows better than I do what is good for me:

How do EITC recipients spend their refunds?, by Andrew Goodman-Bacon and Leslie McGranahan, FRB Chicago: Introduction and summary The earned income tax credit (EITC) is one of the largest sources of public support for lower-income working families in the U.S. The EITC operates as a tax credit that serves to offset the payroll taxes and supplement the wages of low-income workers. For tax year 2004, the EITC transferred over $40 billion to 22 million recipient families... Nearly 90 percent of program expenditures come in the form of tax refunds; the remaining 10 percent serve to reduce tax liability. While other income support programs distribute benefits fairly evenly across the calendar year, EITC payments are concentrated in February and March when tax refunds are received. Because the EITC makes one relatively large payment per year, it may provide low-income, credit-constrained households with a rare opportunity to make important big-ticket purchases. Research on the EITC has tended to focus on the important labor supply effects of the program (Eissa and Liebman, 1996; Meyer and Rosenbaum, 2001; and Grogger, 2003). Relatively little is known about how recipient households actually use EITC refunds. In this article, we use data from the U.S. Bureau of Labor Statistics’ Consumer Expenditure Survey (CES) over the period 1997–2006 to investigate how households spend EITC refunds.[1] ... Barrow and McGranahan found that the EITC has a larger effect on spending on durable goods than on nondurable goods. In this article, we are particularly interested in determining what items within the durables and nondurables categories are purchased using the credit and whether these expenditures reinforce the EITC’s prowork and prochild goals. Our primary finding is that recipient household spending in response to EITC payments is concentrated in vehicle purchases and transportation spending. Given the crucial link between transportation and access to jobs, we believe this finding is consistent with the EITC’s goals. In the next section, we present a brief history of the EITC and the key features of the program. We then review prior research on the uses of the EITC by recipient families. Next, we introduce the CES data and the methodology we use to investigate the data. Finally, we present our results and discuss their implications.

Update: In comments, Robert Waldmann adds (here too):

There is a justification for forced savings which is not at all based on market failure.  It is based on dynamically inconsistent preferences.  If people discount future rewards with any function other than the exponential, they may wish to deprive their near future selves of freedom of action in order to protect their more distant future selves.  In particular, if a two period discount factor is greater than the square of a one period discount factor, people will want to force their one period future selves to save.

Given standard assumptions including individual rationality and dynamically consistent preferences, a public intervention is desirable only to deal with a market failure or to redistribute from the rich to the poor.  The assumptions are standard not because they are plausible but because they make model building much easier.  It is possible to gain some insight on whether people have dynamically inconsistent preferences by asking them their discount factors.  It is not clear that people really have the answer to that question in their minds, but they do answer the question and generally on average claim to have dynamically inconsistent preferences.

Another way to test would be, say, to give people a choice between the EITC and the AEITC.  If people have dynamically inconsistent preferences, they may rationally chose the EITC over the AEITC.  Thus the fact that they do so is evidence (not proof given the red tape but evidence) that people are right when they claim to have dynamically inconsistent preferences.

Now, forcing people to save might be paternalistic, but giving people the option to force their future selves to save can't be.  A program where people can choose between the EITC and the AEITC gives them more freedom and is less paternalistic than one in which they are forced to accept the AEITC.

More generally, the basic principle that we should have laissez faire (or laissez faire with redistribution) unless we can point to a market failure is based on theory which, in  turn, is based on making assumptions that lead to nice simple results like ... we should have laissez faire (or laissez faire with redistribution) unless we can point to a market failure.

Update: More on time-inconsistent preferences.

Update: Felix Salmon:

...And I'd note that given the choice, people nearly always prefer their income more frequently rather than less frequently. In some situations, workers are now being paid daily, and that's a good thing:

Upon completion of a daily work shift, an employee's payroll card account is credited with salary payment as quickly as two hours after an approved time card is submitted.
Temporary workers can receive payments on the day that a shift is completed, giving them faster access to funds to pay basic living expenses such as groceries, gas and utility bills.

If it's a good idea for income to arrive on a daily basis, why is it a good idea for the EITC to arrive only on an annual basis? Or is there a useful distinction to be made between income, on the one hand, and a tax credit, on the other?

Update: Manipulating Yourself for Your Own Good, by Daniel Hamermesh is related.

Comments

[Farrar]

Maybe the EITC is necessary, although I would prefer the negative income tax as easier to administer. But I think that either should be coupled with a strong minimum wage. Otherwise, the general public is paying for subsidies to employers to enable them to pay below fair market.

[reason]

Maybe it coming once a year is a substitute for a decent minimum wage in that it acts as a discouragement to capture of the EITC by employers.

[kharris]

Save a little each month and mimic EITC, with interest? Have you checked into banking practices lately. An account funded entirely by AEITC payments would, in many cases, carry a negative nominal interest rate, after fees. That's why Social Security is moving to debit cards. It's why Wal-Mart can enjoy a tidy little business cashing government checks in the middle of a cash-register farm. Banking is not for the poor.

[Larry]

@Farrar - whatever the minimum wage represents, it has nothing to do with "fair market". Market wages are where supply meets demand. The whole point of the minimum wage is artificially constrict demand by setting a price floor.

This reminds me a bit of the recent discussions of the morality of opt-in vs opt-out. Studies show that if you enroll employees in 401-k programs by default, while still allowing them to opt-out, you get much higher participation rates than you do when you make non-enrollment the default.

The same goes with organ donor options.

If on average, the "savings" option works out better for recipients, then there is nothing wrong with making it the default - as long as you allow opt-out!

[save_the_rustbelt]

Mark:

Are you aware of the advance payment of EITC available to workers? Check the back side of a 1040, the amount if offset against the annual EITC amount and withholding on Line 61.

Economists messing with accounting issues - dangerous indeed!

:))

[reason]

Larry...
I guess you and Farrar just have different concepts of "fair". You mean market clearing, I don't think Farrar does (because he thinks at very low wages demand is very inelastic).

[save_the_rustbelt]

Logical or not, many people see their tax refund (withheld or EITC) as a forced savings plan and a once a year financial kicker.

[Robert Waldmann]

There is a justification for forced savings which is not at all based on market failure. It is based on dynamically inconsistent preferences. If people discount future rewards with any function other than the exponential, they may wish to deprive their near future selves of freedom of action in order to protect their more distant future selves. In particular, if a two period discount factor is greater than the square of a one period discount factor, people will want to force their one period future selves to save.

Given standard assumptions including individual rationality and dynamically consistent preferences, a public intervention is desirable only to deal with a market failure or to redistribute from the rich to the poor. The assumptions are standard not because they are plausible but because they make model building much easier. It is possible to gain some insight on whether people have dynamically inconsistent preferences by asking them their discount factors. It is not clear that people really have the answer to that question in their minds, but they do answer the question and generally on average claim to have dynamically inconsistent preferences.

Another way to test would be, say, to give people a choice between the EITC and the AEITC. If people have dynamically inconsistent preferences, they may rationally chose the EITC over the AEITC. Thus the fact that they do so is evidence (not proof given the red tape but evidence) that people are right when they claim to have dynamically inconsistent preferences.

Now, forcing people to save might be paternalistic, but giving people the option to force their future selves to save can't be. A program where people can choose between the EITC and the AEITC gives them more freedom and is less paternalistic than one in which they are forced to accept the AEITC.

More generally, the basic principle that we should have laissez faire (or laissez faire with redistribution) unless we can point to a market failure is based on theory which, in turn, is based on making assumptions that lead to nice simple results like ... we should have laissez faire (or laissez faire with redistribution) unless we can point to a market failure.

[JeffF]

I recall reading somewhere that something like 40% of EITC's people could get are not claimed. I really don't think that the poor are all that savvy at filling out tax forms, so are unlikely to fill out forms to get payments earlier. I wonder how many EITC refund checks are lost or misallocated as people move, divorce, die, etc?

[Mark Thoma]

Thanks Robert - I almost talked about neuroeconomics too - even had the word nudge in at one point, then took it out. I didn't mean to rule out other possible justifications, and I should have been explicit about that.

[Kaleberg]

I am willing to bet that there is a big downside risk to signing up for the AEITC and then either losing your job or getting a raise and winding up owing the IRS money. The kind of people who get the EITC don't get those "heads I win, tails you lose" offers that are so popular in the executive suite.

[Farrar]

Reason - Thanks for defending me in my absence, You are quite right, tho I have lost the habit of thinking in terms of elasticities.

[Richard Davis]

A scandalously large portion of the one-time EITC payments go to H&R Block and Jackson Hewitt, as interest and fees for usurous advance loans. Approximately $450 on a $3500 EITC. And from my experience working at Jackson Hewitt, <1% of EITC recipients opt for the Advance EITC (the every paycheck payment option).

[Blissex]

«A scandalously large portion of the one-time EITC payments go to H&R Block and Jackson Hewitt, as interest and fees for usurous advance loans. Approximately $450 on a $3500 EITC.»

Well, winners should win and losers and suckers should get screwed. EITC are meant to be a big support for the profits of employers of low wage workers, why not for the profits of usurers to those same low wage workers? That's the American Way.

If the recipients of EITCs were not suckers and losers they would have become VPs at Enron or Bear Stearns or Countrywide, and not be a burden on the public purse.

The middle class find very hard to feel compassion for the exploitative parasites who get free money as EITCs, the welfare queens who use them to buy cadillacs and the strapping young bucks to buy t-bone steaks. At least EITC usury means that a bit of that STOLEN MONEY goes back to deserving entrepreneurs who are often loyal Republican campaign donors.

[Be ever vigilant]

Actually, alot of employers discourage filing for the advanced payment, my employer doesn't even carry the paper work for it. When I discovered I could get it on every paycheck instead of lump sum at the end of the year, I had to go to the IRS.GOV web site and print it out, the local library didn't even carry the forms. I discussed it with other parents I worked with and most were interested and wanted to opt-in, I printed out about 100 forms and took them to the break room so people who wanted to take the advance option could, I was called on the carpet for it and the forms were removed from the break room.