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Thursday, May 15, 2008

"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.

    Posted by on Thursday, May 15, 2008 at 12:24 AM in Economics, Market Failure, Social Insurance | Permalink  TrackBack (0)  Comments (15)


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