Implicit tax rates of the expanded earned income tax credit for welfare recipients in North Carolina

Reforming the welfare system is receiving increasing attention. One of the goals of many proposed reforms is to encourage more market work by welfare recipients. A problem in the current system is the apparent high implicit tax rates on earnings. An implicit tax rate is the proportionate reduction in disposable income that occurs when earnings increase. For example, if earnings increase by $1,000, but disposable income increases only $600, then the implicit tax rate is 40 percent. The implicit tax rate on earnings occurs as a result of three factors: (1) income and Social Security taxes on earnings, (2) expenses related to working and child care, and (3) the reduction in welfare program benefits when earnings increase. The last factor can be particularly significant for households receiving benefits from multiple programs.

In part to reduce the implicit tax rates on earnings for welfare recipients and other low income households, the federal government expanded the federal earned income tax credit (EITC) beginning in 1994. The increased generosity of the EITC was phased in over the 1994-1996 period. The EITC is a reduction in federal income taxes for low income households with labor earnings. The EITC is also a form of a "negative income tax" in that, if the EITC reduces the household's tax liability to less than zero, the negative tax liability is paid to the household.

Previous work on implicit tax rates faced by welfare participants can be divided into two categories. The first category primarily focuses on measuring the implicit tax rates (Albrecht and Pogue 1978; Fearn 1981; Frater, Moffitt, and Wolf 1985; Moffitt 1979, 1986a). These studies have found implicit tax rates to be high and a significant deterrent to more work effort by welfare recipients. The second category of studies concentrates on estimating the labor supply effects of changes in implicit tax rates (Levy 1979; Moffitt 1985, 1986a, 1986b). These studies suggest that the short-run effect on labor supply of lowering implicit tax rates may not be large, as the increased labor supply of existing recipients can be cancelled by the reduced labor supply of new recipients attracted to the now more generous program.

This paper fits into the first category of studies by measuring the impact on implicit tax rates of...