Adjust the EITC for Cost of Living

Adjust the EITC for Cost of Living
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With the presidential election season in full swing, lots of candidates are making lots of promises, many of them short on details and long on rhetoric. As in a fifth-grade student council election, where proposals may include extending recess or increasing the number of days the cafeteria serves chocolate milk, there is little assurance that campaign promises are backed by solid and feasible policy.

This year, many promises focus on ways to improve the lives of working families and to expand economic opportunity. These are noble goals, to be sure, but also areas where carefully crafted policy is needed. It so happens that the federal government already has a policy on the books that works to improve the lives of hard-working families: the Earned Income Tax Credit. Alas, it's a policy in need of a serious refresh.

The EITC offers an income-tax refund (and, in many cases, an additional boost to wages) for workers who earn less than certain income limits that are set nationally. The credit currently benefits nearly 29 million families and costs the Treasury about $64 billion annually, making it the most wide-reaching anti-poverty policy no one has ever heard of. Benefits are accrued only when a recipient works; no one benefits from the program without holding a job and earning a paycheck on their own. Eligibility also depends on a worker's income, marital status, and the number of children he or she has. The EITC is particularly generous to single working parents, who need it most.

But as a policy, the EITC isn’t without its flaws. Significant differences in the cost of living between different metro areas result in very real differences in how much the credit benefits the working poor in different cities. While the cost of feeding a family in Boston is 53 percent higher than it is in Jackson, Tenn., the federal EITC does not recognize that difference when determining the size of the tax break. For a single taxpayer with one child, the real value of the EITC ranges from $4,131 in Harlingen, Texas, to $1,531 in New York City. These differences mean the EITC helps the working poor in low-cost areas much more than it does in high-cost areas of the country.

These factors also limit one of the EITC's most attractive features — that it encourages a worker to find and keep a job. Scholars have demonstrated that previous EITC expansions are responsible for large increases in labor-force participation. The working poor in high-cost cities largely miss out on these benefits. For example, the EITC claims rate (the number of EITC claims per tax filer) in Memphis, Tenn., is nearly three times greater than that in San Francisco. Even controlling for other local economic factors, a 10 percent increase in the local cost of living reduces EITC claims by 7.5 percent, meaning that poor workers living in expensive cities are not reached by the policy.

Ignoring local labor-market conditions also makes the EITC's so-called "phase-out" tax even worse. The phase-out tax kicks in when an EITC-eligible worker starts to earn more income; eventually, they hit an earnings level where policy dictates that they have to start paying back the credit. This payback acts like an additional tax on working. The Congressional Budget Office estimates that workers paying the phase-out tax (combined with the loss of other benefits) can face marginal tax rates in excess of 90 percent, even though such workers may earn less than $20,000 annually.]

Because the EITC is not adjusted for local labor-market conditions, similar workers in different parts of the country will be subject to the phase-out tax after working radically different numbers of hours. For example, a single parent working as a dishwasher (someone who is poor by any reasonable definition) and living in Brownsville, Texas, will likely never be subject to the phase-out tax. If that same single parent lived in San Francisco, they will be hit with the phase-out tax after working about 85 percent of their normal hours — drastically reducing their effective wage rate and destroying the incentive to work harder.

Presidential candidates who are serious about improving the lives of working families should also be serious about improving the EITC. A simple, fair, and efficient solution is to adjust the EITC for local labor-market conditions. The current EITC has wide-ranging benefits in the U.S. labor market and is superior to a minimum wage in that it creates, rather than destroys, jobs. In this season of political promise-making, it would be nice to see some practical solutions put forward that genuinely would help working families. Updating the EITC is certainly one of them.

Andrew Hanson is an associate fellow of the R Street Institute and an associate professor at Marquette University. Zackary Hawley is an assistant professor at Texas Christian University.

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