In the new Cato Handbook for Policymakers, I propose cutting the earned income tax credit (EITC). I previously critiqued the credit in this study with Veronique de Rugy. While the credit receives support from both parties in Congress, the closer you look the more flawed it appears.

The EITC provides benefits to households with earnings from employment. In 2021, it provided $71 billion in benefits to 27 million recipients. The EITC is mainly a spending program, not a tax‐​cutting program. The credit is “refundable,” meaning that individuals who pay no income taxes receive payments from the government. In 2021, $69 billion of the benefits were refundable.

The EITC encourages some individuals to join the workforce, but it also discourages many individuals already in the workforce from increasing their earnings. The EITC has a high error and fraud rate, and the spending part of the EITC imposes a large cost on the taxpayers who fund it.

There is another problem. To the extent that the EITC boosts labor supply, it pushes down market wages. This effect is usually overlooked by EITC supporters. People complain that some employers, such as fast-food restaurants, pay low wages, but the EITC puts downward pressure on those wages. To an extent, the EITC is a business subsidy helping employers pay low wages.

Michael Keen and Joel Slemrod summarize this unfortunate wage effect of the EITC in their excellent 2021 book Rebellion, Rascals, and Revenue. The book provides a fascinating and nonpolitical history of taxation, with a focus on the underlying economics.

Keen and Slemrod report:

By making work more attractive, the EITC induces an increase in labor supply among low-income workers. Unless the demand for their labor is perfectly [elastic] … this increase in labor supply drives wages down. To the extent that wages fall, the benefit of the EITC to the intended beneficiaries—low-income, often low-skill, workers—is reduced, and some of the intended transfer redounds to employers. Moreover, low-skill workers who do not receive the EITC are hurt even more, because—as they compete with the workers who do receive it—they receive the lower wages but do not get the credit.

… One estimate is that for every dollar that single mothers receive from the EITC, they ultimately lose $0.30 through lower wages. Employers of low-skill labor capture a whopping $0.73 per dollar: $0.30 of this decline coming from those EITC-eligible single workers and another $0.43 from workers who are not EITC-eligible but whose wages nevertheless fall. The net transfer to all low-skill workers, considering both those who get the EITC and those who do not, is, according to this study, just 27 (that is, 100 minus 73) cents per dollar of the EITC.

The authors cite this study by economist Jesse Rothstein for the figures.

“Things aren’t always what they seem,” note Keen and Slemrod in introducing their EITC discussion. With government, the “risk that measures intended to improve the lot of the poor can end up benefiting, maybe even more, the better-off, is a recurrent one.”

In sum, the EITC is not the clear-cut winner for workers and the economy that supporters may believe. Against the modest gains in labor force participation that it may create are numerous damaging effects, including pushing down market wages for lower-skilled workers.