The Impact of the Earned Income Tax Credit on Incentives and Income Distribution

For more than three decades, economists have advocated the use of the tax system as a means of transferring income to low-income families. Studying the Earned Income Tax Credit (EITC) offers the opportunity to learn how well the tax system functions in roles traditionally handled by the welfare system. There are two features of the EITC that distinguish it from other US income transfer programs. First, the EITC budget constraint is unusualin particular, only taxpayers who work are eligible for the EITC. The shape of the constraint influences who receives the credit, what incentives recipients face, and how much the program costs. Second, the credit is administered through the tax system rather than through the welfare system, and is usually received as part of a taxpayer's annual tax refund. This administrative structure has important implications for EITC participation and compliance rates, for administrative costs, and for the ways in which recipients perceive its incentives. This paper discusses these features of the EITC, and presents evidence that the EITC has increased labor force participation among single women with children, and has offset a significant share of recent increases in income inequality. The limited evidence available suggests that the labor supply impact of the phaseout of the credit is minimal. Rates of noncompliance are falling, and are now similar to the overall rate of noncompliance for the individual income tax.