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Businessweek Archives

A Tax Credit That Delivers

Economic Trends


Efficient aid for the working poor

Ronald Reagan called it the best anti- poverty and job creation measure to come out of Congress, and Clinton Administration officials cite its expansion as one of their major achievements. Today the earned income tax credit (EITC) benefits some 19 million working families at a cost of $28 billion.

Is it worth it? Advocates claim the credit--which provides cash to low-wage earners with children--reduces poverty and income inequality without the hefty administrative costs or work disincentive effects of welfare. Businesses like it because it rewards workers without raising employer costs and thus encourages both job-seeking and hiring. But fiscal critics worry about its high cost and susceptibility to fraud.

In a recent study, Harvard University economist Jeffrey B. Liebman assesses the EITC's track record. Because it is keyed to earnings, and many poor households have had little or no earnings or fail to apply, he finds that the credit has helped more near-poor families than families under the poverty line. In the process, it has mitigated the effect of rising income inequality in the economy, offsetting nearly a third of the 14% drop in income share suffered by the lowest fifth of households with children over the past two decades.

Liebman also finds that the tax credit has substantially boosted work activity by single mothers. Their labor-force participation rate has risen by about 10 percentage points since 1984 (chart), mirroring almost exactly a decline in the number of such women on welfare who do no work. Meanwhile, labor-force participation by single women without children (who qualify for a negligible tax credit if they work, compared with as much as $3,656 for single working moms) has actually declined.

One concern about the EITC is that many low-wage workers face a huge marginal tax of more than 50% as it is phased out at earnings levels over $12,000--that is, the combined effects of losing the credit and paying payroll and income taxes mean that workers may take home less than half of each additional dollar earned. But while economic theory suggests that such workers will reduce their work effort when they reach the phaseout range, Liebman finds no evidence this actually occurs. A possible explanation: Many beneficiaries have little awareness of how the tax credit works.

What of charges that the tax credit program is plagued by fraud? Liebman estimates that rule changes and closer monitoring by the Internal Revenue Service have reduced the incidence of noncompliance to a level comparable to that found in the income-tax system in general. Moreover, most ineligible recipients have low incomes, and close to half of erroneous claims appear inadvertent rather than fraudulent.

Thus, Liebman concludes, the EITC seems a reasonably effective way to accomplish several goals: reducing earnings inequality, rewarding low-income workers, and--perhaps most important in light of welfare reform--encouraging welfare recipients to join the workforce.BY GENE KORETZReturn to top

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Prices may plummet in a recession

With consumer prices up less than 2% over the past year, it's hardly news that we now live in a relatively inflation-free environment. What many people seem to be ignoring, however, is the potential for significant deflation if a recession hits, says James W. Paulsen, chief investment officer of Norwest Investment Management Inc.

Paulsen believes that prices have been held down not only by excess capacity overseas but by unusually robust capacity expansion in the U.S. To show how strongly domestic supply has grown relative to demand, he divides the manufacturing capacity index by real GDP, which is a proxy for basic demand. Whereas in previous business cycles this ratio has risen only during downturns, it has taken off in recent years and is now higher than the levels reached in four of the past five recessions.

This has occurred, says Paulsen, because much of the current expansion has been fueled by investment in capacity, with consumption assuming a smaller role than in past upturns. As a result, domestic supply is now at a record level relative to demand--a state reached previously only when demand evaporated in the depths of recessions.

The upshot, Paulsen argues, is that a recession today would exert far more severe downward pressure on prices than in past contractions, when the emergence of excess supply acted simply to cool inflation. "What the Federal Reserve should be thinking about as it considers easing," he says, "is the unprecedented risk of escalating deflation if the economy slips into recession."BY GENE KORETZReturn to top

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