President Biden expanded and fundamentally changed the one-year Child Tax Credit (CTC) in the US bailout (ARP) passed in March 2021. Policymakers are now deciding the future of the expansion in the framework of the proposed reconciliation plan, but a wide range of estimates of the effects of a permanent expansion cloud the debate.
The ARP made the maximum CTC more generous, increased the maximum age of eligible children, and provided the credit in the form of monthly installments made in the second half of 2021. It also made the full credit amount fully accessible. to low-income households, removing the work incentive – or the participation premium – which was built into the previous credit structure.
Expanding credit will dramatically reduce the number of children living in poverty, which may have positive long-term effects, but expansion will also have unintended consequences. In particular, removing the participation premium and increasing marginal tax rates on labor income reduce incentives to work, which may partially counteract poverty reduction.
Substitution effects and income effects: what is the difference?
The ways in which changing the CTC might affect work decisions are often confused. Clear the differences between income effects and substitution effects may help shed light on why analyzes indicate job loss among beneficiaries if the expanded CTC continues.
A change in policy can influence labor supply decisions through a income effect. The idea is that if people have more money overall, they might choose to work less and have more free time. The literature, however, indicates that the income effects are generally quite small and might even be zero.
The other way that a policy change can affect labor supply decisions is through a change in policy. substitution effect. The idea is that if people see a decrease in pay for an extra hour of work, for example, thanks to higher marginal tax rates, work becomes less valuable than leisure and they might choose to work less. . Substitution effects persist in the literature, and research indicates that they are more important than income effects.
For example, the Congressional Budget Office (CBO), to estimate the responsiveness (or “elasticity” of labor supply to a change in after-tax income), uses a central estimate of -0.05 for the effects on income and a range of 0.15 to 0.35 for substitution effects (for main earners and varies according to income level). Under a 2 percentage point increase in tax rates on all income, the substitution effect would reduce labor supply by 0.70% and the income effect would increase labor supply by 0.13% , a net decrease of 0.57%.
What does this have to do with the child tax credit?
It is important to clarify what effect is at play when discussing how the expansion of the CTC might affect decisions about work.
Until the changes in 2021, the CTC included a ‘participation bonus’ for labor, as eligibility depended on earned income, and the credit gradually integrated into labor income, thereby reducing marginal tax rates. for people in the progressive range. But the new structure eliminates the participation premium and increases marginal tax rates for low-income households along the phased-in range (see blue line vs. gold line in attached graph) . Therefore, we should expect to see a substitution effect in response to the higher marginal tax rates and the elimination of the participation premium..
At the same time, in a review of the literature, the CBO finds “evidence that low-income workers have higher labor supply elasticities than other workers, particularly in the component of their labor response. work that reflects the entry and exit movements of the labor force ”.
A new paper from University of Chicago economists estimated that compared to current policy, the proposed extension of the ARP CTC would reduce returns to work by at least $ 2,000 per child for families with children by removing the participation premium. Taking into account the labor supply response to reduced returns to work, the authors estimate that 1.5 million workers would leave the workforce. Overall, they believe that poverty would decrease less than what other estimates suggest due to the labor supply response, and that deep poverty in particular would not decrease at all.
While the estimates may seem implausibly high, when the National Academy of Sciences modeled a proposal to extend the Working Income Tax Credit (EITC), it used a similar estimate of the labor supply response. -work. Since the EITC and CTC generally target the same populations, it is consistent to assume that these populations will react in the same way to both policies. And the preponderance of evidence suggests that the EITC is boosting labor supply for many workers by increasing returns to work.
How quickly does the job respond to changes in marginal tax rates?
According to the CBO, it depends on factors such as how quickly workers are notified of changes in marginal after-tax wages and whether the policy changes are subtle or salient. The literature tends to use a three-year period to estimate the responses of the permanent labor supply to policy changes.
A forthcoming article titled “Labor supply responses to learning the tax and benefit calendar” explains that while a three-year period is typically used to account for “slowness from behavioral adjustments to tax changes ”, important responses continue to occur for up to eight years. after the policy change. In other words, it may take a while, but as people learn, people react.
As such, we generally shouldn’t expect to see a significant labor supply response right now in this year’s expanded CTC, as the policy is new, complicated, and temporary. Take the example of a June 2021 survey revealing that 29% of low- or moderate-income households had heard little or nothing about credit.
If the expanded CTC policy is extended or made permanent, we would expect people to learn more about how the changes affect their circumstances and react accordingly in the medium term. For example, if the estimate of 1.5 million workers leaving the labor market took eight years, that would mean an average of 187,500 jobs lost per year.
But don’t other countries have such policies?
Proponents often cite studies of policy changes in other countries in an attempt to inform the political conversation in the United States. But it is important to determine which evidence is relevant and which is not.
For example, many point to Canada’s 2015 expansion of its universal child care credit and a new benefit introduced in 2016 to argue that the expansion of the CTC in the United States would have only limited effects. on the labor supply of single mothers. The Canadian proposals are not a useful comparison to the changes being considered in the United States because none of the Canadian policies were work-conditioned.
In other words, unlike the reforms envisaged in the United States, the reforms in Canada did not remove a participation bonus and would therefore not result in a substitution effect. Instead, the Canada Child Benefit might only have an income effect, which research indicates is small. Likewise, the University of Chicago paper discussed above also estimates a small income effect for the proposed expansion of the CTC in the United States.
What about the other effects of the expanded child tax credit?
Many proponents of the CTC expansion will cite studies showing that spending on children can have positive effects on their well-being much later in life, and that any policy assessment should take this range into account. advantages.
Columbia University’s Center on Poverty & Social Policy estimated, for example, that a $ 1,000 increase in household income could increase children’s future incomes by $ 1,129 per year, based on estimates between $ 651 and $ 2,320 per year. These estimates, however, are based primarily on studies of food stamps in the 1960s and 1970s and WWI military pensions for mothers in the 1920s and 1930s. smaller in past periods, it is not clear to what extent we can extrapolate to conclude that a CTC expansion would have similar effects in the future. Another estimate cited in the Center study examines the EITC, a program similar to the CTC, and finds that the benefit is considerably smaller, at $ 660 per year for a $ 1,000 transfer.
Another drawback is that such studies do not always provide a full accounting of the costs and benefits of the extended CTC as they often exclude the substitution effects discussed above and the taxes that would be required to fund the extended CTC in the long run. term.
As lawmakers consider whether to reintroduce a participation bonus to the Expanded Child Tax Credit or make other changes to its structure in preparation for reconciliation, they must keep in mind how the CTC may affect labor supply decisions and the implications of the impact of credit on poverty reduction.