Redistributing Income and Relative Efficiency

I. INTRODUCTION The welfare costs associated with a demo-grant reform and with spending on a publicly provided good have been extensively investigated, as in Browning and Johnson (1984), Stuart (1984), and Ballard (1988). The welfare cost of marginal spending on earnings or wage subsidies has received less attention, even though, as Scholz (1996) reports, the income subsidy rate of the Earned Income Tax Credit (EITC) has increased from 10% to 40% in the past 20 years. (1) Triest (1994) and Browning (1995) are two articles that analyze the welfare gains and losses associated with reforms to the EITC. Triest concludes that the EITC is a relatively efficient way to redistribute income, whereas Browning suggests considering alternative methods of assisting the working poor. This article calculates the welfare gains and losses for marginal reforms to three different policies designed to redistribute income. Increased spending on an earnings subsidy program, as defined by the EITC, is compared with the effects of higher spending on means-tested cash transfers to low-income households, a negative income tax (NIT). An NIT is used to represent welfare policies because Hoffman and Siedman (1990) suggest that programs such as Aid to Families with Dependent Children (AFDC) have properties similar to an NIT. Reforms to the NIT and EITC are compared to the effects of increasing the subsidy rate of a wage subsidy, or a negative wage tax as defined by Browning (1973). Understanding the normative effects of an earnings subsidy are important because the EITC has grown, and it is now larger than the food stamp program. Although the EITC is best known as an earnings subsidy, it actually has three phases. For a household with one child (in 1997), labor income up to $6,500 is subsidized at a rate of 34%. Households receive the subsidy in the form of a refundable tax credit, and the household receives a check from the government if their credit exceeds their tax liability. For income between $6,500 and $11,930 households receive the maximum tax credit, but for earnings above $11,930 the tax credit diminishes 15.98 cents for every dollar earned. According to Rosen (1999), over 70% of those receiving a tax credit are in the last two phases of the program. For these households, the credit takes the form of a cash transfer, and for most it is a means-tested transfer. Unlike traditional assistance to the poor, the EITC only provides assistance to those employed. A priori, one might expect a subsidy on labor earnings to be more efficient than an NIT at redistributing income to the working poor. This view is consistent with the survey results of Fuchs et al. (1998), who find that economists do not generally support increased funding of programs such as AFDC. However, if the EITC is just an NIT for most households it services, it is not obvious that the EITC is more efficient at marginally redistributing income to the poor. Steuerle (1990) envisioned that effort would be made to convert the tax credit system to an hourly wage subsidy. More recently, Browning (1995) suggested that a negative wage tax (NWT) be considered instead of the EITC. An NWT, like that proposed by Browning (1973; 1995), involves subsidizing the difference between a target wage rate and a household's actual wage rate, and it does not have a cash transfer or the high (positive) implicit marginal tax rates (MTRs) associated with most redistributive programs. Browning (1973) demonstrates that a wage subsidy is more efficient that an NIT, but less is known about the relative efficiency of an NWT and the EITC. Traditional welfare programs, such as AFDC and food stamps, provide most of their benefits to those who receive no labor income, whereas wage and income subsidies only aid those employed. How does one compare redistributive programs that serve different populations? To address this question, two different sets of reforms are considered. …