Earned income tax credits and labor supply: new evidence from a British natural experiment.

INTRODUCTION

During recent years, earned income tax credits (EITCs) have been introduced or expanded in many developed nations. EITCs generally have three goals: to boost labor supply, "make work pay," and improve the wellbeing of children. According to an international comparison by Banks, Disney, Duncan, and Van Reenen (2005), the largest EITC program is the UK tax credit, whose maximum benefit is one and a half times as large as the US EITC.

As well as being sizeable, the UK tax credit is also interesting because of its different structure. While the US, Belgian, Dutch and Finnish tax credits have a range in which the value of the credit increases with earnings, the UK tax credit (and the Irish EITC) becomes fully available at a certain threshold (Gradus, 2001). (1) Without a "phase-in" range, theory predicts that the effect of the UK tax credit on labor force participation for singles should be unambiguously positive, the effect on labor force participation for secondary earners should be unambiguously negative, and the effect on hours for those already in the labor force and earning over the threshold should be unambiguously negative.

This paper considers the impact of the UK tax credit on labor supply and earnings, exploiting a 1999 increase in the credit as a natural experiment. In contrast to most research on tax credits, which have used cross-sectional data, I make use of a fifteen-month panel dataset, making it possible to hold constant individual-specific factors and identify the policy impact by comparing changes in the treatment group with changes in the control group.

To presage my results, I find that the 1999 increase in the UK tax credit boosted the labor force participation, hours and earnings of workers who were eligible for the tax credit. These results are robust to a range of different treatment and control groups, and do not appear to be driven by other policy changes that occurred in 1999 and 2000.

The remainder of this paper is organized as follows. The second section provides some background on the UK tax credit and briefly discusses the relevant literature. The third section presents the empirical strategy and results. The fourth section provides robustness checks, and the final section discusses the results and concludes.

EARNED INCOME TAX CREDITS IN THE UNITED KINGDOM

Since 1971, Britain has had some form of means-tested benefit for adults with children who worked more than a certain number of hours per week (Dilnot and McCrae, 1999). This has variously been known as the Family Income Supplement (1971-88), the Family Credit (1988-99), the Working Families Tax Credit (1999-2003) and, most recently, the Working Tax Credit. Due to the ever-changing nomenclature of the program, this paper will simply refer to it as the "UK tax credit." I begin by describing the basic parameters of the UK tax credit, before moving to describe the 1999 reform that is the focus of this paper.

During the time period covered by this study, a family needed to meet four requirements to be eligible for the UK tax credit. The family must have had: (a) at least one adult who is working 16 hours or more per week; (b) at least one dependent child (aged under 16, or aged 16-18 and in full-time education); (c) fungible assets below 8000 [pounds sterling]; and (d) income below the phaseout point. If a family met these conditions, the credit amount depended on the age and number of eligible children, and the family's income. For family incomes below a specified threshold (80.65 [pounds sterling] per week before the reform, 90 [pounds sterling] afterwards), the full credit was paid. Beyond this point, the credit tapered off with additional earnings (at a rate of 70 percent before the reform, 55 percent afterwards). The UK tax system operates on an individual basis, but married or de facto couples claiming the credit must apply together, based on their joint circumstances.

The UK tax credit differs from the US EITC in five major respects. First, the UK credit has no phase-in range. The credit is unavailable to those working below 16 hours, and fully available to those working 16 hours or more, with a small additional credit amount available to those who work 30 hours or more. Second, the phaseout range is substantially steeper (the effective marginal tax rates in the phaseout range after the 1999 reform was at least 55 percent, higher than the top marginal tax rate in the UK at the time). Third, while the US has made a small EITC payment available to childless workers since 1994, UK tax credits were only extended to those without children in 2003. (2) In the years that this paper focuses on, UK tax credits were unavailable to childless adults; furthermore, the UK tax credit system also provided a generous childcare tax credit. Fourth, while over 99 percent of US EITC recipients obtain their credit at the end of the tax year (US Treasury, 2003), UK recipients chiefly obtain the credit through their pay packet, with the amount based on their earnings over the previous three months. Indeed, since April 2000 many recipients--and most lone parents--have been paid the credit in this manner. (3) And fifth, the levels of income support in the UK are similar to the value of the tax credit. (4) For example, after the October 1999 reforms, a single woman with two children aged under 11 would have been entitled to income support of 101.20 [pounds sterling] per week if she worked less than 16 hours per week; or a tax credit of 92.00 [pounds sterling] if she worked 16 hours or more, but earned below 90 [pounds sterling] (working would also entitle her to a 70 percent rebate on childcare costs). Moreover, in the case of those with young children, income support was also increased by a similar amount to the tax credit in October 1999, making it likely that any estimates in this paper will be an underestimate of what would have occurred if the tax credit were increased, but welfare remained constant. (5)

Figure 1 shows how the budget constraint is affected by the UK tax credit and the US EITC. The graph is constructed based on the UK tax credit after the 1999 reform and the US EITC parameters in 1999. It assumes a single worker with two children under 11, earning US$10 per hour, which was then equivalent to 6.20 [pounds sterling]. (6) The jagged piece of the budget constraint for the British tax credit reflects the fact that, although low-wage employees get a basic tax credit at 16 hours and an additional amount at 30 hours; the 16-hour credit has already begun to phase out before the 30-hour credit becomes available. For many recipients, the UK tax credit does not have a flat region. In the stylized example in Figure 1, there is no flat region, since 16 hours at 6.20 [pounds sterling] per hour equates to weekly earnings of 99.20 [pounds sterling], which is already in the phaseout range. Where individuals face a flat region, it typically only covers a short range of hours (even after the October 1999 increase, a single mother on the minimum wage would be in the phaseout range if she worked more than 25 hours per week). Overall, the UK tax credit is more targeted than the US EITC, but has an immediate phase-in, only a short flat area, and a rapid phaseout. (7)

[FIGURE 1 OMITTED]

The change that this paper will focus upon is a significant credit increase, which took place on October 5, 1999. The new tax credit was more generous than its predecessor in five main respects (Blundell, Duncan, McCrae, and Meghir, 2000): (8)

* it increased the basic credit from 48.80 [pounds sterling] to 52.30 [pounds sterling] per week;

* it increased the per-child credit for children under 11 from 14.85 [pounds sterling] to 19.85 [pounds sterling] per week;

* it increased the threshold before earnings began to taper off from 80.65 [pounds sterling] to 90 [pounds sterling] per week;

* it reduced the taper rate from 70 percent to 55 percent; (9) and

* it included a childcare credit of 70 percent of actual childcare costs up to 150 [pounds sterling] per week. (10)

The effect of these changes on the budget constraint is shown in Figure 2, which uses the same parameters as Figure 1. Note that both charts assume that the worker does not take advantage of the childcare tax credit. Under the old credit, this particular worker was eligible for the tax credit only if she earned less than 208 [pounds sterling] per week. Under the new credit, the worker remained eligible with earnings of up to 277 [pounds sterling] per week.

[FIGURE 2 OMITTED]

Additionally, at the same time as Britain increased the tax credit, it also boosted out-of-work benefits for families with one or more children aged under 11. Since the timing was coincident with the increase in the tax credit, this paper will not attempt to disentangle the two reforms. However, it is worth noting that the labor force participation effect that might be expected to occur from boosting in-work benefits alone is larger than the labor force participation effect one might expect given an increase in both in--work and out-of-work benefits.