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International Tax and Public Finance

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27-07-2018

Tax refunds and income manipulation: evidence from the EITC

Authors: Florian Buhlmann, Benjamin Elsner, Andreas Peichl

Published in: International Tax and Public Finance | Issue 6/2018

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Abstract

Welfare programs are important in terms of reducing poverty, although they create incentives for recipients to maximize their income by either reducing their labor supply or manipulating their taxable income. In this paper, we quantify the extent of such behavioral responses for the earned income tax credit (EITC) in the USA. We exploit the fact that US states can set top-up rates, which means that at a given point in time, workers with the same income receive different tax refunds in different states. Using event studies as well as a border pair design, we document that raising the state EITC leads to more bunching of self-employed tax filers at the first kink point of the tax schedule. While we document a strong relationship up until 2007, we find no effect during the Great Recession. These findings point to important behavioral responses to the largest welfare program in the USA.

previous article Using small businesses for individual tax planning: evidence from special tax regimes in Chile

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For surveys, see Hotz and Scholz (2003), Eissa and Hoynes (2006), Meyer (2010) and Nichols and Rothstein (2016).

A key result of the existing literature on labor supply reactions to the EITC is that there are positive effects at the extensive margin (Eissa and Liebman 1996; Meyer and Rosenbaum 2001; Grogger 2003; Hotz and Scholz 2006; Gelber and Mitchell 2012). This result, which was found primarily for single mothers, does not hold true for secondary wage earners, for whom Eissa and Hoynes (2004) find a decrease in participation. In contrast to these findings, previous research suggests that there are none or only small effects at the intensive margin (Rothstein 2010; Chetty and Saez 2013).

See, e.g., Hausman (1985), Pencavel (1986), Killingsworth and Heckman (1986), Heckman (1993), Blundell and MaCurdy (1999), Meghir and Phillips (2008), Keane (2011), Keane and Rogerson (2012), McClelland and Mok (2012) and Bargain et al. (2014).

See Fig. 6 in Appendix A for an illustration. For families with two children, the kink points for 2009 are at $12,570 and $16,420. The maximum tax credit is $5,028, which results in steeper phase-in and phaseout regions compared to the schedule for families with one child.

Wisconsin has a top-up rate of zero for childless people, but top-up rates of 4, 14 and 43% for families with one, two and three and more children, respectively.

We are aware that DC is technically not a state. However, it has its own EITC.

To put these numbers into perspective, in 2009, the total number of people with income from self-employment was 16.8 million, which represents 10.7% of the workforce (Source: Social Security Administration). According to Chetty et al. (2013), the share of self-employed EITC claimants was 19.6%, whereas the share of EITC-eligible filers among all tax filers was 18.9% (Source: Brookings Institution, Characteristics of EITC-eligible tax units 2015). Therefore, the share of filers that were both eligible for the EITC and had income from self-employment was around 3.7%.

For this reason, our analysis spans these years, although in the future it would be desirable to have data past 2010, which would allow us to study the effects of the EITC during and after the Great Recession. In Appendix D, we explain in greater detail how we convert zip-code-level information to the county level.

As explained in footnote 14 in Chetty et al. (2013), the results are robust to (i) defining the denominator of the bunching measure using only self-employed individuals rather than the full population, (ii) the choice of bandwidth around the kink point and (iii) a measure whereby bunching is measured as the excess mass over a smoothly fitted polynomial within a certain bandwidth.

See Feenberg and Coutts (1993) for a documentation.

In our main analysis in Sect. 5, these county pairs will be included. We also performed the event study including these cases. The results remain unchanged. The tables are available from the authors upon request.

This approach—controlling for leads and lags as well as year fixed effects—is similar to that used by Jäger (2016) and Fuest et al. (2018).

Similar approaches have been used by Dube et al. (2010) to evaluate changes in minimum wages in the USA, and by Lichter et al. (2015) to estimate the impact of government surveillance in East Germany.

This result is also consistent with the findings of Castanheira et al. (2012) for income tax reforms in Europe and Foremny and Riedel (2014) for local business taxes in Germany. Both studies show that tax setting is driven by political factors rather than the business cycle.

While these two dummies are multicollinear, it is possible to include these interactions in the regression because we do not include the dummies on their own.

Sources: minimum wages: St. Louis Fed, welfare benefits: welfare rules databook, tax revenue: Annual Survey of State Government Tax Collections, consumer price index: St. Louis Fed, marginal income tax rates: NBER TAXSIM.

We found splitting the number of claimants evenly between counties the most transparent way of converting zip-code-level data to county-level data. It would also be possible to (dis-)aggregate the numbers based on population measures. However, without further assumptions, this would only be possible for disaggregation (one zip code contains more than one county), but not for aggregation (one county contains more than one zip code).

This procedure follows Kennedy (1995) and Chetty et al. (2009).

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Title: Tax refunds and income manipulation: evidence from the EITC
Authors: Florian Buhlmann
Benjamin Elsner
Andreas Peichl
Publication date: 27-07-2018
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 6/2018
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-018-9510-7

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