Tax Refunds and Income Manipulation: Evidence from the EITC

That is a new paper in International Tax and Public Finance by Florian Buhlmann, Benjamin Elsner, and Andreas Peichl. An important concern about many social insurance programs is that their incentives create “welfare traps,” one of which is a high implicit marginal tax rate if expanding work results in losing welfare benefits (a nice collection of state estimates by Sebastian Leguizamon here).

The Buhlmann et al. investigate piece takes advantage of a couple of important sources of discontinuities and looks for evidence of bunching, i.e. an unusual clustering of observations around an important policy discontinuity. As bunching increases, so does presumably the social cost of offering the program. Here is the 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.

The authors aren’t able to distinguish whether these are “real” responses (e.g. people working less) versus “reporting” responses (i.e. people manipulating what they report as income to the government). This matters because the policy response should be different for the two response types, and social costs are lower if it is just a reporting response. But the study uses multiple strategies to provide credible evidence that we have cause to investigate further, because something is happening.

 

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