The Earned Income Tax Credit: Targeting the Poor but Crowding out Wealth

In this paper, we quantify the effects of the Earned Income Tax Credit (EITC) from a macroeconomic perspective. We use an incomplete markets model to analyze jointly the labor supply and saving responses to changes in tax credit generosity and their aggregate and distributional implications. In line with existing literature, our results show that the EITC is an effective policy instrument to raise labor force participation and provide insurance to working poor households. However, we show that the EITC also disincentivizes private savings for a large part of the population, except for the poorest transfer recipients. Furthermore, since unskilled labor supply reacts more strongly than skilled workers’ labor supply, wages for low skilled workers fall relative to high skilled workers. Whilst reducing post-tax earnings inequality, the EITC contributes to both a higher skill premium and wealth inequality. Finally, our welfare analysis suggests that EITC expansions are welfare improving for the majority of the population, both ex ante and when accounting for transitional dynamics.