Employment, Hours of Work and the Optimal Design of Earned Income Tax Credits

This paper examines the optimal schedule of marginal tax rates and the design of earned income tax credits. The analysis is based on a structural labour supply model which incorporates unobserved heterogeneity, fixed costs of work and the detailed non-convexities of the tax and transfer system. An analytical framework is developed that allows explicitly for an extensive margin in work choices and also the partial observability of hours of work. This is contrasted to the standard case in which only earnings (and non-labour income) are observable to the government. The empirical motivation is the earned income tax credit reforms in Britain which include a minimum hours requirement at 16 hours per week and a further bonus at 30 hours. Our analysis examines the case for the use of hours-contingent payments and lends support for the overall structure of the British tax credit reforms. However, we also provide a strong case for a further reduction of marginal rates for lower earners but only those with school age children. Acknowledgements: This study is part of the research program of the ESRC Centre for the Microeconomic Analysis of Public Policy at the IFS. We thank Mike Brewer, Guy Laroque, Ian Preston, Emmanuel Saez and participants in the Mirrlees Review of Tax Reform and at the DWP Labour Economics Study Group 2007 Conference for helpful comments. We are responsible for all errors and interpretations.