Wyden-Smith’s Child Tax Credit expansion in proposed spending bill would have little net impact on work incentives. (Commentary)
by Kyle Pomerleau
Lawmakers are currently negotiating a tax deal that would temporarily expand the Child Tax Credit (CTC). The debate over CTC expansion has centered, in part, on work incentives. Certain expansions of the CTC can reduce work incentives and have a negative impact on the labor supply. Although some have expressed concerns that this proposed expansion could halve work incentives, the proposal should not have a significant impact on the labor supply of parents.
The Wyden-Smith deal would make four temporary changes to the CTC. First, it would phase-in full refundability of the CTC. Under current law, refundability is capped at $1,700 per child. Under this proposal, tax filers could receive the entire CTC ($2,000) without any income tax liability by 2025. Second, it would phase-in the refundable portion of the CTC at 15 percent per child. Tax filers with multiple children would receive a larger credit at lower levels of earned income. Third, it would index the value of the credit to inflation. Fourth, it would enact a “lookback” provision that would allow tax filers to use last year’s earned income to qualify for the refundable portion of the CTC.
The CTC impacts work incentives in two primary ways. First, through the income effect: since the CTC increases after-tax income, it increases consumption of goods and services, including leisure (although spending time with your child may or may not be leisurely).
Second, the CTC impacts work incentives through the substitution effect, or its impact on the return to work. Since the credit requires earned income (wages, salaries, net self-employment income), it increases the willingness to enter the labor force by increasing the opportunity cost of leisure. In addition, the credit both phases-in and phases-out with additional income and can impact the hours worked by individuals. Research suggests that the substitution effect tends to matter more than the income effect and that individuals respond more to the phase-in of these credits than the phase-out.
This CTC expansion would both increase and decrease work incentives.
The increased phase-in for tax filers with multiple children would increase work incentives. Under Wyden-Smith, the CTC will reduce marginal rates by 15 percentage points per child for those with earned income that places them in the phase-in range. Under current law, the phase-in reduces marginal rates for these tax filers by a fixed 15 percentage points.
Making the credit fully refundable would reduce work incentives for tax filers that currently have income tax liability but only receive a portion of the CTC. A non-refundable credit depends on income tax liability. A tax filer with income tax liability less than the full CTC faces a lower marginal rate until they earn enough to receive the full credit. This reduces a tax filer’s marginal rate by their statutory tax rate (for example, a 10 percentage point reduction for a household in the 10 percent tax bracket). Making the credit fully refundable means that these tax filers receive the full credit regardless of the income tax liability, eliminating that marginal tax rate reduction.
The larger overall credit (due to inflation indexing) would slightly increase the returns to work and encourage individuals to enter the labor force.
Finally, the lookback provision could also impact work incentives. A simple way to think about the lookback provision is that tax filers will work this year to generate next year’s credit. Under current law, if a tax filer works this year, they generate earned income that qualifies them for a credit this tax year. Under this provision, generating earned income this year does not necessarily generate a credit for this year because a tax filer could use last year’s earned income to calculate the credit. However, working this year means that the tax filer will generate earned income that they could use next year for purposes of the CTC. The exact impact of the lookback provision on work incentives depends on a few factors, but should not have a large impact in the aggregate either way.
Lawmakers should consider how tax policy impacts incentives to work. This expansion will increase work incentives for some and reduce them for others, but overall, there is little reason to be concerned about a large reduction in labor supply.
Originally published by the American Enterprise Institute. Republished with permission.
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