Poverty Traps

There is a lot of talk in economic and sociological circles about so-called "poverty traps". While the two fields might define the term differently, the jist in both fields is that a confluence of certain factors, whether cultural, social, or economic, can serve to perpetuate poverty. Thus the term "poverty trap", as those in poverty can find it more difficult than it should be to escape.

Many people, myself included, believe in helping those in need. As a result of this human tendency, and democracy, our government reflects this desire to help others. One of the most prominent government programs helping low income people is the Earned Income Tax Credit (EITC), which essentially gives varying tax credits based on marital status, income, and number of children. While well-intentioned, some economists believe that tax-based programs like the EITC are at the core of the apparent self-perpetuating poverty cycle. The EITC, while designed to offset the burden of regular income taxes, can end up creating a disincentive to earn income beyond the EITC threshold due to a sharp increase in the effective marginal tax rate as the EITC phases out.

When someone is no longer eligible for a tax credit due to higher income, the lost credit is essentially a tax. For example, if $100 more of income causes you to lose $10 of tax credit, you have effectively been taxed 10% on that additional $100. So, your effective marginal tax rate has increased by 10%. This spike in the effective marginal tax rate due to a loss of credit, combined with the fact that many credits phase over a higher income tax bracket, can create a formidable incentive to avoid taking a higher income. Sometimes, it makes economic sense for someone to turn down a higher paying income to maintain eligibility for the EITC. Clearly this defeats the purpose. The raison d'etre of the EITC is to help working people earn more, not force them to remain in stasis.

While the EITC and many other welfare programs are politically appealing, tampering with the tax code can often have unintended consequences. Making it more expensive for low income people to escape poverty is just one of those unintended consequences. For example, someone phased out of the EITC earning income just over the threshold will be paying higher effective marginal tax rates than other taxpayers in their bracket. One reform option is that once someone is phased out of EITC, their effective marginal tax rate needs to be adjusted to match the income bracket they are in (as in the note in the following paragraph). Another fairly obvious, yet important, option is to question whether the EITC is worth having at all. In considering any reform option, the most important consideration is the tradeoff - what are we giving up?

Click on the image below for a numerical example of how the EITC creates distorted incentives. In this example, the effective marginal tax rate on the $36,000 should be adjusted to 15% instead of the 30% it is under current tax code.