Right now, I am working on modeling the impacts of a Child Tax Credit in Ohio. One of the questions I am trying to answer is how introducing a new tax credit will impact peoples’ decision to participate in the labor force.
The particular phenomena I am interested in is called the Benefit Cliff, where small changes in earned income can result in large changes in benefit amounts. For example, if we say that only people who earn less than $50,000 annually get $1,000 in benefits, then it would be beneficial for someone earning $50,000 to reduce their earned income somehow, either by working less or taking a pay cut in order to qualify for the benefit. If there is a minimum amount needed to qualify for a benefit, then low-income individuals would have a greater incentive to increase their earned income to take advantage of the new credit.
We can change how severe the benefit cliff is by including benefit phase-ins and phase-outs. This approach is common for tax policies such as the Earned Income Tax Credit. The purpose of structuring our benefits like this is to reduce the benefit cliff, particularly the disincentive that exists as the benefit goes away.
In practice, benefit cliffs don’t have as severe of a workforce impact as they potentially could. This is because in the real world, people don’t often have the ability to fine tune how much labor they choose to supply. People get scheduled in shifts, they don’t often get to negotiate how long those shifts are.
In theoretical terms, we call this a labor demand constraint. Employers don’t purchase labor on a continuous spectrum, they purchase it in discrete increments. Additionally, those increments regularly come in the form of contracts that are not flexible in the short term, reducing the ability of individuals to adjust their labor supply in response to tax changes.
Despite this, there are two reasons why we still expect a new child tax credit to have an impact on Ohio’s workforce. First, all of the practical concerns above exist in the short to medium term. In the long run, people can adjust their working habits to maximize their utility in light of a new tax credit.
Second, we are currently in a historically tight labor market. Unemployment is extremely low, and employers are having difficulty finding people to fill open positions. This reduces labor demand constraints, and gives more power to individuals to choose how much they want to work.
I’m still crunching the numbers to figure out exactly what this impact will be, but I suspect the net result will be fairly small. The far more substantial impact will be the money that goes to low- and middle-income families with young children.
We saw during the pandemic just how significant the Federal child tax credit was in reducing child poverty. Even if there are some negative workforce impacts, it is very likely that the benefits will outweigh those costs.