Feel that earning power

I'll have more on the Obama tax plan sometime in the next week; I'm trying to go through and look at the sum total spending and tax proposals by the candidates, which takes time.

Meanwhile, one proposal I'm surprised not to find being talked up is the Earned Income Tax Credit, a variation on Milton Friedman's famed negative income tax proposal that is very well regarded by Democrats and Republicans alike. Defying the aphorism that "a program for the poor is a poor program", the EITC has been expanded in every major tax package in the last two decades, and with good reason: it helps out marginal members of the labor force, while still encouraging work.

But this Raj Chetty profile suggests that it may not work as well as it could:

Chetty is drawn to the psychological underpinnings of economic theory. Before deciding on a change to the tax code, he argues, politicians should study how consumers think about taxes. With that in mind, he created an experiment to determine whether separately labeling the sales tax on an item would affect a shopper’s behavior. He persuaded a large grocery chain to allow him to post tags next to 750 of their products for three weeks, showing how much the item would cost after sales tax was added. Fearing the experiment would result in lower sales, the chain did not allow Chetty to post signs on its most popular items.

The store management’s fears were well founded. When consumers knew just how much more taxes would cost them, they reduced their purchases of the items by about 7 percent. As part of the working paper—titled “Salience and Taxation: Theory and Evidence,” coauthored by Adam Looney of the Federal Reserve Board and Kory Kroft of Berkeley’s economics department—Chetty surveyed customers entering the store to determine whether they knew which goods were taxed and which ones weren’t. They were generally able to distinguish the two categories. In other words, they knew that an item was taxable, but actually seeing the total cost—including the tax—at the time of a potential purchase discouraged them from buying it.

“It may not sound unusual. But in economics, most people don’t do experiments. They’re happy to take the data as they find it. They don’t create novel experiments to understand the way the world works,” Feldstein says. “It was a very ingenious way of showing how taxes actually affect shopping behavior—that people actually shopped less when they recognized the full cost of what they were doing.”

Given that consumers seem to weigh taxes more heavily when they are reminded of the burden, Chetty wondered whether Americans understand the implications of the Earned Income Tax Credit, a program meant to motivate low-income people to work by subsidizing their wages. Enacted in 1975, the program was expanded in 1986, 1990, 1993, and 2001. It is considered one of the government’s central anti-poverty policies. Under the program, those who earn, say, $10,000 a year might be given a credit once a year for $4,000, or 40 percent of their salary. But after surveying some of the beneficiaries of the EITC , Chetty found that most people who get it don’t understand how it works.

“They just know that after they file their taxes, they get a big check,” Chetty said. “That is seriously problematic for public policy, because the whole point of the program is to give people an incentive to work. To give them an incentive to work, they really need to understand that they’re really being paid $14 an hour, not $10 an hour.”

The EITC seems to function less as a wage boost than as a system of forced savings for the poor. That's not a perjorative, either; forced savings are popular even with the forcees. Witness the number of (middle class) people I used to work with who would overwithhold in order to experience the joy of getting a check back from the IRS. When I tried to explain that they were essentially making an interest-free loan to the government, they countered that they liked having a big check they could spend on something memorable, like a vacation or a downpayment on a car. The EITC beneficiaries I've known seemed to view it much the same way.

But how to make it work more like a direct wage subsidy? Refunding the money in each paycheck would be outrageously expensive to administer, and poor people who were overpaid the credits in the beginning of the year are vanishingly unlikely to have the money to cover a shortage at year's end. Moreover, the forced savings aspect can be a real benefit; money that would otherwise trickle away on small sundries can instead be put towards a reliable car to get to work, a rental deposit, or something else that measurably improves their lives. Perhaps a statement issued with each paycheck, showing the accumulated EITC?