Nonparametric Estimation of Labor Supply under the Earned Income Tax Credit and Welfare Programs

Abstract

This paper examines the effect of the Earned Income Tax Credit (EITC) and welfare programs on the labor supply of single mothers. The EITC consists of an earning subsidy program in the form of marginal tax credits to the working poor. The presence of different marginal tax rates at the various earning levels makes the recipients' budget constraint a non-linear function of hours worked. Correspondingly, I estimate a flexible nonparametric labor supply function, taking full account of the nonlinear budget constraint. I then simulate the impact of each program component and their combined impact on hours. Contrary to the standard assumption of constant policy effect, I show that the EITC effect is heterogenous. An expansion of the EITC increases the hours of poor single mothers whose tax credits increase with earnings, while it decreases the hours of those not so poor whose tax credits decrease with earnings. These two effects cancel out, which explains why previous studies, focusing on the average treatment effect, found that the EITC substantially increased the participation, but had little net effects on the average hours worked. I also find that the recent EITC expansion and welfare reform worked together to significantly increase the hours worked by single mothers. Moreover, despite its disincentive effect on part of the population, the EITC improved the family income for all affected groups.