Implementing the Earned Income Tax Credit: Shall Governments Design an Employee or an Employer-Based System

Abstract

In this paper, I use a labor market equilibrium model and a social welfare analysis for comparing between an employee-based Earned Income Tax Credit (EITC) and an employer-based system. Since the labor supply of the low-wage workers is relatively rigid, firms enjoy market power that might be used in detriment of the policy-maker's goals when implementing an EITC. While the employee-based system avoids coordination among firms, and thus reduces their market power, an employer-based system allows for automatic take-up at the initial stage of the program’s implementation, which constitutes an advantage. These pros and cons in both systems shall be weighted one against the other; for that purpose, I run simulations using empirically plausible parameters taken from Israel, where an EITC has been implemented for a decade and a half. The simulations show that in terms of social welfare, the employee-based EITC tends to dominate the employer-based system.

JEL Numbers– H21, H24, and I38.

Keywords

EITC employee social welfare

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