(3) The document uses the concept of a “poverty trap” while this does not exist.
The EITC, direct payroll tax reduction and wage cost subsidies
Pearson and Scarpetta (2000:22) rightly conclude: “Furthermore, there is growing evidence that there is no single measure which, of itself, will have a major impact on employment. Hence, [minimum wage policies] have to be seen as an element of a comprehensive policy strategy, e.g. the ten broad policy guidelines of the OECD Jobs Strategy. But any policy that has empirical evidence supporting claims that, in certain circumstances, it could promote both efficiency and equity by fostering employment and decent levels of family income deserves to be considered in countries facing such problems.” It should be clear that the current analysis, e.g. on the tax void, does not constitute a ‘single measure’. The analysis can only be understood within the whole discussion.
Modern systems of taxation tend to favour the Tax Credit instrument, notably the “Earned Income Tax Credit” (EITC), as opposed to direct payroll tax reduction and wage cost subsidies, see e.g. Hotz & Scholz (2000) and Dilnot & McCrae (2000).
However, tax exemption should be set at subsistence income (the net minimum wage). Tax credits then could be used for productivity levels below that subsistence levels. Tax credits that are applied above subsistence are not required and have the psychological drawback that the recipient is no longer considered self-reliant but reliant on the state.
The discussion in the literature suffers from obscurity on this issue, as can be shown below. In the following discussion, we will limit our attention to earners, so that we do not have to speak about the ‘earned exemption’ versus EITC, and just discuss ‘exemption’ and ‘tax credit’.
(1) Hotz & Scholz (2000:37) conclude: “The problems facing workers with low levels of human capital in the US are severe. Our reading of the economic and policy literatures is that the EITC is the most sensible, primary policy to support low-wage labour markets in the US. Our conclusion is tempered by the institutional facts about US labour markets noted in the introduction. Economies with different institutional features may find EITC-like policies to be less effective or administratively infeasible. Though reliance on the EITC is sensible, we view targeted employment subsidies as a complementary policy. We see less wisdom in minimum wage increases, payroll tax reductions for low-income families, and wage rate subsidies as proposed by Phelps, at least in the US.”
However, it will be better to choose tax exemption at the subsistence level. If that implies a ‘payroll tax reduction’ or ‘wage rate subsidy’ then this is not a drawback.
(2) Hotz & Scholz (2000:26) give this useful bit of information on the US situation: “the EITC, gives nothing to those without earnings. (…) the EITC provides a subsidy to earnings up to a specific income threshold. For example, consider taxpayers with two or more children in 1998. The EITC gives a 40 per cent earnings subsidy up to $9 930. Taxpayers with earnings between $9 390 and $12 260 receive the maximum credit of $3 756. The credit is reduced by 21.06 per cent of earnings between $12 260 and $30 095.”
They note: “The US has a fairly low minimum wage of $5.15 per hour. While in perfectly competitive markets employer-based and supply-side subsidies (like the EITC) will have equivalent effects, with a binding minimum wage, employer-based subsidies may be more effective policy. A binding minimum wage limits the ability of employment and wages to adjust to an increase in labour supply prompted by the supply-side subsidy.” (Hotz & Scholz (2000:27)).