Tax Reform and Poverty

The tax system has a pervasive impact on poverty, both directly through its role in the distribution of society’s resources and indirectly through its effects on the incentives for economic decisions like working and saving. The two most important facets of the tax system for low-income families are payroll taxes and the Earned Income Tax Credit (EITC), the former of which levies a tax on earned income and the latter provides a tax credit for earned income. Attention to the impact of tax reform on low-income families is especially important in light of the persistence of poverty, wage stagnation at the bottom, and the growth of income inequality. In 2004, 37 million Americans were below the official poverty line, including 13 million children.1 Underlying the persistence of poverty has been wage stagnation at the bottom. From 1973-2003, real hourly wages for men at the 10th percentile of the earnings distribution fell 3 percent. At the same time, median wages fell 1 percent and wages for workers at the 90th percentile rose 22 percent. The economic blow for families at the bottom of the income spectrum was partially cushioned by several expansions in the EITC which more than account for the entire 7 percent growth in after-tax incomes for the bottom quintile over this period. The causes of wage stagnation and rising inequality have been much debated. Many of the potential causes, like skill-biased technological change, a shift to a winnertake-all society, and increased competition undermining the bargaining power of labor, do not lend themselves to direct policy solutions. Regardless of the cause, however, further reforms and changes in the tax system have the potential to continue to ameliorate some of the underlying economic trends and ensure that all income groups share in the continued strong productivity growth. President Ronald Reagan once called the tax bill that included the EITC ‘‘the best anti-poverty, the best profamily, the best job creation measure to come out of Congress.’’ Although some conservatives criticize the EITC, it continues to maintain substantial bipartisan support and frequent calls for its expansion. Recently, for example, New York Times columnist David Brooks stated, ‘‘we should raise the earned-income tax credit to lessen [low-income families’] economic stress.’’2 Kevin Hassett of the American Enterprise Institute (AEI) also noted that, ‘‘low wages generally in some sectors of the economy may be a legitimate policy challenge. A correct response might be to expand the earned income tax credit.’’3