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Self-Employed Workers More Likely to Adjust Their Income if Government Incentives Are Strong

Summary:
Tax Credits in the US Self-employed workers in the US adjust their income if government welfare and aid programmes provide the incentive to do so. Though some make this adjustment legally by working more or fewer hours, other self-employed workers choose to illegally misreport their income. These are the findings of a study conducted by the Centre for European Economic Research (ZEW), Mannheim, in cooperation with the ifo Institute, Munich, and the Institute of Labor Economics (IZA), Bonn. Using the example of tax credits in the US, which function similarly to wage subsidies or the German combination wage, the study shows that workers are more likely to engage in tax avoidance or tax evasion if the incentives to do so are

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Tax Credits in the US

Self-employed workers in the US adjust their income if government welfare and aid programmes provide the incentive to do so. Though some make this adjustment legally by working more or fewer hours, other self-employed workers choose to illegally misreport their income. These are the findings of a study conducted by the Centre for European Economic Research (ZEW), Mannheim, in cooperation with the ifo Institute, Munich, and the Institute of Labor Economics (IZA), Bonn.

Using the example of tax credits in the US, which function similarly to wage subsidies or the German combination wage, the study shows that workers are more likely to engage in tax avoidance or tax evasion if the incentives to do so are particularly high due to the tax credits programme in their state of residence. Dependent employees, meanwhile, barely respond to such incentives.

For the study, researchers used data on US “earned income tax credit” (EITC) on both the county and state level between 1996 and 2009. Covering around 26.7 million workers drawing 63 billion dollars a year in benefits, the EITC is currently the largest anti-poverty programme in the US. The programme serves to supplement workers’ wages and reduce the income tax burden primarily on low-wage earners, whilst also providing incentives to work. Whether someone is entitled to this form of subsidy is determined based on the amount of taxable income they earn as well as the number of children they have.

Taxpayers in different states receive different amounts in tax rebates

The size of the EITC subsidy varies greatly from state to state, with taxpayers with the same income but living in different states receiving different amounts in tax rebates from the programme. As a result of this state of affairs, the top tax rate for the EITC also fluctuates considerably in the individual states and over the course of the observation period for the study. Remarkably, the higher the top tax rate is, the higher the number of self-employed people claiming these subsidies.

“We can see that when a state raises the EITC top tax rate, this is followed by a disproportionate number of claims from self-employed workers who report their taxable income in such a way as to receive the highest possible tax credit they can,” explains Florian Buhlmann, researcher in the ZEW Research Group “International Distribution and Redistribution” and co-author of the study. “The more generous the incentives from the government programme, the more strongly workers reacted by using strategies to get as high a subsidy from the programme as possible,” says ZEW Research Associate and department head at the ifo Professor Andreas Peichl, summarising the findings of the study.

Though the results of the study can be tracked over the entire observation period, there is a significant drop between the years 2007 and 2009 which the researchers attribute to the onset of the financial crisis in the US. This is because during this period in general there was a higher number of self-employed workers applying for subsidies.

Publication

  1. Buhlmann, Florian, Benjamin Elsner and Andreas Peichl, "Tax Refunds and Income Manipulation Evidence from the EITC", ZEW Discussion Paper No. 17-060 , ZEW Zentrum für Europäische Wirtschaftsforschung GmbH, Mannheim, 2017, 32, Download PDF | Details

Clemens Fuest
Clemens Fuest took over from Hans Werner Sinn as chairman of the IFO Institute in April 2016. He is professor at the Faculty of Economics of the University of Munich.

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