The Macroeconomics of the Child Tax Credit
JThe nonpartisan Joint Committee on Taxation (JCT) recently provided lawmakers with a dynamic score and macroeconomic analysis of a policy to permanently extend the Child Tax Credit (CTC) enacted in the American Rescue Plan President Joe Biden’s Act of 2021 (ARP). A permanent extension of the ARP CTC, which originally lasted for one year, would be very costly in budgetary terms and detrimental to the economy as a whole.
Currently, the maximum CTC is $2,000 per eligible child, but will drop to $1,000 after 2025 with the expiration of most provisions of the Tax Cuts and Jobs Act of 2017 (TCJA). JCT compares this current law baseline to a credit of $3,600 for children under six and $3,000 for children ages 6 to 17. The ARP also raised the phase-out threshold for married filers and eliminated the $2,500 earned income threshold and phase-in.
The conventional JCT revenue estimate (i.e. assuming no macroeconomic impact) from a permanent CTC ARP is a $1.25 trillion reduction in federal revenue over the period 2023-2032. The dynamic estimate (ie taking into account changes in the size of the overall economy) is 9% pe, or $1.37 trillion, higher. The loss of additional revenue is due to a reduction in taxable income that would occur as a result of slightly slower GDP growth.
Why does an increase in the CTC cause a moderation in economic growth? It has a lot to do with higher marginal tax rates and resulting labor supply adjustments. First, the current CTC law is phasing in to low-income households at the rate of $15 for every $100 of additional income. Eliminating this phased introduction eliminates an incentive to work. Second, the CTC is being phased out for high-income taxpayers at the rate of $5 for every $100 of additional income. A larger credit creates a longer phase-out window, thereby hitting more taxpayers with higher effective marginal tax rates.
In February and March 2021, Kyle Pomerleau, Grant M. Seiter and I analyzed the impact of the expansion of the ARP CTC. In each income decile, the marginal tax rates for households with children increase, and for the lower half of the income distribution, the change is quite significant (see Figure 1). These changes, along with changing average tax rates, lead to reduced labor supply estimates and contribute to the policy’s negative impact on the economy. (In a separate April 2021 analysis, we pegged the loss of full-time equivalent jobs from this policy at 296,000 +/- 155,000.)
The high cost and negative impact on labor supply are strong reasons for Congress not to resurrect President Biden’s CTC. But Congress will likely do something about this in the next few years, and simply letting the CLC go back to $1,000 per child will be politically untenable.
A reasonable middle ground is to set the credit at $1,500 per child, eliminate the $2,500 income threshold, and keep the tiering. According to this alternative, the credit would more than triple its initial value in 1997 and be $500 more generous than the CTC in effect from 2003 to 2017. Unlike the ARP version, it would encourage work among low-income families and the removing the income threshold increasing the credit to $375 for low-income households. Additionally, increasing the value of CTC for low-income households reduces child poverty, a clearly desirable goal with long-term benefits not captured by traditional macroeconomic models.
Compared to a permanent extension of the TCJA credit, this alternative would save $22 billion a year while slightly improving work incentives. The macroeconomic effect of this policy would be small but greater than either of the above alternatives.
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This article originally appeared in the AEIideas blog and is reproduced with the kind permission of the American Enterprise Institute.