The Impact of EITC on Education, Labour Market Trajectories, and Inequalities

Abstract As a complement to the federal earned income tax credit (EITC), some states offer their own EITC, typically calculated as a percentage of the federal EITC. In this paper, we analyse the effect of state EITC on education using policy discontinuities at US state borders. Our estimates reveal that an increase in the state EITC leads to a statistically significant increase in the high school dropout rate. We then use a life-cycle matching model with directed search and endogenous educational choices, search intensities, hirings, hours worked, and separations to investigate the effects of EITC on the labour market in the long run and along the transitional dynamics. We show that a tax credit targeted at low-wage (and low-skilled) workers reduces the relative return to schooling, thereby generating a powerful disincentive to pursue long-term studies. In the long run, this results in an increase in the proportion of low-skilled workers in the economy, which may have important implications for employment, productivity, and income inequality. Finally, we use the model to determine the optimal design of the EITC.