The Impact of EITC on Education, Labour Market Trajectories, and Inequalities
What this paper finds — and why it matters
This paper studies the effect of the Earned Income Tax Credit (EITC) on educational attainment and labor market trajectories through two complementary approaches. Using policy discontinuities at U.S. state borders—exploiting variation in state EITC generosity set as a percentage of the federal EITC—the paper finds that an increase in the state EITC leads to a statistically significant increase in the high school dropout rate. The mechanism is that a tax credit targeted at low-wage (low-skilled) workers increases the value of low-skilled employment and reduces the relative return to schooling, generating a powerful disincentive to pursue long-term studies. A structural life-cycle matching model with directed search and endogenous educational choices, search intensities, hirings, hours worked, and separations is developed to quantify the long-run general equilibrium effects: in the long run, EITC reduces the proportion of high-skilled workers, with ambiguous effects on income inequality that depend on the competing channels through which EITC affects both the supply and demand sides of the labor market.
Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.
Q1. What is the empirical strategy for identifying the effect of EITC on education?
The paper identifies the causal effect of state EITC on education by exploiting policy discontinuities at U.S. state borders, comparing contiguous PUMA pairs on opposite sides of state borders that differ in state EITC generosity. State EITC rates are set as a percentage of the federal EITC and have varied considerably since the mid-1980s. Borrowing from the minimum wage literature (Dube et al., 2010; Hagedorn et al., 2015), the border-discontinuity design controls for local labor market conditions that vary continuously across state borders while isolating the effect of the discrete EITC policy difference.
Q2. What is the labor market mechanism linking EITC to education?
EITC raises the value of low-skilled employment by directly increasing the earnings of low-wage workers, which in turn reduces the relative return to investing in education, generating a powerful disincentive to pursue long-term studies. When directed search is present—as supported by recent empirical studies—educational decisions affect both job-finding probabilities and labor incomes over the life cycle. EITC’s subsidization of low-skilled work contracts the education premium in this framework, making the forgone earnings cost of staying in school larger relative to the low-skilled employment option supported by the EITC.
Q3. What does the life-cycle matching model contribute?
The structural life-cycle matching model with directed search and endogenous educational choices, search intensities, hirings, hours worked, and separations quantifies the general equilibrium and long-run effects of EITC that purely reduced-form studies cannot capture—including the feedback of an expanded low-skilled labor force on equilibrium wages and job creation. The model endogenizes labor demand, capturing both household responses (education, hours, search intensity) and firms’ responses (job creation and destruction). It is solved and estimated to replicate the life-cycle profile of labor market variables.
Q4. What are the long-run implications for inequality?
In the long run, EITC reduces the proportion of high-skilled workers in the economy, with ambiguous effects on income inequality because of offsetting channels: EITC directly increases earnings of low-skilled workers, but by expanding the supply of low-skilled labor it may also depress low-skilled wages; additional channels through unemployed workers’ search effort and employed workers’ hours further complicate the net effect. The model is used to determine the optimal design of the EITC that balances the income-support objective against these unintended long-run effects.
Key concepts
state EITC : a supplement to the federal Earned Income Tax Credit set as a fixed percentage of the federal credit; varies across states; used in this paper as the identification source for the effect of EITC generosity on education via border discontinuities. directed search : a labor market framework in which workers and firms direct their search to specific submarkets with posted wages; in this setting, educational choice affects both job-finding probabilities and wages over the life cycle, amplifying the disincentive effects of EITC on education relative to random-search models. education-EITC disincentive : the mechanism by which EITC targeted at low-wage workers raises the relative value of low-skilled employment and reduces the return to schooling, generating an increase in high school dropout rates as a side effect of the anti-poverty policy.