Search-Matching | Macro Paper Warehouse

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

Mon, 01 Jan 0001 00:00:00 +0000

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.

In depth

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.

The role of wage expectations in the labor market

Mon, 01 Jan 0001 00:00:00 +0000

This paper develops a Mortensen-Pissarides (DMP) search and matching model with internally rational (IR) agents who hold subjective beliefs about wages rather than perfect knowledge of the Nash bargaining outcome. The standard DMP model struggles with two empirical regularities: high volatility of U.S. labor market variables relative to productivity, and a near-zero correlation between labor market tightness and productivity post-1989. The IR model significantly improves alignment with U.S. labor market data relative to the standard rational expectations benchmark, by generating a self-referential belief mechanism: shifts in beliefs about the future returns to labor affect current wages, which agents use to update beliefs. Wage expectations in the model are consistent with European Commission professional forecasters data, and an econometric test rejects the rational expectations null hypothesis for survey real wage expectations.

Summary based on a working paper version, AI-assisted and human-reviewed. See the linked published article for the authoritative version.

In depth

Q1. What is internal rationality and how does it differ from standard rational expectations?

Internal rationality (IR) means agents know all internal aspects of their optimization problem and maximize their objectives given their knowledge, but lack perfect information about the equilibrium wage function that emerges from Nash bargaining; they therefore hold subjective beliefs about wages. Under standard rational expectations, workers and firms know the exact wage function from Nash bargaining. Under IR, they have limited foresight about the outcome of wage negotiations and use a subjective model to form wage expectations. This is a small but disciplined departure from RE: the paper considers belief systems implying only a small deviation from rational expectations that match aspects of survey wage expectations.

Q2. What is the empirical failure of the standard DMP model that motivates the paper?

The standard DMP model fails on two counts: it cannot reproduce the high observed volatility of unemployment, vacancies, and market tightness relative to productivity, and it cannot generate the near-zero post-1989 correlation between productivity and labor market tightness. The first failure—the Shimer (2005) puzzle—has attracted extensive research, but the near-zero tightness-productivity correlation has been largely neglected. The paper shows that allowing for small deviations from rational expectations in the form of internal rationality resolves both puzzles simultaneously.

Q3. What is the self-referential belief mechanism and how does it generate extra dynamics?

The model has a self-referential mechanism: shifts in beliefs about future returns to labor affect current wages, and agents use realized wages to update their beliefs about future wages; this creates an additional dynamic source beyond technology shocks that helps match the data. When firms and workers revise beliefs about future wages upward, current wages rise through the Nash bargaining outcome (since reservation values of both parties shift); this realization then feeds back into updating beliefs, generating wage and employment dynamics not tied to current productivity. This mechanism provides a microfoundation for previous adaptive learning models of unemployment.

Q4. What is the empirical validation of the model’s wage expectations?

Wage expectations in the IR model are validated against survey data from European Commission professional forecasters, and an econometric test rejects the rational expectations null hypothesis for real wage expectations from survey data. The consistency between model-implied and surveyed wage expectations provides external validation for the IR departure from RE, showing that the subjective beliefs assumed in the model correspond to beliefs actually held by professional forecasters rather than to arbitrary deviations.

Key concepts

internal rationality (IR) : a bounded rationality concept in which agents fully optimize given their beliefs and knowledge of their own decision problem, but lack perfect knowledge of equilibrium objects (here, the wage function emerging from Nash bargaining); allows small, disciplined deviations from rational expectations. DMP model : the Mortensen-Pissarides-Diamond search and matching model; the standard theory of equilibrium unemployment; criticized for generating insufficient labor market volatility relative to productivity (the Shimer puzzle) and for counterfactual positive tightness-productivity correlation. belief shock : an exogenous shift in agents’ subjective beliefs about future wages; generates employment and wage dynamics independently of current productivity shocks via the self-referential mechanism; introduced as an additional structural shock in the IR-DMP model.