Early Child Investment - Child Tax Credit

During recent budget negotiations, the Child Tax Credit in the US was significantly scaled down. What impact will this have on the macroeconomy?

In discussing the structure of the US budget last week, I describe that one of the consequences of the way the US budget is done means that certain programs need to be re-authorized. One such program is the Child Tax Credit (“CTC”), of which a critical part was not re-authorized in 2022. The part of the program that was not renewed has resulted in a significant scaling down of benefits to predominantly low and no income families with children starting from 2023. 

The original US CTC was a program introduced in 1997 that intended to improve outcomes for families with children by offering a tax credit when filing taxes (i.e. all tax filers with children, regardless of income level, could reduce their tax obligation by deducting $500 per child off their tax bill). Because this was a tax credit, families could only directly benefit from this program if they had a tax obligation. If you were not making any income, you would not owe any tax in the first place, so there was no benefit from reducing your tax obligation. 

In 2017, under the Tax Cuts and Jobs Act, the tax credit was increased to $2,000 per child and eligibility criteria were reduced for the CTC, including expanding the credit to a majority of no income families (i.e. they were transferred money even if their owed tax was $0). In 2021, under the American Rescue Plan Act, the program was further expanded, including an increased annual credit from $2000 to $3600 per child and removal of all income eligibility restrictions, making all low and no income families eligible to receive the full amount of the CTC regardless of their tax obligation. Essentially, the CTC was no longer a credit on your tax obligation but rather a cash transfer for all tax filers with children. 

However, this last program expansion in 2021 was not permanent as it expired at the end of 2022 (the 2017 expansion is scheduled to expire in 2025). The 2021 expansion was not renewed as part of the 2023 budget and many low to no income families have lost their CTC benefits. Should this program be renewed? To answer this question, I will turn to research that studies the impact of the CTC and other similar programs on the impacted families, as well as the wider economy.

The CTC and Child Development

The CTC is a program that increases the incomes of impacted families. In order to establish what impact the program had, we are interested in looking at how children's outcomes, such as educational attainment, income in adulthood and malnutrition change due to the increased incomes. As is typical in such situations, establishing causation is not straightforward, as there can be many other factors that may be influencing outcomes (for example, wealthier parents may have attained higher educational degrees, which impacts how they raise their child – in this case, the causal impact would be the parents having a higher degree rather than higher income). 

To establish the causal impact of increases in income, researchers have used natural experiments¹ (the method is discussed previously in another post on student loan forgiveness). In the US, the 2017 and 2021 expansions of the CTC program have been used as a natural experiment, along with the implementation of another program, the Earned Income Tax Credit (“EITC”). The EITC program, introduced in 1975, offered low income tax filers a direct cash transfer, which ranged from $560 to $7000 in 2022. Researchers were able to use the fact that some people who were eligible applied for the EITC, while others didn’t, even though they were eligible.

Before delving into the specific impacts of increased cash transfers to families, it is important to discuss through what potential channels children are impacted in their development. Wimer and Wolf (2020) summarize the research on child development by emphasizing two channels: family stress and family resources (or investment). Family stress focuses on “the economic hardship that comes along with low income and poverty”. These hardships generate numerous negative consequences such as worse mental health and impaired family functioning. There are also direct health impacts on babies due to maternal stress. Higher levels of maternal stress hormones have been shown to correlate with their children’s IQ and educational attainment. Family stress also impacts the bonding process between children and parents, and impacts behavior outcomes of children as well.

The family resources channel focuses on the investment into children in the form of financial investment (learning materials, toys, extra-curricular activities) and time investment (parents spending time with their children). The impact of family resources has been documented and demonstrated to have a proven positive impact on children’s outcomes. However, this does not necessarily demonstrate that only increasing income will have a positive effect, as the additional income may or may not be spent toward child investment. 

Wimer and Wolf summarized that income has been found to matter in three key ways. Firstly, the depth of poverty matters – the scarcer the resources, the more detrimental it is for children’s development. Secondly, the duration of poverty – the longer the child lives without the necessary resources, the worse the developmental outcome. Lastly, the timing of poverty is important – income is significantly more important in early childhood, between the ages 0 and 5, than it is in older childhood or adolescence. It is very difficult, if not impossible, to catch up with any development deficiencies that occurred in early childhood, regardless of subsequent investments made.

The Causal Channel

Bastian and Michelmore (2018) used changes in the EITC over the last 40 years to determine the impact of additional income on children’s outcomes. They found that for 13-18 year olds, an extra $1,000 in EITC given to their families increases the likelihood of completing high school by 1.3%, completing college by 4.2%, being employed as a young adult by 1.0% and higher earnings by 2.2%. Additionally, Manoli and Turner (2018) showed that $1,000 of EITC increased college enrollment among low income families by 0.5 percentage points. Regarding short term benefits, the EITC has been shown to also reduce incidence of low birth weight – for every additional $1,000 in EITC, low birth weights fell by 2-3% (Hoynes, Miller and Simon, 2015). It has also resulted in an increase in children’s test scores (Dahl and Lochner, 2012). 

Recent research by Ananat et al. (2021), specifically on the CTC, has shown that the expanded CTC reduced food insufficiency by 7.5 percentage points (25% reduction). The effect was most concentrated on families with annual incomes less $35,000. Furthermore, CTC payments reduced child maltreatment reports (Kovski et al., 2022).

CTC Drawbacks?

The CTC has been shown to have a significant amount of positive effects on child development, which translate into long-run benefits such as higher educational attainment and higher incomes. However, evaluating policies requires taking into account the Lucas Critique. When a new policy is introduced, individuals impacted by this policy might alter their behavior. Regarding the CTC, as families may now receive unconditional extra income, they may choose to reduce the amount of labor they supply, reducing their income. Thus, the net impact of the CTC might not be equivalent to the CTC amount.²

Focusing on the recent CTC expansion, Ananat et al. (2022) find no discernible impact of CTC on labor supply decisions either on the intensive margin (number of hours worked) or the extensive margin (the decision to look for a job)³, implying that parents do not work less when receiving this benefit. However, due to the recent and temporary nature of the CTC program, the result might not hold true if this benefit were made permanent. Other studies that looked either at natural experiments (Akee et al., 2010) or the EITC (Nichols and Rothstein, 2015) find varied (certain people increase work, others decrease work)⁴ but small impacts on labor supply decisions.

Overall, in economic research, there is evidence that higher income does reduce supplied labor (i.e. the more one earns, the fewer hours they want to work). This relationship is frequently used in economic modeling (Blundell and Macurdy, 1999); however, it appears this effect is far more muted or non-existent when looking at low income families. 

The CTC, as mentioned above, could potentially impact the family stress component by improving parents' mental health. Glasner et al. (2022) looked at the impact of the recent CTC expansion and found no significant change on the perceived well-being or mental health of parents. Although this result is surprising, especially in lieu of research that has found that the EITC does have positive impacts on mental health, the authors speculate that this could be due to the temporary nature of the expansion of the CTC program. 

Estimating the Net Impact of the CTC

The above discussion focused predominantly on the impact of the CTC on the direct recipients of this benefit. When evaluating the policy economy and society wide, it is important to assess the total impact on all participants in the economy, which naturally includes the tax cost of this program.

In a recent study, Goldin, Maag and Michelmore (2022) estimate the direct budget impacts of the expanded 2021 CTC. The additional cost of the expanded CTC (i.e. the incremental additional cost to the 2017 CTC) is estimated to be approximately $25.5bln. To be conservative, the authors also assume that families would reduce labor supply in response to the CTC benefit, which would reduce tax revenues by $0.7bln. Since children in the families impacted by the CTC benefit would have overall better educational and employment outcomes, their future income and therefore, future taxes would increase. As this is a benefit in the future, it needs to be discounted. The increased tax revenues from the children’s higher incomes would be expected to be larger by $5bln in present value terms. This would put the fiscal cost of the program at $21.2bln. 

However, this estimate does not take into account many of the other societal costs that can impact the budget. As I discussed in this post on the US budget, there are many cross-departmental impacts of policy decisions. Focusing only on the direct fiscal impact of the CTC is insufficient in estimating the true costs and benefits of the program. The CTC reduces many other future costs – it reduces the need for government health expenditures on both parents and children, reduces food assistance costs, reduces crime costs, increases the children’s life expectancy among other things. 

Garfinkel et al (2022) estimate the impact of the CTC (or any cash transfer program that impacts families) by factoring into account many of the additional effects (some of which were mentioned above) that have been estimated in economics research. The authors find that the total cost of the 2021 CTC is approximately $97bln (not incremental), but the overall societal benefits are at $982bln. In terms of breaking out the impact, the table below presents the estimated changes of the 2021 CTC by looking how a $1,000 CTC transfer would impact the different budgetary considerations.

The vast majority of the benefit goes to the direct beneficiaries – the recipients of the benefit. However, for the indirect taxpayer (the taxpayers that do not receive the benefit), the program is also marginally net positive. The main positive impact for indirect taxpayers is a significant reduction in the expenditure related to crime. This is one of the largest impacts of many cash transfers that is not easily noticeable – the absence of crime is not something that is tangible. Thus, very often this positive impact is not taken into account either by individuals or policy makers, although individuals would be willing to pay a large amount to avoid being victims of crime.

Conclusion

The expanded 2021 CTC, based on economic research, appears to be a very beneficial program. Direct beneficiaries see a very large positive impact from the program with better health, higher education attainment, improved longevity, and better mental health. Indirect taxpayers also benefit from this transfer, primarily through crime reduction, but also through increased future tax revenues and reduced costs of other public assistance programs. The 2021 expanded CTC was a very beneficial program that has unfortunately expired, significantly worsening the US economy in the long run. In 2025, the 2017 CTC expansion is also set to expire, which will further negatively impact the US economy.

1. In the hard-sciences (e.g. biology, chemistry), an experiment is when we take two groups and treat one of them with an intervention (for example, a medicine) and argue that any difference of outcomes between the groups is due to the treatment. That is because there shouldn’t be any difference in the group prior to the treatment if the enrollment into the groups was random. In social sciences (e.g. economics, psychology), such experiments are usually not allowed for ethical reasons or feasibility. However, they tend to occur naturally due to laws and regulations that arbitrarily divide people into two groups. For example, two groups with no discernible difference between them: one that receives government intervention and one that doesn’t.

2. A family receiving $1,000 CTC might now work less, reducing their income and the overall net effect would be $1,000 plus any change (reduction) in income.

3. The intensive margin is how much you do of a certain action and the extensive margin is the decision whether to do a certain action.

4. The reason parents might work more when receiving an unconditional benefit could be because they are able to afford child-care and therefore, have a permanent job.