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Tax Credits, the Minimum Wage, and Inflation

Elaine Maag

Published: December 29, 2006
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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in PDF Format.

The text below is a portion of the complete document.


Abstract

Two primary wage-support policies help low-income families: the minimum wage and targeted tax credits. Since 1997, when Congress last raised the minimum wage, the real value of the minimum wage has fallen about 20 percent because of inflation, while the earned income tax credit (EITC) and child credit have been expanded. This brief illustrates how current tax rules interact with the minimum wage and considers whether increased tax credits could substitute for minimum-wage increases for those earning the federal minimum wage. Increasing tax credits enough to substitute for raising minimum wage is probably infeasible because of the cost and the high marginal tax rates required. A more direct route to helping low-wage workers is to raise the minimum wage and index it to inflation.


Introduction

Two primary wage-support policies help low-income families: the minimum wage and targeted tax credits. The minimum wage serves as a floor on earnings for most low-wage workers, regardless of their family characteristics. The earned income tax credit (EITC) and child tax credit target benefits almost exclusively to families with children and are based on a family’s total income rather than an individual worker’s. Congress sets the minimum wage; as of December 2006, it had last been raised in 1997 to $5.15 an hour. Since that time, the real value of the minimum wage has fallen about 20 percent because of inflation. A recent proposal would increase the minimum wage to $7.25 an hour. While the minimum wage stagnated, Congress expanded both the EITC and the child credit. Full-time minimum-wage workers received no benefit from the EITC expansions and only benefited from the child credit expansions from 2001 through 2004. The expansions helped workers with higher—though still relatively low—wages much more.

This brief illustrates how current tax rules interact with the minimum wage and considers whether increased tax credits could substitute for minimum-wage increases for those earning the federal minimum wage. Raising the EITC enough to offset the loss in purchasing power of the minimum wage could prove costly. If wages were held constant at $5.15 an hour for a full-time worker,1 the maximum EITC would have to increase by about $5,000 for a one-earner household to achieve the same after-tax income as an increase in the minimum wage to $7.25; the EITC would have to increase about $6,500 for a twoearner household to achieve the same gains. In 2006, a family does not benefit from the child credit until its earnings exceed $11,300—or $5.43 an hour for one full-time worker. Because that threshold increases each year, families must increase earnings to benefit in future years. To receive the maximum $1,000 per child benefit in 2006, a couple with one child must earn at least $17,970; couples with two children must earn at least $24,180.

This analysis shows that increasing tax credits enough to substitute for raising minimum wage is probably infeasible because of both the cost and the high marginal tax rates required. However, relatively straightforward modifications to the child credit could help households earning near the minimum wage and others that face a declining child credit each year. A more direct route to helping low-wage workers would be to raise the minimum wage and index it to inflation.

Note: This report is available in its entirety in PDF Format.