Taxation and labor supply decisions: impact of the earned income tax credit in Italy

Purpose - The earned income tax credit – so-called “monthly 80 euros bonus” – introduced in Italy in 2014, has been characterized by a rapid phase-out area for budget-constraints reasons, leading to very high effective marginal tax rates. The aim of our analysis is to empirically investigate whether this policy design has effectively determined a reduction of the intensive margin of the labor supply of employees. Design/methodology/approach - The empirical analysis is based on the longitudinal electronic database of Personal Income Tax returns from 2011 to 2017 assembled by the Department of Finance of the Italian Ministry of Economy and Finance. The timing and the structure of the reform allow us to exploit the “Regression Discontinuity in Time” (RDiT) framework using the before/after with the discontinuous policy change. Findings - Despite a close to 100% effective marginal tax rate for a substantial income range, a unique feature among EU and OECD countries, we found that the tax credit design had no negative effect on changes of the labor effort in Italy, challenging the economic theory but confirming previous empirical evidence. We identify the following explanations of this result: the unawareness of the workers of their effective marginal tax rate, caused by the complexity of the tax system, the limited ability of workers to actually decide their labor effort and the fact that labor supply also responds to anticipated future wage changes. Originality/value - First, this is the first paper that applies the RDiT approach to measure the impact of the EITC policy, as previous studies applied difference-in-differences. Second, in previous empirical studies analyzing the effects of EITC on labor effort, the taxpayers’ behavioral response is observed where the EMTRs are around 50% or lower. Our application tests, in a quasi-natural experiment, an extremely high EMTR, reaching 96%, and has the added advantage of being based on the entire dataset of dependent employees. Third, our paper also specifically contributes to the literature on EITCs in Italy and their impact on the labor market.