The Optimal Tax Treatment of Families with Children

In the United States, the value of child tax benefits in the federal income tax have increased dramatically since 1992 and now exceed $140 billion annually. This paper examines the efficiency implications of child tax benefits. Using a representative agent framework, it lays out conditions under which a child subsidy is part of an optimal tax policy. The key finding is that child tax benefits are not part of an optimal tax policy if children and leisure (time not spent doing market work) are complements or weak substitutes. The results imply that children and leisure are complements and thus child subsidies are not optimal. The sign of the optimal tax result remains unchanged when the model is extended to allow for time costs associated with raising children, but the optimal child tax is likely lower. Explicitly including quality-producing expenditure on children as a fourth good in the model leads to the result that child subsidies likely reduce the average quality of children. Distributional considerations may play an important role in providing a justification for child subsidies, although this paper suggests that this is only true at the lower range of the income distribution.