Over the Cliff's Edge? Incentives Hurting Low-Wage Workers

June 13, 2019

Man at edge of dollar bill cliff

One day a single mother in Florida phoned Brittany Birken with a vexing dilemma.

The woman's employer was offering a dime-an-hour raise, a material boost at her low wage. But the woman, who had two children under five years old, was unsure whether to accept the pay hike because the additional income would make her ineligible for $11,000 a year in public childcare assistance.

"I am so sorry, but unfortunately I cannot make that decision for you," replied Birken, then head of the Office of Early Learning, the lead entity for childcare tuition subsidies in Florida.

The woman refused the raise rather than lose childcare benefits. The pay increase would not have come close to exceeding $11,000. Birken, now strategy officer at a University of Florida educational innovation center, said the woman's plight stuck with her. Birken is now part of a group of researchers and policymakers launching a demonstration project to help low-income workers in four Florida counties avoid so-called benefits cliffs as they gain new skills and thus higher pay.

The Florida mother who called Birken faced such a benefits cliff. The term refers to the scenario when means-tested public supports fall off a cliff as recipients earn more income by working more hours or securing promotions by learning new skills. Basically, these benefits cliffs result in relatively high penalties for advancing one's skills. They are, in effect, high marginal tax rates for the least wealthy: when low earners' pay inches up, they may wind up worse off.

"This is not so much about average tax rates," said Federal Reserve Bank of Atlanta research director Dave Altig, who is studying how benefits cliffs impede human capital development and the accompanying economic mobility. "What matters are incentives to engage in something that earns one more dollar. And those incentives are worse for the poorest than they are for the richest, and in fact worse than they are for everybody else."

Factoring in the additional tax paid and benefits lost

Altig figures the conundrum is rightly viewed as a problem with marginal tax rates, or the additional tax workers pay as their wages climb. For the lowest-wage workers, marginal tax rates are high not only because of the incremental boost in income tax, Altig explains, but also because of the accompanying loss of public benefits (see the table).

Incentives Worst for the Least Wealthy

Wealth Percentile

Median Effective Marginal Tax Rate

Lowest quintile (20%)

44%  (44 cents tax for every additional $1 earned)

Second quintile

43%

Third quintile

32%

Fourth quintile

33%

Highest quintile

35%

Note: The methodology used in these calculations is described here and here.
For a representative set of households with household heads aged 30–39, living in Florida. Wealth is the sum of lifetime earnings from working and the value of assets net of liabilities.
Source: 2016 Survey of Consumer Finances, the Fiscal Analyzer

Benefits cliff issues are gaining increased attention in workforce policy circles. A recent conference at the Atlanta Fed assembled dozens of leading researchers and practitioners who are studying benefits cliffs and how policymakers might address the problems.

This field of study is of particular interest to those who shape and study workforce development and training strategy because those are designed to help people, especially low-wage earners, gain skills and climb a career ladder. If people have to sacrifice a benefit or income, even in the short term, then they may be far less likely to stick with a training or education regime even if it is likely to pay off in the long term.

A 2018 study by the Urban Institute examined the Health Profession Opportunity Grant Program, a federal initiative aimed at helping low-income individuals enter the booming health care field. The research showed that only 3 percent of people who completed a certified nursing assistant program continued their training to earn licensed practical nurse or registered nurse status, even though those jobs would command far higher pay. Median pay for a licensed practical nurse, for instance, was $46,240 in 2018, about $19,000 more than the median pay for a certified nursing assistant, or CNA, according to the U.S. Bureau of Labor Statistics.

Benefits cliffs are probably not the sole reason for the low rate of CNAs moving on to more rigorous but rewarding "upskilling" programs. But cliffs and income given up during the additional training are doubtless factors illustrating that "something is wrong with the incentives," Altig said.

Data can be imprecise

Determining exactly how many people face benefits cliffs each year is difficult. Indeed, the difficulty in gathering data to quantify how many are about to encounter a cliff is itself a big problem in understanding the issue and devising solutions, said Alex Ruder, a senior adviser who specializes in workforce development in the Atlanta Fed's community and economic development group.

Still, data make clear that millions of low-income families potentially confront cliffs. Research by the U.S. Department of Health and Human Services shows that about 12.6 million households receive some combination of eight federal aid programs, including the supplemental nutrition assistance program, the earned income tax credit, Medicaid, and child tax credits.

Monetary policy, the traditional province of the Federal Reserve, can do little to address issues that affect the societal distribution of income and wealth. However, these distributional concerns powerfully influence macroeconomic developments such as overall consumption, the single biggest engine of growth in our economy, as Federal Reserve governor Lael Brainard explained in a recent speech.

What's more, addressing the problem of benefits cliffs would help not just the families directly affected. The larger economy and taxpayers also stand to gain. For this reason, Altig stresses that the desire to address benefits cliffs is not about "do-gooderism."

"This is about a bottom-line proposition for businesses. It's about a bottom-line proposition for public policymakers," he said.

Consider the CNA case again. Under certain assumptions, taxpayers on net can save roughly $55,000 for every one person who moves from a CNA to a licensed practical nurse, and $130,000 for every CNA who goes on to become a registered nurse, according to research by Altig; Ruder; Ellyn Terry, an Atlanta Fed economic policy analysis specialist; and Laurence Kotlikoff of Boston University. This savings is in the form of assistance no longer paid out and additional tax revenue from a worker earning more money.

For businesses, the payoff is in expanding the pool of skilled workers as many industries face acute shortages of them. Staying with the nursing field, the United States faces a shortage of 154,000 registered nurses by 2020 and more than 510,000 by 2030, according to a 2017 study in the American Journal of Medical Quality. The more people who receive training and earn certifications rather than getting deterred by benefits cliffs, the smaller those shortages will be. Similar dynamics are at work in manufacturing, information technology, and other fields.

Some speakers at the Atlanta Fed conference noted that the current federal safety net system is inherently ill-suited to promote long-term career development for low-income workers. Rather, the system is structured primarily to support consumption today—to help families buy groceries, pay for childcare, and keep the utilities turned on.

For that reason, among others, devising policies to lessen the damage from benefits cliffs is complex, experts say. But a few potential approaches mentioned at the Atlanta Fed conference include making tools available to help low-wage workers plan their finances; phasing out benefits gradually rather than abruptly ending eligibility, a strategy being piloted in some Florida counties; and not immediately counting certain income against benefits eligibility.

Most of those approaches involve public policy. Altig points out that it is also critical to appeal to private employers' own motives by demonstrating how they benefit from helping to solve the problems of low-income earners. For example, most employers design benefits with middle- to upper-income earners in mind, such as tuition reimbursement programs that require the employee to pay tuition up front.

At the Atlanta Fed conference, Holly Hankinson, advocacy director at the Woman's Fund of the Greater Cincinnati Foundation, provided an example of where well-meaning employer-provided benefits can fall short. A measure for lower-wage earners can be as simple as replacing public transport reimbursement policies with direct distribution of company-funded monthly bus passes of equal value. Low-wage workers might be able to spend $2 a day for transportation, but some would be hard-pressed to hand over $75 for a monthly pass. Hankinson said employers find such benefits reduce employee turnover and thus save them considerable money.

photo of Charles Davidson
Charles Davidson

Staff writer for Economy Matters

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