An Overview of the Work Opportunity Tax Credit

The Work Opportunity Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. and Jobs Act was introduced in the Senate earlier this year by Senator Roy Blunt (R-MO), Senator Sherrod Brown (D-OH), Senator Ben Cardin (D-MD), Senator Bill Cassidy (R-LA), Senator Bob Menendez (D-NJ), and Senator Rob Portman (R-OH). This bill would make permanent the Work Opportunity TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Credit (WOTC), which was originally established as a temporary tax credit, as part of the Small Business Job Act of 1996. It replaced the Targeted Jobs Tax Credit (TJTC), a similar tax credit which had expired in 1994.

The WOTC has been extended multiple times, and it is set to expire at the end of this year. Before voting to extend the WOTC, or otherwise modifying or even ending it, policymakers should weigh the benefits and costs of the tax credit, along with the trade-offs between equity and efficiency.

The WOTC is a firm-level tax credit intended to help workers from certain disadvantaged groups get jobs. There are 10 targeted groups, which include certain veterans, ex-felons, Supplemental Nutrition Assistance Program (SNAP) recipients between the ages of 18 and 39, and long-term Temporary Aid for Needy Families (TANF) recipients.

There are two ways that firms can obtain the tax credit. For one, qualified workers can obtain a conditional certification form from a state or local workforce agency. Once hired, their employers complete a certification request form. Alternatively, employers can fill out a certification request form and an individual characteristics information form if they think their employee is in a target group. Either way, employers must mail both forms to their state’s WOTC coordinator within 28 days of the employees’ first workday.

States, which receive administrative funding from the Department of Labor (DOL), then verify that these employees are members of WOTC groups. Once verified, the state agency notifies the employers, after which the employers can claim the tax credit. The size of the tax credit is 25 percent of the qualified employee’s first year wages if the employee works between 120 and 400 hours of that year. This grows to 40 percent of the employee’s first year wages if the employee works more than 400 hours of that year.

There is a cap on the amount of WOTC-eligible wages per qualified employee; this varies by group, although most groups have a cap of $6,000 (so employers can claim at most a $2,400 tax credit for each employee’s first year). The WOTC is a nonrefundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit (EITC). that can be carried back up to one year or carried forward up to 20 years. In FY 2017, the Office of Management and Budget estimated that there were around $1.3 billion in WOTC claims.

Because administration of the WOTC is split between the IRS and state-level labor agencies, no unified dataset exists. This means that there is a limited amount of research. Of the few studies that do exist, most suggest that the WOTC has resulted in positive employment gains for targeted disadvantaged groups, at least in the short term. For example, one study argues that the WOTC increased employment rates among eligible groups by around 12.6 percentage points.

Other studies, which arguably use more detailed datasets or more advanced statistical techniques, have found smaller gains. One study by the RAND Corporation, looking specifically at qualified veterans, found that the WOTC increased their employment rates by 1.8 percentage points and their wage income by 39.9 percent. Another study, looking at a Wisconsin dataset, found that the WOTC increased employment rates by 5.9 percentage points and wages by around 9 percent. However, unlike the other two studies, this study differentiates between short-term and long-term impacts. It ultimately finds no evidence for the WOTC having a positive impact on either employment rates or wages for targeted groups in the long term.

Therefore, it seems possible that the WOTC only results in short-term gains for these groups, failing to improve their long-term employment outlook. If this is the case, it might be because the jobs that these workers get fail to provide them adequate training, or otherwise improve their human capital, which they would need for future jobs.

Participation in the WOTC is also low. One study estimated participation in 1999 among eligible disadvantaged youth as less than 17 percent and among welfare recipients as less than 33 percent. With higher participation rates, the WOTC could potentially have a much larger impact on the employment outcomes of the targeted groups. Participation rates might be higher with a higher tax credit, more publicity/outreach efforts, a more streamlined application process, and/or more lax standards and targeting.

One potential issue is cost. On this point, the RAND study conservatively estimated a cost of $10,000 for each job generated by the WOTC. For comparison, one study estimated that the TJTC cost around $7,900 per job generated, while other studies have estimated that the Earned Income Tax Credit, a more general worker-side tax credit aimed mostly at poor families, cost around $6,100 per job generated. As such, the costs of the WOTC appear to be in line with similar job tax credits. Moreover, these costs are significantly lower than the costs of direct job programs. For example, a report by the Hamilton Project analyzed several job guarantees in which the government would provide a job to any qualified worker that wanted one, and found a per job cost of at least $31,000 for these programs.

Another potential issue is that employers might try to game the WOTC, to maximize the total amount of tax credits they receive. There are two ways this could happen. The first is displacement: employers fire non-qualified employees in order to hire qualified employees. The second is churning: employers fire qualified employees who are no longer eligible (e.g., they reached the wage cap) to hire “fresh” qualified employees. Displacement would be an issue, since the employment outcomes of poor, non-eligible workers would be negatively impacted. Likewise, churning would be an issue, since eligible workers would be less likely to have stable, long term-employment. However, a study by the Government Accountability Office (GAO) found no evidence for either displacement or churning. In fact, the study found that 93 percent of survey firms thought that displacement and churning were not cost-effective. These firms said that the WOTC only covered around 47 percent of the costs to recruit, hire, and train new employees, on average.

A bigger potential issue is that of intramarginal effects: the WOTC might be subsidizing firms for hiring workers that they would have still hired without the tax credit. Indeed, a study by the GAO found that, while a decent number of analyzed firms changed certain recruitment or training policies, 57 percent of these firms said that eligibility for the WOTC played no role in their hiring process. Another survey, conducted by the DOL, of 16 firms found that the WOTC played “little or no role” in their recruitment processes. Also, a study that specifically surveyed 101 temporary help services (THS) firms, which are intermediaries that provide temporary workers to other firms, found that 60 percent claim the WOTC. However, only one firm said that WOTC eligibility could impact its hiring decisions. Given these survey results, it seems likely that a very substantial number of tax credits are being used to subsidize hiring decisions that would have already occurred otherwise, especially in industries like THS that have high turnover.

Finally, because the WOTC essentially subsidizes jobs filled by workers with low productivity, it provides a tax advantage to high-turnover, labor-intensive firms, like THS firms, compared to other firms. This tax wedgeA tax wedge is the difference between total labor costs to the employer and the corresponding net take-home pay of the employee. It is also an economic term that refers to the economic inefficiency resulting from taxes. results in an economic efficiency loss, since it favors certain activities and firms over others. This is also a divergence from neutrality, which is one of the main principles of sound tax policy.

The WOTC appears to have had at least a modest, but noticeable, positive impact on the short-term employment outcomes of disadvantaged groups. Moreover, the WOTC has accomplished this at a cost in line with other job tax credits and significantly lower than that of direct job programs. However, there is currently no evidence that the WOTC positively affects long-term employment outcomes for these groups. The WOTC also seems to suffer from large inframarginal effects, subsidizing firms for hiring workers that they would have already hired. Finally, the WOTC results in an efficiency loss, by providing a tax advantage to high-turnover, labor-intensive firms, relative to other firms. Ultimately, the costs of the WOTC might outweigh its benefits.

Possible reforms could include further targeting (e.g., making THS firms ineligible for the credit), to reduce inframarginal effects, or expanding the tax credit size or streamlining the application process, to increase participation rates. Each of these reforms would also carry their own trade-offs, of course. Last, if policymakers are concerned about the long-term employment outcomes of these disadvantaged groups, they could also look at the tax treatment of human capital investment, alongside other non-tax-related policies.

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