Association for Public Policy Analysis & Management

Small dollar credit is widely used by subprime consumers to meet short-term financial needs over pay cycles. However, relatively little is known about the income sensitivity of demand for credit in this market. This paper provides a causal estimate of income elasticity of demand for small dollar credit using income shocks from Earned Income Tax Credit (EITC) benefits and a unique proprietary loan level dataset from a credit bureau. Identification relies on regression discontinuity in generosity of state EITC top-up rates by zooming in areas within the same commuting zone that straddles state borders. The empirical results show that $100 additional EITC benefits leads to 7.7% reduction in originated loans, and demand for small dollar credit is very sensitive to income shocks, with an income elasticity of 2.5. This translates to sizeable reductions in loan volume and savings in financial charges. Consumers significantly reduce their use of costly credit when cheaper liquidity is available, indicating that EITC recipients might be liquidity constrained. More broadly, the results suggest that public programs offering income benefits could help with consumption smoothing for their recipients in the presence of credit market frictions. This paper also underlines the importance of income for underwriting and product design in the credit market. An accurate measure of income is critical to evaluate the risk of borrowers and to reduce default rate for lenders.