Labour Economics assignment 1
zaleel503
Chapter03.pptxChapter Three Labour Supply and Public Policy
Work Incentive Effects of
Alternative Income Maintenance Schemes
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
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Learning Objectives
Chapter 3
© 2012 McGraw-Hill Ryerson Ltd.
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Differentiate between different types of income maintenance programs, including demogrants, social assistance, unemployment insurance, earned income tax credits, worker’s compensation, and child care benefits.
Graphically illustrate how key aspects and program parameters of income maintenance programs can be captured by budget constraints.
Using the labour supply (income-leisure) model, analyze and compare the work incentive effects of different income maintenance programs. Also, be able to show how individual well-being can be compared across programs within this framework.
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Learning Objectives
Chapter 3
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Discuss the key challenges to estimating the “real world” effects of income maintenance programs on work incentives.
Evaluate the potential validity or shortcomings of empirically based arguments concerning the merits of one income maintenance program versus another, and to be able to cite representative studies from the empirical economics literature.
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Income Maintenance Schemes
Designed to supplement low incomes, which can arise from a various number of reasons
No single program can address the multiple reasons for low income
Chapter 3
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Income Maintenance Schemes
Chapter 3
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Income Maintenance Schemes
Universal Programs vs. Targeted Programs
Universal Programs
Administratively simple
Everyone receives the same transfer regardless of income
Expensive
Also benefits non-low income people
Chapter 3
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Income Maintenance Schemes
Targeted Programs
Cheaper method
Individuals are given exactly enough of a transfer to reach the poverty line
Only those below poverty line would receive transfer
Creates a disincentive to earn income and, hence, may cause individuals to reduce work effort
Chapter 3
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Income Maintenance Schemes
Permanent or Transitory?
Compensating low wages or shortage of hours worked?
Low income may be due to the shortage of hours worked or low wage rate:
Shortage of hours is mainly associated with the loss of transitory income (needs transitory type policy)
Low wage rate, on the other hand, may represent permanent low income (needs permanent type policy)
Difficult to isolate permanent from transitory
Chapter 3
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Lump sum transfer or income grant (universal)
Specific to a demographic group
Old Age Security (OAS): Providing monthly benefits to people aged 65 and over
Previous Family Allowance Program
Chapter 3
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Demogrant
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Work Incentive Effects of a Lump Sum Demogrant
Chapter 3
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Demogrant
0
U0
T
E0
At E1 the working hours are not altered – lower U
At Ed the working hours are reduced – higher U
Income
Leisure
U1
E1
Y1
Ud
Ed
Yd
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Work Incentive Effects of a Lump Sum Demogrant
No substitution effect
Work incentives are reduced
Pure leisure-inducing income effect
Increase in income is less than the amount of demogrant (all or a portion of the demogrant is used to buy leisure)
Chapter 3
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Welfare
Administered by the provinces
Financed partly by the federal government
Benefits depend on:
needs of the family
assets
other sources of income
Chapter 3
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Welfare: 100% “Clawback”
Chapter 3
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0
U0
T
E0
Potential income constraint is horizontal at Yw (the welfare payment)
Strong incentive to move to corner solution
Welfare
benefit
Y0
Uw
Ew
Income
Leisure
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Welfare: 100% “Clawback”
Adverse effect on work incentives
Work is not chosen because of the 100% tax on earned income
Chapter 3
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Possible Solutions
To improve work incentive of welfare programs:
(a) Reduce the welfare benefit
(b) Increase the wage rate
(c) Reduce the implicit tax (clawback)
(d) Change the preference
Chapter 3
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Welfare: (a) Reduce Benefit
Chapter 3
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U0
E0
0
T
No incentive to go on welfare
since the individual is already
maximizing at E0.
Uw’
Welfare
benefit
Income
Leisure
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Welfare: (a) Reduce Benefit
Successful in reducing the number of people on welfare
May deny welfare to those in need or provide inadequate income support to the unemployable
Chapter 3
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Welfare: (b) Incerase the Wage Rate
Chapter 3
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0
Uw
T
A higher wage rate can
make working more attractive,
as E1 yields utility U1 versus Uw
Welfare
benefit
Y0
U1
Ew
E1
Income
Leisure
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Welfare: (b) Increase the Wage Rate
Increase wage rate through:
training
job information
mobility
government wage subsidy
institutional pressure (unionization, minimum wage)
Costly
Chapter 3
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Welfare: (c) Reduce the Implicit Tax
Chapter 3
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0
Uw
T
The implicit tax is reduced so that the welfare recipient can keep some of her earnings. This increase in the returns to work can lead to participation at Ew’
Welfare
benefit
Y0
Uw’
Ew
Ew’
Income
Leisure
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Welfare: (d) Change Preferences
Chapter 3
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0
Uw
T
Sufficient stigma (for example) is attached to being on welfare, so that E0 is the preferred choice.
Welfare
benefit
Y0
E0
U0
Income
Leisure
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Negative Income Tax
Income guarantee
Implicit tax rate of less than 100%
Recipients receive more from the guarantee than they will pay out in taxes
Child Tax Credit
Guaranteed Income Supplement
Y = G + (1 - t)E
Where: G = Guaranteed Income
t = Tax rate
E = Earnings
Chapter 3
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Effects of a Negative Income Tax
Chapter 3
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Eo
G
Slope=(1 - t)w
Income guarantee shifts the income
constraint up by the amount of the
guarantee
0
U0
T
B
Income support declines as income from work increases
slope = w
Leisure
Income
UN
EN
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Wage Subsidy
Chapter 3
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0
T
U0
E0
Us
Es
As with a wage , a subsidy
rotates the income constraint
upward
Substitution effect and income effect work in opposite directions: ambiguous incentives
Income
Leisure
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Wage Subsidy Effects
Theoretically indeterminate
Adverse effects of wage subsidy are not as great as those of the negative income tax
Disadvantage: does nothing for the income of those who are unable to work
Chapter 3
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Earned Income Tax Credit
An new “income-tested” wage subsidy program used in both US and Canada to reduce the cost associated with the pure wage subsidy programs
It is a refundable tax credit or subsidy that is paid irrespective of other income taxes paid by the individuals
Chapter 3
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Work Incentives of an Earned Income Tax Credit
Chapter 3
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0
T
Between C and B, the phase-in part of the EITC program consists of
a standard wage subsidy. The maximum value of the subsidy is reached at point B. After that point is reached, the subsidy
is gradually phased out
between B and A.
“Phase-in”
A
B
C
“Phase-out”
Income
Leisure
c
a
d
b
Individuals in the phase-in section move from point a to b. Hours of work can increase or decrease, depending on the substitution and
income effects.
Individuals in the phase-out section move from point c to d. Hours of work will be reduced.
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Earned Income Tax Credit (EITC)
Two Phases of EITC
Phase-in: Similar to pure wage subsidy program. Substitution and income effects work in opposite directions.
Phase-out: Similar to negative income tax. Both substitution and income effects work in the same direction and reduce the incentive to work.
Compared to the welfare program, EITC results in more work incentive
Chapter 3
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Work Incentives of an Earned Income Tax Credit
Chapter 3
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The EITC increases hours
of work (and participation) to
EE , compared to a traditional
welfare program (EW ).
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Employment Insurance
The largest single income security program for non-elderly individuals in Canada
The amount of income replacement rate is 55% of lost earning, subject to a maximum
The duration of benefit ranges from 14 to 45 weeks, depending on the regional rate of unemployment
To qualify individuals must have worked at least approximately 12 to 20 weeks, depending the unemployment rate of the region
Chapter 3
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WORKED EXAMPLE Unemployment Insurance and Work Incentives
Recipients receive 60 percent of their weekly pay in the case of unemployment
It requires a minimum of 14 weeks of employment in order to qualify for benefits.
The maximum period of receiving benefits is 20 weeks
Chapter 3
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WORKED EXAMPLE Unemployment Insurance and Work Incentives
Chapter 3
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0
52
A
B
C
Slope = W
Income
Leisure
a
c
b
d
D
F
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20
Slope = (1-0.6)W
Full benefit (0.6)20W
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Disability Payments and Worker’s Compensation
Effect of a Disability
Budget constraint or preference curve could be altered
Factors to be considered:
hours able to work
medical expenses
reduced ability to earn wages
disutility of labour market vs. other activities
Chapter 3
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Effects of Disability
Chapter 3
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The individual’s potential working time is reduced to a maximum of HP or HF under partial or full disability
The disutility of work increases. Indifference curves become steeper at H0 (from U0 to Ud’) and desired work falls to Hd .
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Compensation: No Incentive to Return to Work
Chapter 3
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0
U0
Income
Leisure
H0
Y0
EC
Uc
Hf
Utility under compensation (less than former earned income) is
greater than utility under work
Uf
Not providing compensation
would reduce individual’s utility to Uf
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Compensation: Restoring Income
Chapter 3
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0
U0
Income
Leisure
H0
Y0
C
UY
Y
M
Ud
Permanent injury forces
individual to locate at Hf
Medical costs reduce utility to Ud
Court award for income and medical costs to restore individual income (or utility) to its former level
Hf
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Child Care Subsidy
Daycare costs can be modelled as a special case of fixed costs associated with working
Effect of child care subsidy
Fixed costs may increase reservation wage
Fixed costs may also affect hours-of-work
Increased hours for those who participate
Create a discontinuity in labour supply
Chapter 3
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Childcare: Impact on Budget Constraint
Chapter 3
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0
T
Income
Leisure
A
B
E
M
Cost of
Daycare
Y
Y-m
Fixed daycare cost results in
a vertical drop in the budget
constraint
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Daycare: Impact on Participation
Chapter 3
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0
U0
E
M
R
Income
Leisure
T
E0
Hm
M’
R’
RR’ = Reservation wage if no daycare cost exists
MM’ = Reservation wage if daycare cost exists
Cost of daycare (EM) increases reservation wage
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Daycare: Impact on Hours Worked
Chapter 3
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Em
0
T
Income
Leisure
M
Eo
M’
U0
U1
H1
H0
Hm
Eo no childcare costs
Daycare costs shift the budget constraint down parallel
The distance THm Indicating the number of
hours below which it would not be worthwhile
to enter the labour market
Um
Y
Y - m
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Daycare Subsidy
Encourages labour force participation and part-time work
Reduces the hours of work for those already participating
Chapter 3
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Summary
The Goal of Income Maintenance Programs
Demogrants
Welfare
Negative Income Tax
Wage Subsidies
Employment Insurance
Worker’s Compensation
Childcare Subsidies
Chapter 3
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