EC306 Labour Economics. Chapter 3" Labour Supply and Public Policy

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1 EC306 Labour Economics Chapter 3" Labour Supply and Public Policy 1

2 Objectives Income/payroll Taxes Income Maintenance Schemes Demogrant Social assistance/welfare Programs Negative Income Tax Wage Subsidy Earned Income Tax Credit Employment Insurance Workers Compensation Childcare Subsidies 2

3 Income and Payroll Taxes Income taxes - Largely a tax on labour income Payroll taxes EI, CPP Affects the price of leisure Altered budget constraint with proportional tax: After tax actual income = value of purchases of consumption goods à (1-t)w(T-L) = C à C + (1-t)wL = (1-t)wT à MRS = (1-t)w characterizes optimal choice 3

4 Consumption Before the income tax, Ava chooses L 1. C 1 An income tax rotates the budget constraint. BC 2 BC 1 L 1 Leisure

5 Consumption Substitution effect is larger Consumption Income effect is larger Ava works less. Ava works more. C 1 C 1 C 2 C 2 BC 1 BC 2 BC 1 BC 2 Leisure L 1 L L 2 2 L 1 Leisure

6 Taxes on labour supply In the first picture, Ava consumes more leisure and less hours of work. Here leisure increases from L 1 to L 2. In this case, the substitution effect is larger than the income effect. In the second picture, Ava consumes less leisure and more hours of work. Here leisure decreases from L 1 to L 3. In this case, the substitution effect is smaller than the income effect. At low levels of labor supply, it seems very unlikely that income effects could be larger than substitution effects, because the income effects are proportional to hours worked before the wage change. Review show income and substitution effects of the tax graphically 6

7 Empirical evidence The general conclusions from econometric studies are that: Labor supply elasticities for primary earners are around +0.1, a fairly small effect. Labor supply elasticities for secondary earners are in the range of +0.5 to +1.0, a much larger effect. This effect comes mainly from the extensive margin of whether to work or not, rather than the intensive margin on the actual number of hours to work. 7

8 Can reducing tax rates increase total tax revenue? w S (net) wage rate (1-t 1 )w (1-t 2 )w (1-t 3 )w H 0 Hours of work

9 Laffer Curve Tax revenues t 1 t 2 t 3 Tax rate

10 Income Maintenance Schemes Designed to supplement low incomes, which can arise for a various number of reasons No single program can address the multiple reasons for low income 10

11 Income Maintenance Schemes 11

12 Income Maintenance Schemes 12

13 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 13

14 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 14

15 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 15

16 Income Maintenance Schemes Demogrant 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, UCCB 16

17 Work Incentive Effects of a Lump Sum Demogrant Income At E 1 the working hours are not altered lower U At E d the working hours are reduced higher U Y 1 E 1 E d Y d E 0 U 1 U d U 0 Demogrant 0 T Leisure 17

18 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) 18

19 Income With progressive taxation on earnings and benefits E d Y d E 0 0 T Leisure 19

20 Welfare Administered by the provinces Financed partly by the federal government Benefits depend on: needs of the family assets other sources of income 20

21 Welfare: 100% Clawback U 0 U w Potential income constraint is horizontal at Y w (the welfare payment) Strong incentive to move to corner solution Y 0 Y w 0 E 0 E w T Welfare benefit 21

22 Welfare: 100% Clawback Adverse effect on work incentives Work is not chosen because of the 100% tax on earned income 22

23 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 23

24 Welfare: A. Reduce Benefit Inco me U w No incentive to go on welfare since the individual is already maximizing at E 0. E 0 0 Leisure T U 0 Welfare benefit 24

25 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 25

26 Welfare: B. Increase Wage Rate E 1 wage rate to encourage individuals to voluntarily leave Welfare increases incentive to work U w U 0 E w Welfare benefit 0 T 26

27 Welfare: B. Increase Wage Rate Increase wage rate through: training job information mobility government wage subsidy institutional pressure (unionization, minimum wage) Costly 27

28 Welfare: C. Reduce the Implicit Tax Income U w U w tax by requiring recipients to give up only a portion of welfare if they have earned income increases incentive to work E w E w Welfare benefit 0 Leisure T 28

29 Welfare: D. Change Preferences Income Alter preferences away from welfare flattens the indifference curve E 0 0 Leisure T U 0 Welfare benefit 29

30 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 = w(t-l) 30

31 Effects of a Negative Income Tax Income slope = w Income guarantee shifts the income constraint up by the amount of the guarantee Income support declines as income from work increases B U 0 Slope=(1 - t)w E o E N U N G 0 Leisure 31 T

32 Wage Subsidy Income As with a wage, a subsidy rotates the income constraint upward U 0 U s E s Substitution effect and income effect work in opposite directions: ambiguous incentives E 0 0 Leisure T 32

33 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 33

34 Wage Subsidy vs. Negative Income Tax Income E s negative income tax E N U 0 Leisure T 34

35 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 35

36 36

37 37

38 Earned Income Tax Credit (EITC) Two Phases of EITC 1. Phase-in: Similar to pure wage subsidy program. Substitution and income effects work in opposite directions. 2. 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 38

39 39

40 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 (VER), depending the unemployment rate of the region 40

41 Employment Insurance 41

42 Employment Insurance Maternity, Parental, and sickness benefits Compassionate care benefits Fishing benefits Negative income tax Training Family Supplement 42

43 Employment Insurance C Why don t we see everyone using EI? Expect mass point? L (weeks) 43

44 Green and Riddell (1997) If we change EI parameters, to what extent, if any, will this affect individuals labour supply decisions? Unemploymentà VER VERà Unemployment Need exogenous change in VER 44

45 Sidetracked Differences in Differences

46 Green and Riddell. (1997) 46

47 Green and Riddell (1997) Hazard Rates 47

48 Green and Riddell (1997). 48

49 Disability Payments and Worker s Effect of a Disability Compensation 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 49

50 Effects of Disability 50

51 Effects of Disability 51

52 Compensation: No Incentive to Return to Work Income Utility under compensation (less than former earned income) is greater than utility under work Not providing compensation would reduce individual s utility to U f Y 0 E C U c U 0 U f 0 H 0 H f Leisure 52

53 Compensation: Restoring Income Permanent injury forces individual to locate at H f Income Medical costs reduce utility to U d Court award for income and medical costs to restore individual income (or utility) to its former level Y Y 0 U d C U Y U 0 H f 0 H 0 M Leisure 53

54 Childcare: Impact on Budget Constraint Income A Fixed daycare cost results in a vertical drop in the budget constraint B Y Y-m E M Cost of Daycare 0 Leisure T 54

55 Daycare: Impact on Participation Income M RR = Reservation wage if no daycare cost exists MM = Reservation wage if daycare cost exists EM = Cost of daycare R E 0 E M U 0 R 0 H m T Leisure 55

56 Daycare: Impact on Hours Worked Income E o no childcare costs Daycare costs shift the budget constraint down parallel since market wages haven t changed Indicating the number of hours below which it would not be worthwhile to enter the labour market E o Y Y - m M U 0 E m U 1 M U m 0 H 1 H H 0 T m Leisure 56

57 Daycare Subsidy Encourages labour force participation and part-time work Reduces the hours of work for those already participating 57

58 Reading and references Required " BGLR Ch. 3" Suggested" CRA Working Income Tax Benefit " Green, David A & Riddell, W Craig, Qualifying for Unemployment Insurance: An Empirical Analysis, Economic Journal, vol. 107(440), pages 67-84, January. (up to p. 74)" Note: slides make use of material from BGLR and Gruber texts" 58

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