Chapter Three Labour Supply and Public Policy: Work Incentive Effects of Alternative Income Maintenance Schemes

Learning Objectives Income Maintenance Schemes Demogrant Welfare Programs Negative Income Tax Wage Subsidy Earned Income Tax Credit Unemployment Insurance Workers Compensation Childcare Subsidies

Income Maintenance Schemes Designed to supplement low incomes No single program can address the multiple reasons for low income Difficult for policy makers to design the ideal program

Income Maintenance Schemes

Characteristics of a Demogrant Lump sum transfer Income grant Specific to a demographic group Old Age Security (OAS) Universal

Work Incentive Effects of a Lump Sum Demogrant Y1 Ud Ed Yd Work Incentive Effects of a Lump Sum Demogrant - if working time is not altered the equilibrium is E1 -income constraint shifts up by amount of the grant Income - slope is the same and there is no substitution effect E0 U0 T Leisure

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 demogrant (used to buy leisure)

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

Welfare: 100% “Claw-Back” Uw Ew Yw U0 - potential income constraint is horizontal at the amount of the welfare payment - at max leisure the income constraint shifts vertically up by the welfare payment -strong incentive to move to corner solution Y0 E0 Welfare benefit T

Welfare:100% “Claw Back” Adverse effect on work incentives Work is not chosen because of the 100% tax on earned income Negative impact on work incentives Not an acceptable policy

Welfare Reduce Benefit Uw’ - lower welfare payments - no incentive to go on welfare since the individual is already maximizing at E0 T

Welfare: Reduce Benefit Successful in reducing the number of people on welfare May deny welfare to those in need Inadequate income support to unemployable

Figure 3.2 b Welfare:Increase Wage Rate - wage rate to encourage individuals to voluntarily leave welfare Uw E1 Ew Welfare benefit T

Welfare Increase Wage Rate through: Costly Increase work incentives training job information mobility government wage subsidy institutional pressure (unionization, minimum wage) Costly Increase work incentives

Welfare:Reduce the Implicit Tax - tax by requiring recipients to give up only a portion of welfare if they earn income by working Welfare benefit Ew Uw ’ Ew ’ Uw T

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

Figure 3.4 Effects of a Negative Income Tax -income guarantee shifts the income constraint up the amount of the guarantee slope = w UN EN B - income support declines as income from work increases Eo G Slope=(1-t)w U0 T Leisure

Figure 3.5 Wage Subsidy -as with a wage  a subsidy Us Es -as with a wage  a subsidy rotates the income constraint upward U0 -substitution effect and income effect work in opposite directions E0 T

Wage Subsidy 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

Figure 3.6 Wage Subsidy vs. Negative Income Tax EN negative income tax U wage subsidy T Leisure

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

EITC: Phase-in: It provides a refundable tax credit equal to 20% of earned income-up to $500 for individuals and $1,000 for families. To target assistance to those with lower incomes. Phase-out: The credit is reduced by 15% of net income for individuals earning more than $9,500 and families earning more than $14,500.

Welfare with 100% clawback

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

Employment Insurance (Worked Example)

Unemployment Insurance-Assisted Work-Sharing Es Ys Us Y0 U0 E0 5 Days - income falls by 40 percent for every day of work reduction -new equilibrium is on higher indifference curve because the individual gets a day of leisure for only a 40% drop in income Note:Current rate 45% 2 3 4 Days 7

UI-Assisted Worksharing in Canada an experimental program established in Canada in 1977 under which layoffs were avoided in twenty-four firms by reducing the hours worked of all employees. Workers take advantage of a temporary modification of unemployment insurance legislation that allowed workers to receive UI benefits for the day or so each week that they no longer worked. an extra day off per week while experiencing only a 5% reduction in after-tax income. The experiment ended in 1979, but in January 1982 the government again implemented the program on a temporary basis.

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

Effects of Disability

Effects of Disability

Effect of Compensation Income - two thirds of the loss of income U0 - compensation is available for any combination of partial disabilities Y0 Hf Yd=2/3Y0 H0 Leisure

Compensation: No Incentive to Return to Work U0 Income Leisure H0 Y0 Utility under compensation is greater than utility under work EC Uc Uf Not providing compensation would reduce individual’s utility to Uf Hf

Compensation: Restoring Income Permanent injury forces individual to locate at Hf Medical costs reduce utility to Ud Income Court award for income and medical costs to restore individual income (or utility) to its former level U0 Y Y0 Ud UY C Hf H0 M Leisure

Child Care: Impact on Budget Constraint Income A - fixed day-care cost results in a vertical drop in the budget constraint B E Y Cost of Daycare M Y-m Leisure T

Daycare: Impact on Participation Income RR’ = Reservation wage if no daycare cost exists MM’ = Reservation wage if daycare cost exists EM = Cost of daycare M’ R’ E0 E U0 R M T Leisure Hm

Day-Care:Impact on Hours Worked - Eo no child care costs Income - day-care costs shift the budget constraint down parallelly since market wages haven’t changed - indicate the number of hours below which it would not be worth while to enter the labour market M’ Eo U0 U1 Em M H1 Hm H0 Leisure T

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

End of Chapter Three