1. Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 12 Government and the Labor Market: Employment, Expenditures, and Taxation

2. 12-2 1.Public-Sector Employment and Wages

3. 12-3 Government Employment The number of federal civilian and state and local government employees has risen over time. The growth of federal employment has been much smaller than the growth at the state and local level.

4. 12-4 Relative Government Employment The share of employment in the public sector has risen over time. This increase is due to increased demand for government services due to factors such as the schooling needs of the baby boom, higher real income, public sector unions, and increased regulation.

5. 12-5 Public vs. Private Pay oMost government units attempt to set pay equal to those to comparable private-sector workers. oIn the past, Federal government workers earned premium relative to their private sector counterparts. The premium has fallen over time. oPublic sector workers receive a greater fraction of their compensation in the form of fringe benefits.

6. 12-6 2. The Military Sector: The Draft Versus the Voluntary Army

7. 12-7 Draft vs. Voluntary Army oBefore 1973, the military used to draft or compel people to serve in the military. The pay for those serving in the military was low. oIn 1973, military switched to an all volunteer army. Military pay was raised significantly.

8. 12-8 Draft vs. Voluntary Army If the military drafts OG number of workers and pays them OA, the wage bill to taxpayers (OAfG) will be less than the total opportunity costs (OBcG) to those drafted. Under a voluntary system, the relevant demand curve becomes D v, the cost to taxpayers increases (OBeH as compared to OAfG), those who volunteer are fully compensated for their opportunity costs (OBeH) and the military is likely to reduce its total workforce (OG to OH). The true cost of employing any specific group of workers is independent of the wage bill. DvDv H e Quantity of Labor Hours Wage rate S G A B DdDd f c O

9. 12-9 Question for Thought 1. Explain why a voluntary army may be less expensive to society than an army composed of draftees. Which will be less expensive to taxpayers?

10. 12-10 3. Nonpayroll Spending by Government: Impact on Labor

11. 12-11 Government Purchases of Private-Sector Output oGovernment purchases include procurement of items such as computers, tanks, paper clips, and weather satellites. oThis spending creates a derived demand for workers who make these kinds of products. oIn sectors where the government is a larger purchaser, changes in government spending will affect the wages and employment of workers.

12. 12-12 Transfer Payments and Subsidies oTransfer payments such as Social Security and unemployment compensation transfer income from the government to individuals and families. Recipients provide no current productive activities in return. oSubsidy is a transfer payment for firm, institution, or household that consumes or provides a specific good or service. For example, Medicare for the elderly and public education for youth

13. 12-13 Demand Effects oTransfer payments and subsidies increase the product demand by certain groups of individuals and families. oThis will translate into higher derived demand for workers that make those products. Medicare programs increase the demand for workers in the medical field.

14. 12-14 Supply Effects oTransfer payments create an income effect that reduces work effort by recipients. The payments increase income that enable recipients to purchase more of all goods including leisure. oIf the transfer payment is inversely related to earned income, then it creates a substitution effect that reduces work effort by recipients. This occurs because the opportunity cost of leisure is reduced.

15. 12-15 Supply Effects oTransfers and subsidies may also reduce long-run labor supply decisions. Transfers may reduce the incentive to invest in human capital since the gains from education are reduced by the loss in transfer payments. oTransfers and subsidies may increase long-run labor supply decisions. If the government lowers the private cost of education, then the incentive to invest in human capital is greater.

16. 12-16 4. Labor Market Effects of Publicly Provided Goods and Services

17. 12-17 Demand Effects oProvision of a public good that is a complement in either consumption or production of a private good will increase the demand for workers who help produce the private good. A new dam will increase the demand for farm workers due to more irrigation. oProvision of a public good that is a substitute in either consumption or production of a private good will decrease the demand for workers who help produce the private good.

18. 12-18 Supply Effects Leisure Public & Private Goods 24 0 If real income is defined as the total quantity of public and private goods and services obtainable from any specific level of work, then the presence of $60 per day of public sector goods causes a parallel shift of the budget constraint. Assuming leisure to be a normal good and disregarding the tax consequences of the increased public-sector provision, this creates an income effect that increases the optimal number of hours of leisure by 1 hour (and reduces work effort by 1 hour). $240 I1I1 16 U1U1 I2I2 17 U2U2 $300

19. 12-19 Question for Thought 1. Assuming that “income” includes both private and public goods, and that leisure is a normal good, explain how a major reduction in governmentally provided goods might increase a person’s optimal number of hours of work.

20. 12-20 5. Income Taxation and the Labor Market

21. 12-21 Wages and Employment: Inelastic Labor Supply The demand curve D is the before-tax wage rate that firms face. If the labor supply curve is perfectly inelastic (S), then the quantity of labor supplied does not depend on the wage rate. Without an income tax, the market wage is $18.00. DtDt S 14.40 b 6 a 18.00 0 Quantity of Labor Hours Wage rate D 30.00 With an income tax, the after- tax demand curve facing the worker is D t. The amount of the tax is measured by the vertical distance between D and D t. ($18.00-$14.40=$3.60). Since the pre-tax wage does not change, workers bear all of the burden of the income tax.

22. 12-22 Wages and Employment: Positive-Sloped Supply If the labor supply curve is positively-sloped (S), then the quantity of labor supplied depends on the wage rate. Without an income tax, the market wage is $18.00. S 0 Quantity of Labor Hours Wage rate D 30.00 With an income tax, the equilibrium hours work drops from 6 to 5. As a result, the pre-tax wage will rise to $20.00. The after-tax wage will be $15.50. Since the pre-tax wage rises, firms bear some of the burden of the income tax. 6 a 18.00 The greater the elasticity of labor supply, the larger is the employment loss and the greater is the rise in the wage rate. DtDt 5 15.50 20.00 b

23. 12-23 Income Tax and Individual Labor Supply Leisure Income/day 24 0 An income tax shifts the after-tax wage downward and may either raise or lower a person’s optimal number of hours of work. $240 I1I1 I2I2 16 U2U2 Prior to the income tax, the optimal hours of work is 9 (15 hours of leisure) at point U 1. 15 U1U1 $360 The optimal hours of work would increase if the income effect was larger than the substitution effect. After the income tax, the optimal hours of work decreases to 8 (16 hours of leisure) at point U 2. This implies the substitution effect caused by the tax is larger than the income effect.

24. 12-24 Caveat oThe presence of the income tax will likely increase the amount of public goods which will produce an income effect, which will reduce hours of work. This will end to offset the income effect of the income tax which tends to increase hours of work. As a result, only a substitution effect may remain and thus the income tax may reduce labor supply.

25. 12-25 Empirical Analysis oFor men, the income effect tends to slightly outweigh the substitution effect. The income tax tends to slightly raise hours of work for men. oFor women, the substitution effect outweighs the income effect. The income tax tends to lower hours of work for women. oIn the aggregate, labor supply is highly inelastic and so workers bear most of the burden of the income tax.