Suppose that the Earned Income Tax Credit is set up so that a maximum payment of...

Suppose that the Earned Income Tax Credit is set up so that a maximum payment of $3,000 can be earned when a qualified worker earns $10,000. This payment represents a subsidy of 30 cents for each additional dollar earned up to $10,000.

Workers earning between $10,000 and $14,000 are eligible for the maximum payment. Once labor market earnings exceed $14,000, additional earnings reduce the subsidy by 45 cents for each dollar earned.

The going wage rate is $10 per hour.

Will a person working between working less than 1000 hours in the labor market experience an income effect, a substitution effect, or both as a result of the EITC?

Expert Solution

As per the given scenario regarding EITC , there are usually 3 phases,

Phase 1 - (Phase in period) Those working less than 1000 hours or not working at all, will be incentivized to work more hours or join labour force. They will be induced to earn atleast $10000 or more causing a rise in no. of available workers at low income levels.This is because EITC credit of 30 cents/per dollar is applicable to income range of $10000 to $14000 only. So there is a positive substitution effect towards work over leisure. Further as more labours are available due to this programme this pushes down market wages and firms are able to hire additional workers at lower wages.Therefore negative income effect is observed here.
Phase 2-(Flat period) All those workers who have secured job which pays anything including endpoints between $10000 to $14000, will not be inclined to work further as they will be getting EITC anyways. So there is a negative substitution effect to work. However there is positive income effect for existing workers as their purchasing power increases for the same no. of hours worked. For new workers it could be negative income effect as they will be offered less wages per hour due to increased labour supply and they will have to increase their work hours to stay in the EITC bracket.
Phase 3 - (Phase out period) As earning more than $14000 reduces subsidy by 45 cents/per dollar so workers are disincentivised to earn and work more as it leads to both negative income and substitution effect.

Rahul Sunny answered 5 months ago

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