Question

4. Suppose an individual can earn a wage of $20/hr, has 100 total waking hours this week, and has no source of non-labor income. Let’s compare the incentives generated by two different types of public programs.

• The Aid to Families with Dependent Children (AFDC) program provides $100, at 0 hours of work, but imposes a 25% tax on earned income up to the point where the benefit is paid back.

• The Earned Income Tax Credit (EITC) consists of a 50% wage subsidy for individuals working low hours, up to a maximum benefit of $120, and then is gradually phased out: EITC imposes a 20% tax on individuals who earn more than $500 up the point where the benefit is paid back.

a. Draw what an AFDC budget constraint looks like, including a standard budget constraint for comparison. Why does the AFDC discourage work? (Explain, using the concept of income and substitution effects in your answer)

b. Draw what an EITC budget constraint looks like, including a standard budget constraint for comparison. How does the EITC solve the work disincentive problem created by the AFDC? (Again, refer to income and substitution effects in your answer)

c. The effects of the EITC on labor supply are not positive for all individuals. On a graph, illustrate a case in which the EITC reduces the number of hours worked by an individual. Explain using income and substitution effects.

Answer 1