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In: Economics

Suppose an individual can earn a wage of $20/hr, has 100 total waking hours this week,...

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.

1 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)

2 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)

3 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.

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