Question

1. 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.

Answer 1

Solution(s):

Since the individual earns a wage of $20/hour and has a total of 100 working hours, that means the total wage of the individual would be = $20 x 100

                                                          = $2000

                                  Now, the Aid to Families with Dependent Children (AFDC) program provides $100 at 0 hours pf work but imposes a 25% tax on earned income up to the point where the benefit is paid back. This means the individual will not get any benefit of AFDC, as his income is $2000, and the first tax of 25% collected from him, if he is given AFDC will be $500, i.e. it will cross $100.

                                  Again, the earned income tax credit (EITC) consists of a 50% wage subsidy for the individual working for low hours, up to a maximum additional benefit of $120 and is gradually phased out, also it imposes a 20% tax on individuals who earn more than $500 up to the point where the benefit is paid back. This means, the same individual will also miss this benefit, as 20% of his income ($2000) will be $400 which is way above the subsidy of $120.

Answer (a) :

If we see the graph above, we see that Good A is measured in the X axes and Good B is measured in the Y axes. Here, the curve PQ is the budget constraint. i.e. at his income level of $2000, he will choose OP units of Good B and OQ unit of Good A. Now, if the individual realizes that he can earn $100 free from the Government if his income is NIL (0). The individual also leans that until the amount is paid back his income will be deducted by 25% until it reaches $ 100, i.e. until 400. Now, the individual will think, if he is getting free $100 from the Government if he earns $400 or less, why should be earn more than $400. Therefore, he will be tempted to reduce his work. Here the concept of substitution effect also plays a role. The individual will reduce his per month consumption of Good A and Good B so that he can sustain at $00 or less or substitute Good A and Good B with Good C and Good D, which are cheaper and helps him to sustain somehow, without having to work more.

Answer (b) :

If we see the graph above, we see that Good A is measured in the X axes and Good B is measured in the Y axes. Here, the curve PQ is the budget constraint. i.e. at his income level of $2000, he will choose OP units of Good B and OQ unit of Good A. Now, if the individual realizes that he will earn an additional $120 subsidy from the Government, the individual also leans that until the amount is paid back his income will be deducted by 20% until it reaches $ 500, This will tempt the individual to work more and to increase his work. In the graph we can see that as a result of the subsidy by the Government, the individual now consumes more quantities of both goods A and B and his new budget constraint is RS.

Answer( c) : The same graph GRAPH 1 will also help us to understand how the EITC reduces the interest to work for an individual. When the individual realizes that he is getting a subsidy from the government, the individual will become self-satisfactory and start to consume the new increased quantity of Good A and Good B and be satisfied with what he is consuming and thereby be reluctant to work harder. This will lead to a scenario where in the long run, his net income will reduce and his budget constraint will be lower than the original budget constraint.