Question

Consider a simple Earned Income Tax Credit (EITC) that is equal to a subsidy of .40 on each dollar earned up to $10,000, then constant up to earnings of $20,000. Beyond earnings of $20,000 the credit is phased out at a rate of .50 for each additional dollar earned.

a. Draw the budget constraint before and after the EITC for a worker earning $10 per hour, and able to allocate 4000 hours per year to work and leisure (T=4000). Label the intercepts and all kink points in the budget constraint on both axes.

b. What is the effect of the EITC on the average labor force participation rate of eligible individuals? Why? Explain using income and substitution effects.

c. 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

Let us assume that 4000 hrs (2 full time jobs) allocate hours per year to work and leisure and this worker earn 10$ per hour.

A) The EITC offers an income subsidy to low income workers with children. For a family with 2 Children, this tax credit is 50% for all earnings upto 10000$. The max credit is reached here at 5000$. Families that earn between 10000$ to 15000$ receive this credit as lump sum.

Families that earn above 15000$. The new budget constraint is dark shaded line.B) The EITC has only positive effect on labour force participation rate because EITC effectively raises the wage for some one who initially chose ZERO hours labour.

C) From above graph, we see EITC reduces the hours of work. This is actually not the effect of EITC. In the real world this might not occur because people in the real world do not have complete flexibility in chosing their HOURS of work.

People usually work full time or part-time. People don't understand whether they should reduce hours to maximize their utility as they don't understand how EITC has phased in or phased out.