© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-1

Chapter Three

Labour Supply and Public Policy:

Work Incentive Effects of Alternative Income Maintenance Schemes

Created by: Erica Morrill, M.Ed Fanshawe College

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-2

Chapter FocusLabour Supply Factors

Government transfer programs Welfare programs Workers compensation Child-care subsidies

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-3

Income Maintenance SchemesDesigned to supplement low incomesNo single program can address the

multiple reasons for low income Difficult for policy makers to design the

ideal program

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-4

Universal ProgramsAdministratively simpleEveryone receives the same transfer

regardless of income Results in raising income and

eliminating povertyExpensiveBenefits non-poor

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-5

Perfect Targeting Cheaper method Individuals are given exactly enough of a

transfer to reach the poverty line Only those below poverty line would receive

transfer Individuals below poverty line are guaranteed

to be topped up May cause individuals to reduce work effort Creates a disincentive to earn income

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-6

Permanent or Transitory Design features

to compensate for low wages or lack of hours

Distinction between permanent and transitory are difficult to isolate

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-7

Characteristics of a DemograntLump sum transfer Income grantSpecific to a demographic group

Old Age Security (OAS)Universal

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-8

demogrant

Figure 3.1 Work Incentive Effects of a Lump Sum Demogrant

0

U0

T

E0

-income constraint shiftsup by amount of the grant

- slope is the same and there is no substitution effect

- if working time is not altered the equilibriumis E1

Income

Leisure

U1

E1 Y1

Ud

EdYd

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-9

Work Incentive Effects of a Lump Sum Demogrant

No substitution effect Work incentives are reducedPure leisure - inducing income effect Increase in income is less than the

demogrant (used to buy leisure)

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-10

WelfareAdministered by the provincesFinanced partly by the federal

governmentBenefits depend on

needs of the family, assets other sources of income

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-11

Figure 3.2 Welfare: 100% “Claw-Back”

0

U0

T

E0

- at max leisure the income constraintshifts vertically up by the welfare payment

- potential income constraint is horizontal at the amount of the welfare payment

-strong incentive to move to corner solution

Welfarebenefit

Y0

Uw

Ew

Yw

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-12

Welfare:100% “Claw Back”Adverse effect on work incentivesWork is not chosen because of the

100% tax on earned incomeNegative impact on work incentives Not an acceptable policy

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-13

U0

E0

Figure 3.3 a Welfare Reduce Benefit

0 T

- lower welfare payments

- no incentive to go on welfaresince the individual is alreadymaximizing at E0

Uw’

Welfarebenefit

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-14

Welfare: Reduce BenefitSuccessful in reducing the number of

people on welfareMay deny welfare to those in need Inadequate income support to

unemployable

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-15

- wage rate to encourage individuals to voluntarily leave welfare

Figure 3.2 b Welfare:Increase Wage Rate

0

U0

Uw

T

E1

Ew

Welfare benefit

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-16

Welfare

Increase Wage Rate through: training job information mobility government wage subsidy institutional pressure (unionization, minimum

wage)

Costly Increase work incentives

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-17

- tax by requiring recipients togive up only a portion of welfareif they earn income by working

Figure 3.2 c Welfare:Reduce the Implicit Tax

0

Uw

T

Uw ’

Ew ’

Welfarebenefit

Ew

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-18

Figure 3.2 d Welfare: Change Preferences

0 T

Welfarebenefit

U0E0

-alter preferences away from welfareflattens the indifference curve

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-19

Negative Income Tax income guarantee Implicit tax rate of less than 100%Recipients receive more from the

guarantee than they will pay out in taxes Child Tax Credit Guaranteed Income Supplement

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-20

EoG

Slope=(1-t)w

-income guarantee shifts the income constraint up the amount of the guarantee

0

U0

T

Figure 3.4 Effects of a Negative Income Tax

B

- income support declines as incomefrom work increases

slope = w

Leisure

Income

UN

EN

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-21

0

Figure 3.5 Wage Subsidy

T

U0

E0

Us

Es

-as with a wage a subsidy rotates the income constraintupward

-substitution effect and income effect work in opposite directions

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-22

Wage SubsidyTheoretically indeterminate Adverse effects of wage subsidy are not

as great as those of the negative income tax

Disadvantage does nothing for the income of those who

are unable to work

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-23

0

Figure 3.6 Wage Subsidy vs. Negative Income Tax

T

Uwage subsidy

Es

ENnegative income tax

Leisure

Income

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-24

Figure 3.8 Unemployment Insurance-Assisted Work-Sharing

0 7

Y0

U0

E0

2 3 4 Days5 Days

- income falls by 40 percent forevery day of work reduction

-new equilibrium is on higher indifference curve because the individual gets a day of leisurefor only a 40% drop in income

Es

Ys Us

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-25

Effect of a Disability Budget constraint or preference curve

could be alteredFactors to be considered:

hours able to work medical expenses reduced ability to earn wages disutility of labour market vs. other

activities

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-26

0

U0

Income

LeisureH0

Y0

Figure 3.10 a Effect of Compensation

Hf

Yd=2/3Y0

- two thirds of the loss of income

- compensation is available for anycombination of partial disabilities

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-27

0

U0

Income

LeisureH0

Y0EC

Uc

Figure 3.10 b Compensation: No Incentive to Return to Work

Hf

Utility under compensation isgreater than utility under work

Uf

Not providing compensationwould reduce individual’s utility to Uf

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-28

0

U0

Income

LeisureH0

Y0

CUY

Figure 3.10 c Compensation: Restoring Income

Y

M

Ud

- permanent injury forces individual to locate at Hf

- medical costs reduce utility toUd

- court award for income & medicalIf court

wanted to restore individual to former utility

Hf

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-29

0 T

Figure 3.11 Child Care: Impact on Budget Constraint

Income

Leisure

A

B

E

MCost of Daycare

Y

Y-m

- fixed day-care cost results ina vertical drop in the budget constraint

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-30

Figure 3.11 b Day-Care: Impact on Participation

0

U0E

MR

Income

LeisureT

E0

Hm

- if market wage below reservation wage, individual is better off engaging in nonlabour activities

M’

R’

- slope of MM’ is greater than RR’ indicating a reservation wage greater due

to fixed day-care costs

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-31

Em

0 T

Income

Leisure

M

Figure 3.11c Day-Care:Impact on Hours Worked

Eo

M’U0

U1

H1 H0Hm

- Eo no child care costs

- day-care costs shift the budget constraint down parallel since market wages haven’t changed

- indicate the number of hours below which it would not be worth while

to enter the labour market

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-32

Day-care SubsidyEncourages labour force participation

and part-time workReduces the hours of work for those

already participating

© 2002 McGraw-Hill Ryerson Ltd. Chapter 3-33

End of Chapter Three