Labor Market and Public Policy

Public Policy Issues

• Shape of labor supply curve• Effects of income tax on labor supply• Effects of income tax rate on tax revenue• Why there are different income tax rates for different

income groups?• Income redistribution

– Minimum Wage– Negative Income Tax– Welfare programs– Subsidies

The Labor Market• Marginal product of labor (MP)

– The additional output a firm gets by employing one additional unit of labor

• Value of marginal product of labor (VMP)– The dollar value of the additional output a firm gets by

employing one additional unit of labor– Marginal product of labor multiplied by the net price of

each unit sold ($1)• In a competitive market, each worker is paid the value of

her/his marginal productWage = VMP

Hiring At The Adirondack Woodworking Company

• Labor makes cutting boards from free scrap wood– Price of a cutting board is $20

• Going wage is $350 per week

# of Workers Output Marginal Product

Value of Marginal Product ($)

0 0

1 30 30 600

2 55 25 500

3 76 21 420

4 94 18 360

5 108 14 280

Hiring At The Adirondack Woodworking Company

• The company will hire workers until the value of the marginal product of the last worker is equal to the wage– Cost-Benefit Principle– Workers earn $350 per week

• Adirondack will hire four workers– The fifth worker costs more ($350) than the benefits

he delivers ($280)

Demand for LaborW

age

($/h

our)

Wag

e ($

/hou

r)

Firm 1

Firm 2

Work hours/day

Total Employment

Wag

e ($

/hou

r)

Market

100

12

50

12

150

6

6

100

D1 = VMP1

D2 = VMP2

D = VMP1 + VMP2

150

12

250

6

Individual Labor Supply

• Individuals trade-off income and leisure– More work hours means more income AND less leisure

• Suppose the wage increases– Substitution effect: work more

• Leisure is more expensive– Income effect: work less

• Purchasing power increases for a given work schedule

– A higher wage may increase or decrease the quantity of labor supplied by the individual

Income Effect

Substitution Effect

Work Hours

Deriving Labor Supply Curves

• Labor – Leisure Choice• Work (H = hours) to earn money (w = wage) and buy goods• Don’t work and consume leisure hours, N, and buy goods

from unearned income sources, Y*

• Utility:• Time constraint: • Total income:

• Goal in determining labor and leisure choices is to maximize utility subject to constraints.

Deriving Labor Supply Curves

• Mathematical analysis to determine optimal work hours and leisure hours per day uses calculus to find the tangency point between indifference curve and budget line.

• Maximize utility subject to constraints:

• First-order condition for an interior maximum is:

• Slope of indifference curve = Slope of budget line:

Deriving Labor Supply Curves

• Graphical analysis to determine optimal work hours and leisure hours per day:

Deriving Labor Supply Curves

• Graphically, when wage falls, it is optimal to work fewer hours and increase leisure:

Deriving Labor Supply Curves

• The supply curve for hours worked is the mirror image of the demand curve for leisure hours.

Income and Substitution Effects

• An increase in the wage causes both income and substitution effects.• Total effect of a wage

increase is move from e1 to e2 (work more).

• Substitution effect is e1 to e* (work more).

• Income effect is e* to e2 (work less).

• Thus, income effect dominates in this case.

Leisure is Either an Inferior Good or a Normal Good

• With an increase in income, leisure may increase or decrease

Shape of the Labor Supply Curve• Different effects dominate along different portions of the

labor supply curve.• Potentially backward-bending labor supply curve at higher

wages

Shape of the Labor Supply Curve

• Do labor supply curves slope upward or backward bending? • Economic theory alone cannot answer this question –

empirical research is necessary• Most empirical studies find that American, British, Dutch and

Japanese – Male’s labor supply curves are relatively vertical because the

income and substitution effects are offsetting or both small.– Female’s labor supply curves are more steeply sloped

• Why do we care about the slope of labor supply curve?– One reason is that we can tell from the shape of the labor

supply curve whether an increase in the income tax rate will cause a substantial reduction in the hours of work

Income Tax Rates and the Labor Supply Curve

• An increase in the income tax rate – a percent of earnings – lowers workers’ after-tax wages and may increase or decrease hours worked.• If labor supply is backward bending, lowering wages

through higher income taxes will increase hours worked.• If labor supply is upward sloping, lowering wages through

higher income taxes will decrease hours worked.• The effect of imposing a marginal tax rate of is to reduce

the effective wage from w to (1 – ) w• This rotates a worker’s budget constraint in and

downward.

Income Tax Revenue and Labor Supply• The government’s tax revenue from an income tax is:

• Where is the hours of work supplied by an individual given the after tax wage,

• By differentiating the equation above, we can show how income tax revenue changes as the tax rate increases:

• Two effects from a change in the marginal tax rate:1. Government collects more revenue from higher tax rate.2. Change in tax rate alters hours worked.

w 1 H

Income Tax Revenue and Labor Supply

• If the labor supply curve is upward sloping, and the sign of depends on the magnitudes of the two terms in the above equation.

• If the labor supply curve is downward sloping, and the sign of .

• Empirical Evidence– In the US in 2012, a single person earning between $35,350-$85,650

had a marginal tax rate of . For a small increase in this rate to lower the tax revenue, such a person’s elasticity of labor supply had to be greater 3 (that is – which is unlikely.

Income Tax Revenue and Labor Supply• Income tax revenue is , which has a non-linear

relationship to the marginal tax rate:wH

Regime Years Top Tax Rate

Pre-Kennedy Before 60s 91%

Kennedy 1960s 70%

Reagan 1982-86 50%

1987 38.5%

1988-90 28%

Bush Sen. 1991-92 31%

Clinton 1993-2000 39.6%Bush 2001-03 38.6%

2004-05 37.6%2006-12 35%

Obama 2014- 39.6%

Effect of Unearned Income on Labor Supply

• Would you stop working if you won a lottery jackpot or inherited a large sum of money?

• Such unearned income shifts the budget line upward, and the equilibrium supply of labor depends on whether leisure is a normal or inferior good.

Effect of Unearned Income on Labor SupplyImplication for Welfare Program

• Some legislators oppose welfare program or negative income tax because they claim that giving money to poor people will induce them to stop working.

• Is that assertion true?

• This is an empirical question.

• Imbens et al. (2001) compared the winners of major prizes to others who played the Massachusetts Megabucks Lottery.– Major prizes ranged from $22,00 to $9.7 million, with average winning of

$1.1 million, and were paid in yearly installments over two decades.– The average winner received $55,200 in prize money and chose to work

slightly fewer hours so that his/her labor earnings fell by only $1,877 per year.

– Winners decreased their consumption and savings but didn’t substantially reduce their work hours.

Effect of Unearned Income on Labor SupplyImplication for Welfare Program

• More results from the same experiment– Men and women, big and very big winners, and people of all

education levels behaved the same way. – However the behavior of winners differed by age and income groups

• People ages 55-65 reduced their labor efforts more than younger people

• Most strikingly, people with no earnings in the year before winning the lottery tended to increase their labor earnings after winning the lottery.

• Kuhn et al. (2011) examined the Dutch postcode lottery, in which prizes were awarded weekly – on average, prizes were equal to about eight months of income. – Household heads who received prizes didn’t change how many hours

they worked.

Positively Sloped Labor Supply

• Labor supply for a single profession has a positive slope– Higher wages attract

workers from other careers• An increase in wages from

W1 to W2 increases quantity of

labor supplied from L1 to L2

– Movement along the labor supply curve

Employment of programmers(work-hours/year)

Wag

e ($

/hou

r)

S

L1

W1

L2

W2

Increase in the Demand for Programmers

• Demand for programmers increases from D1 to D2

– Initial impact is a shortage of programmers at W1

– In the short-run, wages are bid up to W3

• In the long run– Movement up the supply curve

and down the demand curve– Quantity of labor supplied

increases from L1 to L2

– Wages settle at W2

Employment of programmers(work-hours/year)

Wag

e ($

/hou

r)

S

L1

W1

D1

D2

L2

W2

W3

Trends in Inequality

• Market outcomes produce disparities in incomeMean Income by Quintile for US (2012 dollars)

Quintile 1980 1990 2000 2010 2012

Lowest 20% 17,009 16,746 18,829 15,715 15,534

Second 20% 37,026 39,059 43,052 38,871 38,184

Middle 20% 55,394 60,154 67,663 63,355 62,464

Fourth 20% 77,601 86,509 99,721 96,659 95,474

Highest 20% 130,656 160,773 209,225 197,055 202,559

Top 5% 185,739 252,260 370,751 329,487 352,338

Recent Trends in Inequality

• From WWII to the 1970s income growth was ± 3% per year for all groups

• Between 1980 and 2012, real incomes from the bottom quintile decline by almost 10%

• Does not show mobility between groups– Median income is not a measure of individual

welfare• In 1980, CEOs earned 42 times salary of average

worker– By 2000, this multiple increased to more than 500

times

The Challenge of Income Redistribution

• Although we as a society have an interest in limiting income inequality, programs for reducing it are often fraught with practical difficulties

• The challenge is to find ways to raise the income of those who cannot fend for themselves– Raising incomes of the needy reduce incentives to work– Difficulty in distinguishing between needy and others

• No perfect solution – choice among imperfect alternatives– Welfare programs and in-kind transfers– Means-tested benefit programs– Negative Income Tax– Minimum Wages– Earned Income Tax Credit

Welfare Payments and In-kind Transfers

• In-kind transfers are direct transfers of goods or services– Food stamps, Medicaid, public housing, free school

lunches• From mid 1960s to 1996, Aid to Families with Dependent

Children (AFDC) provided cash – Sometimes required no adult male in the household

• Destabilizing for families– Created persistent dependence on AFDC

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1996 Personal Responsibilities Act

• Cash grants from federal government to states– States determine distribution criteria– Five-year limit on benefits for each recipient

• Reduced welfare rolls and encouraged self-reliance– May aggravate the condition of the poorest

Means-Tested Benefit Programs

• A means-tested program decreases benefits as the recipient's other income increases– Intends to avoid paying benefits to those who can

support themselves• Administrative structure discourages work

– If benefits are reduced by $1 for each $2 earned, participants in multiple programs may lose more benefits than the income they earn

• Administrative costs are high– Simplify the program and distribute the cost savings to

the needy

The Negative Income Tax (NIT)

• Negative income tax is a tax credit for each person financed by tax on earned income

• With no taxes, pre-tax income equals after-tax income

• With NIT, low income families receive a cash transfer while high income families pay tax

– Family with no income would receive the federal poverty threshold

After

-Tax

Inco

me

($00

0s)

Pre-Tax Income($000s)

No Taxes

10 15 20

10

15

20

NIT14

16tax

transfer

Negative Income Tax

• Advantages– Incentive to work is greater than with welfare– Lower administrative cost

• Disadvantages– Creates an incentive not to work– The political cost is high

• NIT guarantees income to all who do not work

Minimum Wage Legislation

• Minimum wage above equilibrium creates unemployment– Loss in total surplus– L1 workers earn more

– (L0 – L1) are unemployed– Change in total earning

depends on the elasticity of demand for labor• Studies show little effect of minimum wage on employment

– Loss in total surplus may be small

W

L0L1

Wmin

Unemployment

Employment

Wag

e ($

/hou

r) S

D

Minimum Wages and Total Surplus

Employer surplus$12.5K

L (work-hours/day)

W (

$/ho

ur)

S

D

10

5,000

5

0

Worker surplus$12.5K

No Minimum Wage

L (work-hours/day)

S

W (

$/ho

ur)

D

5,000

5

10

0

Total surplus lost ($4K)

Employer surplus($4.5K)

Minimum Wage ($7)

3

3,000

7

Worker surplus

($16.5K)

Earned Income Tax Credit (EITC)

• Earned-income tax credit is a policy under which low-income workers receive credits on their federal taxes

• A family of four earns $15,000– EITC is $4,750– Federal taxes are reduced by $4,750

• If taxes are less than EITC, a refund is issued• EITC does not interfere with market incentives

– Affects only people who work– Allows labor markets to reach equilibrium

EITC Is a Better Option

• Market equilibrium reached with 5,000 work-hours and wage of $5

• Minimum wage reduces worker surplus by $4,000/day• Goal: restore worker surplus to its original level of

$16,500/day– An earned-income tax credit of $0.80/hr. for 5,000 person

hours/day– Deadweight loss of minimum wage is translated into

worker surplus– Finance with a $4,000/day tax on employers

Public Employment for the Poor

• Overcomes the shortcomings of the EITC and NIT– EITC does not help the unemployed– NIT reduces the incentive to work

• Government could employ the poor– If wages are the same as the private sector, some workers

will prefer government jobs• Increases the cost of the program

– Make-work programs are not productive– Increases size of government

A Combination of Methods

– Use a NIT with payment set below the poverty threshold

– Set the public service wage below the minimum wage– Privatize the management of the public service

employment program

NIT

Public Job

NIT + Public Job

NIT + Private Job

Povertythreshold