Chapter Three
Labour Supply and
Public Policy:
Work Incentive Effects of
Alternative Income
Maintenance Schemes
Chapter 3-1
Income Maintenance
Schemes
 Demogrant
 Welfare
Programs
 Negative Income Tax
 Wage Subsidy
 Earned Income Tax Credit
 Unemployment Insurance
 Workers Compensation
 Childcare Subsidies
Chapter 3-2
Income Maintenance
Schemes
 Designed
to supplement low incomes
 No single program can address the
multiple reasons for low income
 Difficult for policy makers to design the
ideal program
Chapter 3-3
Income Maintenance
Schemes
Chapter 3-4
Characteristics of a Demogrant
 Lump
sum transfer
 Income grant
 Specific to a demographic group
 Old
Age Security (OAS)
 Universal
Chapter 3-5
Work Incentive Effects of a Lump Sum
Demogrant
- if working time is not
altered the equilibrium
is E1
Income
Y1
Yd
E1
Ed
E0
U0
0
-income constraint shifts
up by amount of the
grant
- slope is the same and
there is no substitution
effect
Ud
demogrant
T
Leisure
Chapter 3-6
Work Incentive Effects of a Lump
Sum Demogrant
 No
substitution effect
 Work incentives are reduced
 Pure leisure - inducing income effect
 Increase in income is less than the
demogrant (used to buy leisure)
Chapter 3-7
Welfare
 Administered
by the provinces
 Financed partly by the federal
government
 Benefits depend on
 needs
of the family,
 assets
 other
sources of income
Chapter 3-8
Welfare: 100% “Claw-Back”
U0 Uw
Y0
Yw
- potential income constraint is
horizontal at the amount of the welfare
payment
- at max leisure the income constraint
shifts vertically up by the welfare
payment
-strong incentive to move to corner
solution
E
w
E0
Welfare
benefit
0
T
Chapter 3-9
Welfare:100% “Claw Back”
 Adverse
effect on work incentives
 Work is not chosen because of the
100% tax on earned income
 Negative impact on work incentives
 Not an acceptable policy
Chapter 3-10
Welfare Reduce Benefit
- lower welfare payments
Uw’
- no incentive to go on welfare
since the individual is already
maximizing at E0
E0
U0
0
Welfare
benefit
T
Chapter 3-11
Welfare: Reduce Benefit
 Successful
in reducing the number of
people on welfare
 May deny welfare to those in need
 Inadequate income support to
unemployable
Chapter 3-12
Figure 3.2 b
Welfare:Increase Wage Rate
- wage rate to encourage
individuals to voluntarily leave
welfare
Uw
E1
U0
Ew
Welfare
benefit
0
T
Chapter 3-13
Welfare

Increase Wage Rate through:





training
job information
mobility
government wage subsidy
institutional pressure (unionization, minimum
wage)

Costly
 Increase work incentives
Chapter 3-14
Welfare:Reduce the Implicit Tax
Uw
Uw ’
- tax by requiring recipients to
give up only a portion of welfare
if they earn income by working
Ew ’
Ew
Welfare
benefit
0
T
Chapter 3-15
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
Chapter 3-16
Figure 3.4
Effects of a Negative
Income Tax
Income
slope = w
B
0
-income guarantee shifts the income
constraint up the amount of the
guarantee
- income support declines as income
from work increases
Slope=(1-t)w
EN
UN
G
T
Leisure
Chapter 3-17
Figure 3.5
Wage Subsidy
-as with a wage  a subsidy
rotates the income constraint
upward
-substitution effect and
income effect work in
opposite directions
0
T
Chapter 3-18
Wage Subsidy
 Theoretically
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
Chapter 3-19
Figure 3.6
Income
0
Wage Subsidy vs. Negative
Income Tax
T
Leisure
Chapter 3-20
Earned Income Tax Credit
(EITC)
Two Phases of EITC

•
•

Phase-in: Similar to pure wage subsidy
program. Substitution and income effects
work in opposite directions.
Phase-out: Similar to negative income
tax. Both substitution and income effects
work in the same direction and reduce
the incentive to work.
Compared to the welfare program,
EITC results in more work incentive
Chapter 3-21
EITC:
•
•
Phase-in: It provides a refundable tax
credit equal to 20% of earned income-up
to $500 for individuals and $1,000 for
families. To target assistance to those
with lower incomes.
Phase-out: The credit is reduced by
15% of net income for individuals earning
more than $9,500 and families earning
more than $14,500.
Chapter 3-22
Welfare with
100% clawback
Chapter 3-23
Employment Insurance

The largest single income security program for
non-elderly individuals in Canada
 The amount of income replacement rate is 55%
of lost earning, subject to a maximum
 The duration of benefit ranges from 14 to 45
weeks, depending on the regional rate of
unemployment
 To qualify individuals must have worked at least
approximately 12 to 20 weeks, depending the
unemployment rate of the region
Chapter 3-24
Example)
Chapter 3-25
Unemployment Insurance-Assisted
Work-Sharing
E0
Y0
Ys
- income falls by 40 percent for
every day of work reduction
-new equilibrium is on higher
indifference curve because the
Es
individual gets a day of leisure
for only a 40% drop in income
UUsNote:Current rate 45%
0
0
2
3 4 Days
5 Days
7
Chapter 3-26
UI-Assisted Worksharing in
Canada
 an
experimental program established in
Canada in 1977 under which layoffs
were avoided in twenty-four firms by
reducing the hours worked of all
employees.
 Workers take advantage of a temporary
modification of unemployment
insurance legislation that allowed
workers to receive UI benefits for the
day or so each week that they no longer
worked.
Chapter 3-27
Effect of a Disability
 Budget
constraint or preference curve
could be altered
 Factors to be considered:
 hours
able to work
 medical expenses
 reduced ability to earn wages
 disutility of labour market vs. other
activities
Chapter 3-28
Effects of Disability
Chapter 3-29
Effects of Disability
Chapter 3-30
Effect of Compensation
Income
- two thirds of the loss of income
- compensation is available for any
combination of partial disabilities
Y0
Yd=2/3Y0
U0
0
H0
Hf
Leisure
Chapter 3-31
Compensation: No Incentive to Return
to Work
Income
Utility under compensation is
greater than utility under work
Not providing compensation
would reduce individual’s
utility to Uf
EC
Uc
U0
Y0
Uf
0
H0
Hf
Leisure
Chapter 3-32
Compensation: Restoring Income
• Permanent injury forces
individual to locate at Hf
• Medical costs reduce utility to Ud
• Court award for income and
medical costs to restore
individual income (or utility) to its
former level
Y
Income
Y0
0
Ud
C
U0
Hf
H0
M
UY
Leisure
Chapter 3-33
Child Care: Impact on Budget
Constraint
Income
A
- fixed day-care cost results in
a vertical drop in the budget
constraint
B
E
Y
Y-m
0
M
T
Cost of
Daycare
Leisure
Chapter 3-34
Daycare: Impact on
Participation
Income
M’
RR’ = Reservation wage if no daycare
cost exists
MM’ = Reservation wage if daycare cost
exists
EM = Cost of daycare
R’
E0
E
U0
R
M
0
Hm
T Leisure
Chapter 3-35
Day-Care:Impact on Hours
Worked
Income
M’
- Eo no child care costs
- day-care costs shift the budget
constraint down parallelly since
market wages haven’t changed
- indicate the number of hours below
which it would not be worth while
to enter the labour market
Eo
U0
U1
Em
M
0
H1 Hm H0
T
Leisure
Chapter 3-36
Day-care Subsidy
 Encourages
labour force participation
and part-time work
 Reduces the hours of work for those
already participating
Chapter 3-37
End of Chapter Three
Chapter 3-38