31E00700 Labor Economics Lecture 2 · 2012-11-01 · Implications of the neoclassical model of...

31E00700 Labor Economics:Lecture 2

Matti Sarvimäki

1 Nov 2012

Introduction Predictions of the neoclassical model Impact of EITC Expansion Other Examples

First Part of the Course: Outline

1 Supply of labor

1 static labor supply: basics

2 static labor supply: benefits and taxes (today)3 intertemporal labor supply

2 Demand for labor

3 Labor market equilibrium

31E00700 Labor Economics: Lecture 2 Matti Sarvimäki


Introduction

Design of tax and benefits system is an important (and

controversial) policy topic in all countries

Two dimensions

preferences about income distribution (normative)

impact of alternative policies (positive)

Income taxes and welfare benefits are essentially the same

both affect the net income from working

identical to a change in wage rate in the labor supply decision

Implications of the neoclassical model of labor supply

non-labor income decreases labor supply

(net) wages have an income and substitution effect

In this lecture, we will look at the impact of welfare benefits

on labor supply, particularly among single mothers



Introduction



Two dimensions













Introduction



Two dimensions













Basic concepts

Net income

gross income minus taxes plus benefits

Participation tax rate (PTR)

PTR = 1 − net income from work − net income out of workgross earnings

i.e this is the effective tax rate at the extensive margin

Effective marginal tax rate (EMTR)

as PTR, but for an additional hour of work, i.e. the effective

tax at the intensive margin

Real world tax and benefits systems are extremely complex



Basic concepts

Net income

gross income minus taxes plus benefits

Participation tax rate (PTR)

PTR = 1 − net income from work − net income out of workgross earnings

i.e this is the effective tax rate at the extensive marginEffective marginal tax rate (EMTR)

as PTR, but for an additional hour of work, i.e. the effective

tax at the intensive margin

Real world tax and benefits systems are extremely complex



Example: EMTR for a Single Mother, Finland

EMTR for a single mother with one child. Legend (from the bottom): income tax,basic unemployment benefit (i.e. not based on previous earnings), housing allowance,childcare costs. Source: Heikki Viitamäki (TUJA-model).



Example: Average PTR, UK

Source: Ch. 4, Tax By Design: The Mirrlees Review31E00700 Labor Economics: Lecture 2 Matti Sarvimäki


Take-it-or-leave-it Cash Grant

F

Consumption($)

500

Hours of Leisure

0 11070

G

U0

P

Cash grant providing $500 per month for those out of the labor force



Take-it-or-leave-it Cash Grant

F

Consumption($)

500

Hours of Leisure

0 11070

G

U1

U0

P

Cash grant providing $500 per month for those out of the labor force


Welfare Program with Phase-Out

Hours of Work

$500

U0 U1

G

E

P

F

R Q

H

D

D

0 110 100 70

slope = -$5

slope = -$10

Consumption ($)

A cash grant of $500 with a 50% tax on labor earnings. Income effect P → Q,substitution effect Q → R. Note that both effects reduce labor supply.


Earned Income Tax Credit (EITC)

A system that supplements earned income in the U.S.

similar systems in place in many countries

Eligibility

the applicant must have a dependent child

Basic components

Zero income: no credit paid

Low income: top-up for every dollar earned

A bit higher income: total credit constant

Still higher income: total credit decreases

High-income: no credit paid


EITC in 2005

Hours of Leisure

Consumption ($)

110

10,350

13,520

14,490

17,660

33,178

E

J

H

G

F

Net wage is 40% above the actual wage

Net wage equals the actual wage

Net wage is 21.06% below the actual wage

In the absence of the tax credit, the budget line is given by FE. The EITC grants theworker a credit of 40% on labor earnings as long as she earns less than $10,350. Thecredit is capped at $4,140. The worker receives this maximum amount as long as sheearns between $10,350 and $13,250. The tax credit is then phased out gradually. Theworker’s “net wage” is 21.06 cents below her actual wage whenever she earns between$13,520 and $33,178.


Application: The Impact of EITC Extension

(Eissa and Liebman, 1996)

EITC expansion in 1987

phase-in rate increased (11% → 14%)maximum income increased ($5000 → $6080)phase-out rate decreased (12.22% → 10%)As a result, the maximum credit increased by 55% and

taxpayers earning $11,000–$15,432 became eligble

Tax Reform Act in 1986

increase in standard deduction for head of households

($2480 → $4400)increase in child deducution ($1086 → $1950)change in tax schedules favoring head of households

Treatment: shift of budget constraint due to these reforms



Changes in EITCLABOR SUPPLY RESPONSE TO THE EITC 631

1992 Dollars 1,200

7400 11,670 1,000 1988 ETC

800

600

400

200 A B C

\14.081 \\aO31

0 4000 8000 12000 16000 20000 24000 2000 6000 10000 14000 18000 22000 2600(

earned income

FIGURE IV 1986 and 1988 Earned Income Tax Credit

Figure IV displays the 1986 and 1988 earned income tax credits (in 1992 dollars) as functions of income. The predicted impact of the EITC expansion on hours of work depends on the tax- payer's income. For most workers in region A (incomes between $0 and $14,081), the EITC expansion is predicted to have an am- biguous impact on hours of work since the expansion had off- setting income and substitution effects. Workers in region B (incomes between $14,081 and $25,000) are predicted to reduce their hours of work because they are either in the expanded phaseout region and face a 10 percent higher marginal tax rate in addition to having their incomes increased or because they have incomes just beyond the expanded phase-in region and might reduce their hours of work to take advantage of the credit. Workers in region C (incomes above $25,000) are unlikely to be affected by the increase in the credit.'7

17. The TRA86 tax rate changes reinforced the effect of the EITC on the hours of work of household heads relative to single filers. TRA86 reduced marginal tax rates by between three and eight percentage points for most single taxpayers with incomes in the EITC phaseout range, while reducing marginal tax rates for household heads by only two to three percentage points. Thus, the substitution effect from TRA86 should cause a larger increase in hours from single taxpayers than from household heads. In addition, as we explained in the participation section, the new TRA86 brackets, through their interaction with the in-



Predictions of the Neoclassical Model

Impact on hours varies according to the pre-reform hours

Zero hours: hours increase

(no income effect + reduced marginal tax rate)

Region A: ambigious effect

(income effect + reduced marginal tax rate)

Region B: hours decrease

(income effect + increased marginal tax rate)

Region C: no effect

(EITC not relevant before or after the reform)



Differences-in-Differences Design

Treatment group

Single women with children

(largest EITC group, “most relevant”, no income from a spouse)

Three potential control groups

Single women without children (all)

Single women without children (w/ low education)

Single women with children and high predicted income (based

on age, race, state, education)

Identifying assumptions

1 The reform is the only time-variant shock that affects

treatment/control groups differently2 Underlying trends in labor supply similar for the treatment and

the control groups




Treatment group











the control groups




Treatment group











the control groups


Results

Descriptives (Table 1)

Single mothers older, less educated, less likely to be in the labor force

Participation results (Tables 2 and 3)

Participation defined as having positive hours during a yearBasic dif-in-dif estimates suggest that the treatment increasedparticipation (T2)Similar results after controllig for differences in demographiccharactersitics (T3)

Ruling out alternative explanations

No differences in long-run participation trends between women with andwithout children (Fig 2 and 3)

Fig3: “marginal effects” correspond to average differences in thelabor force participation of women with and without children by yearnote the pattern in early 1980s

Other spurious shocks (business cycle, changes in the other parts of thewelfare system) do not seem to explain the results (Col 3 and 4, Tab 3)

Results

Impact of EITC vs. tax changes

EITC does not depend on the number of children in the household, buttax deductions do. There is no effect for the “second child” -dummy (Col5, Tab 3), which is consistent with EITC driving the resultsTiming consistent with EITC driving the results (Col 6, Tab 3)Effects largest among people most likely to be eligible for EITC (Table 4)

Impact on hours (Table 5)

contrary to the model, there is no evidence on the treatment reducinghours among those already working

Why no evidence on the impact on hours?

1 Responses stronger at the extensive than intensive margin?2 EITC paid once a year → recipients may perceive it as a lump sum

benefit (and the income effect is small)?3 Hours measured with more error than participation (finding anything

would require the true effects to be large)

Other Examples: Information Experiment

(Chetty, Saez: Teaching the Tax Code. AEJ Applied, forthcoming)

Survey: Marginal incentive structure of the EITC is not well

understood by eligible tax filers

Experiment

119 offices; 1,461 tax professionals; 43,000 tax filers

50% randomly selected to receive a two minute explanation

about how the EITC works

Results

Significant share of tax professionals did not comply

Customers of the compliers: EITC increase by $58 (3%); more

for the self-employed

Customers of the non-compliers: increase their incomes by

$250 (1.5%)

Conclusion: “information provision is not a very effective tool

for changing earnings behavior on average, though it might

have effects in some subgroups”


Norwegian workfare reformFigure 1. Work incentives before and after the reform for a lone mother with one child 4–6 years of age

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Source: Mogstad, Pronzato (forthcoming): ”Are Lone Mothers Responsive to Policy Changes? Evidence

from a Workfare Reform in a Generous Welfare State”, Scandinavian Journal of Economics



Norwegian workfare reform

Mogstad and Pronzato use similar dif-in-dif approach as above

to study the impacts of the Norwegian reform.

They find that the reform

Increased labor market attachment of single mothers

... but decreased the disposable income (and thus increased

poverty rates) among single mothers

These findings suggest that a substantial number of single

mothers face serious employment barriers



The Optimal Tax Approach

Blundell, Shephard: Employment, Hours of Work and the Optimal Taxation ofLow-Income Families. Review of Economic Studies (2012) 79(2): 481-510

How should the government best allocate a fixed amount of

revenue to the design of earnings taxation?

1 Estimate a structural model of labor supply

2 Use the estimates to design optimal tax/benefits policy

Key result: single mothers with very young children much less

responsive than those with school-age children → tax credits

only optimal for those with older children



The Optimal Tax Approach

Blundell, Shephard (2010): Employment, Hours of Work and the OptimalTaxation of Low Income Families. Unpublished manuscript.



Final Remarks

There seems to be something of a consensus that

Substitution effects are larger than income effects

(i.e. taxes reduce labour supply)Responses are larger at the extensive than at the intensive

margin (especially for low earners)

Responses are largest for women with schoolage children and

for those aged over 50

See Ch. 4, Tax By Design: The Mirrlees Review.

Available at http://www.ifs.org.uk/mirrleesReview


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31E00700 Labor Economics Lecture 2 · 2012-11-01 · Implications of the neoclassical model of...

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