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    The earned income tax credit affects the budget constraint of low-wage individuals in several ways: 1. It provides a wage subsidy up to a certain income level, making work more attractive due to the steeper budget constraint. However, the individual is also made better off, so works less due to the income effect. 2. Beyond the subsidy level but before taxes apply, the budget constraint is parallel to the original, so there is no substitution effect but the individual works less due to the income effect. 3. A tax is applied beyond another level, making work less attractive due to the flatter budget constraint. The individual also works less due to the ongoing income effect. 4. The

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    The earned income tax credit affects the budget constraint of low-wage individuals in several ways: 1. It provides a wage subsidy up to a certain income level, making work more attractive due to the steeper budget constraint. However, the individual is also made better off, so works less due to the income effect. 2. Beyond the subsidy level but before taxes apply, the budget constraint is parallel to the original, so there is no substitution effect but the individual works less due to the income effect. 3. A tax is applied beyond another level, making work less attractive due to the flatter budget constraint. The individual also works less due to the ongoing income effect. 4. The

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    66 views2 pages

    EITC

    Uploaded by

    robertwiblin
    The earned income tax credit affects the budget constraint of low-wage individuals in several ways: 1. It provides a wage subsidy up to a certain income level, making work more attractive due to the steeper budget constraint. However, the individual is also made better off, so works less due to the income effect. 2. Beyond the subsidy level but before taxes apply, the budget constraint is parallel to the original, so there is no substitution effect but the individual works less due to the income effect. 3. A tax is applied beyond another level, making work less attractive due to the flatter budget constraint. The individual also works less due to the ongoing income effect. 4. The

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    ECON2131 Public Economics - Theory Q3 - Tutorial 9

    Earned Income Tax Credit1

    The figure shows the effect of the earned income tax credit on the budget constraint facing a low-
    wage individual (blue line) who receives a wage subsidy up to some level (interval AB), and
    faces a tax beyond a certain higher level (from C onwards).

    Income and substitution effects:

    • AB:
    o SE: Working is more attractive due to the subsidy (blue budget constraint steeper than
    original black budget constraint)  works more.
    o IE: Individual is better off (blue budget constraint above original black budget
    constraint) and consumes more of all normal goods, including leisure  works less.
    • BC:
    o No SE: budget constraint parallel to the initial black budget constraint.
    o IE: as in interval AB (blue budget constraint still above original black budget
    constraint)  works less.
    1
    Adapted from Stiglitz (2000), pp. 537-538.

    1
    ECON2131 Public Economics - Theory Q3 - Tutorial 9

    • CD:
    o SE: Working is less attractive due to the tax (blue budget constraint flatter than
    original black budget constraint)  works less.
    o IE: as in intervals AB and BC (blue budget constraint still above original black budget
    constraint)  works less.
    • DE:
    o SE: as in interval CD (blue budget constraint flatter than original black budget
    constraint)  works less.
    o IE: Individual is worse off (blue budget constraint below original black budget
    constraint) and consumes less of all normal goods, including leisure  works more.

    Participation versus hours decisions:

    Even though for many individuals (those in the interval CE), marginal incentives to work are
    reduced by the EITC (substitution effect induces less work), incentives to participate in the labour
    force are increased (substitution effect in the interval AB induces individuals to participate in the
    labour force). Assume, as an alternative to working, individuals can receive a fixed amount of
    welfare payments, represented in the figure by point W (where they enjoy full leisure). The
    individual is able to reach a higher indifference curve by working with the EITC. Many labour
    economists believe that the participation decision is more important than the hours decision (for
    many jobs, discretion over the number of hours worked is limited.

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