Labor Economics: Welfare Incentives, EITC, and Household Production Theory

Course Logistics and Housekeeping

• Workshops and Quizzes

  • Attendance is required for workshops where students will submit work on-site.

  • Quizzes typically take place at the end of the workshop, although the instructor (Ria) has the latitude to Move them to the beginning.

  • The quiz format usually consists of five Multiple Choice Questions (MCQs) regarding the assigned reading and one written question covering course material from the past week.

  • Post-mock assessments contribute $10\%$ to the overall course grade.

• Assigned Reading

  • The assessment for the upcoming week focuses on the Week 1 reading: the Mitra reading on disability.

Welfare Program Controls and Work Requirements

• Mitigating Negative Incentives

  • Welfare programs often incorporate controls to reduce negative incentive effects on labor supply.

  • One primary example is the implementation of a work component, requiring a minimum number of work hours to qualify for eligibility (e.g., a six-hour minimum).

• Budget Constraint Shifts

  • Under a standard welfare program with no work requirement, the budget constraint has a flattened portion starting at zero hours of work, often leading individuals to choose not to work at all if the welfare income ($y_n$) is sufficient.

  • With a work requirement (e.g., six hours), the flattened portion of the budget constraint ($CD$) only begins after the individual has completed the required hours.

  • The individual earns market wages for the first six hours, which are then "topped up" to the guaranteed welfare income level ($y_n$).

• Labor Supply Implications

  • Individuals are induced to enter the labor market to meet the minimum threshold.

  • A "dead zone" exists between the minimum requirement (Point C) and the point where market earnings exceed the welfare top-up (Point D). Individuals are unlikely to work between these points (e.g., working 7 or 8 hours) because their total income remains the same ($y_n$) as it is at 6 hours.

  • Only individuals with relatively flat indifference curves (representing a lower preference for leisure versus income) will choose to work beyond Point D where the budget constraint is tangent to segment $ED$.

  • The policy goal is to get individuals into the labor market, hoping that once employed for the minimum hours, they may be offered or accept longer shifts (e.g., 8 hours) that move them off welfare entirely.

The Earned Income Tax Credit (EITC)

• Policy Mechanism

  • The EITC is designed to induce labor participation by providing a tax credit only to those who are currently working.

  • It functions as a subsidy on earnings: for every rand or dollar earned, the government provides a specific amount of cents back in the form of a credit.

• US Case Study: EITC for a Taxpayer with Two Children

  • Phase-In Period (Segment AB): For individuals earning up to $\$12,570$, the credit rate is $40\text{c}$ for every $\$1$ earned.

    • The effective wage rate is $1.4 \times \text{market wage}$.

    • This results in a steeper budget constraint.

    • The maximum credit of $\$5,028$ is reached at an income of $\$12,570$.

  • Plateau/Constant Period (Segment BD): For individuals earning between $\$12,570$ and $\$16,420$, the credit remains at a lump sum of $\$5,028$.

    • Point B represents $\$12,570$ (market earnings) + $\$5,028$ (credit).

    • Point D represents $\$16,420$ (market earnings) + $\$5,028$ (credit), totaling roughly $\$21,448$.

    • The effective wage rate in this segment is equal to the market wage rate (slope is parallel to the original budget constraint).

  • Phase-Out Period (Segment DE): For individuals earning above $\$16,420$, the credit is reduced by $21\text{c}$ for every dollar earned above the threshold.

    • The effective wage rate is $0.79 \times \text{market wage}$.

    • The budget constraint becomes flatter as the credit is gradually withdrawn to target the program toward lower-income earners.

Incentive Effects of the EITC

• Segment AB (Phase-In)

  • Labor supply participation increases as the higher effective wage rate may satisfy a person's reservation wage, drawing them from a corner solution (zero work) into the labor market.

  • For those already working, the effect depends on the balance between the substitution effect (promoting more work due to higher wages) and the income effect (promoting less work as the person is wealthier).

  • The substitution effect is typically dominant at lower income levels/hours.

• Segment BD (Plateau)

  • Utility increases due to the lump-sum credit, creating a pure income effect.

  • Because the wage rate remains the same as the market rate but the individual has more total wealth, they are likely to reduce their hours of work.

• Segment DE (Phase-Out)

  • Both the income effect and the substitution effect point toward a reduction in labor supply.

  • The effective wage is lower than the market wage (substitution effect discourages work), and the individual still possesses more income than they would without the program (income effect encourages leisure).

Refinements to the Labor Supply Model: Household Production

• Extending the Income-Leisure Model

  • Standard models categorize time as either "Market Work" or "Leisure."

  • The refined model recognizes that "Leisure" often includes "Household Production" (cooking, cleaning, laundry, childcare).

  • Household decisions are often joint, weighing the relative productivities of partners in both the market and the home.

• Empirical Patterns (2008 Data)

  • In households with children under 6 years old, men typically spend significantly more time in paid work while women spend more time on household production.

  • As children age (6–17 years), women's participation in paid work tends to increase.

  • General trends show women spending more time on household work and men more on paid work, though these patterns shift based on individual career paths and earning potential.

• Decision-Making Models

  • Unitary Models: Assume the household acts as a single unit with shared preferences.

  • Bargaining Models: Suggest that the partner with greater access to market resources (higher earning power) has more bargaining power and will likely specialize in market work, while the other specializes in household production.

• Interdependence of Labor Supply

  • If one partner increases their market work, the other partner’s marginal productivity at home may rise as they "take up the slack."

  • This can cause the second partner's indifference curves to steepen, meaning a higher wage is required to induce them to supply market labor.

  • Alternatively, a partner might enjoy home time less if their spouse is away at work, potentially inducing them to also increase their market labor supply.

Economic Shocks and the Added Work Effect

• The Added Work Effect

  • During a recession, if one partner (traditionally the husband) becomes unemployed or has their hours cut, the other partner (the wife) may enter the labor market or increase their hours to compensate for the lost household income.

  • This represents a temporary increase in labor supply by one family member in response to the job loss of another.

Questions & Discussion

• Evaluation of Household Work Value

  • Question: Could household work be measured by the cost of hiring help, such as a domestic worker or an au pair?

  • Answer: Measuring replacement cost is one valid empirical method. However, economic theory focuses on the decision-making process—specifically how relative productivities determine who stays home and who works in the market.

• Artificial Intelligence in Academia

  • AI is viewed as a significant challenge in academics, particularly regarding how to ensure it enhances learning rather than bypassing it.

  • Setting traditional essays has become more complex, leading many courses to utilize in-class essay tests to ensure academic integrity.

• Effective Wage in EITC Segment DE

  • Question: Between Point D and E, is the wage lower than it would be without the program?

  • Answer: The effective wage rate (the slope of the budget constraint) is lower than the market wage because every dollar earned results in a loss of some benefits ($21\text{c}$ per dollar). However, the absolute level of income at any point on segment $DE$ remains higher than it would be at the same number of hours without the EITC program.