1. Labor Market and Public Policy

2. 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

3. 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 product Wage = VMP

4. Hiring At The Adirondack Woodworking Company Labor makes cutting boards from free scrap wood – Price of a cutting board is $20 Going wage is $350 per week # of Workers Output Marginal Product Value of Marginal Product ($) 00 130 600 25525500 37621420 49418360 510814280

5. 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)

6. Demand for Labor Total Employment Wage ($/hour) Market 100 12 50 12 150 6 6 100 D 1 = VMP 1 D 2 = VMP 2 D = VMP 1 + VMP 2 150 12 250 6

7. 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 Work Hours

8. 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.

9. 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:

10. Deriving Labor Supply Curves Graphical analysis to determine optimal work hours and leisure hours per day:

11. Deriving Labor Supply Curves Graphically, when wage falls, it is optimal to work fewer hours and increase leisure:

12. Deriving Labor Supply Curves The supply curve for hours worked is the mirror image of the demand curve for leisure hours.

13. Income and Substitution Effects An increase in the wage causes both income and substitution effects. Total effect of a wage increase is move from e 1 to e 2 (work more). Substitution effect is e 1 to e * (work more). Income effect is e * to e 2 (work less). Thus, income effect dominates in this case.

14. Leisure is Either an Inferior Good or a Normal Good With an increase in income, leisure may increase or decrease

15. 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

16. 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

17. 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.

18. Income Tax Revenue and Labor Supply

20. Income tax revenue is, which has a non-linear relationship to the marginal tax rate: RegimeYearsTop Tax Rate Pre-KennedyBefore 60s91% Kennedy1960s70% Reagan1982-8650% 198738.5% 1988-9028% Bush Sen.1991-9231% Clinton1993-200039.6% Bush2001-0338.6% 2004-0537.6% 2006-1235% Obama2014-39.6%

21. 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.

22. Effect of Unearned Income on Labor Supply Implication 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.

23. Effect of Unearned Income on Labor Supply Implication 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.

24. 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 W 1 to W 2 increases quantity of labor supplied from L 1 to L 2 – Movement along the labor supply curve Employment of programmers (work-hours/year) Wage ($/hour) S L1L1 W1W1 L2L2 W2W2

25. Increase in the Demand for Programmers Demand for programmers increases from D 1 to D 2 – Initial impact is a shortage of programmers at W 1 – In the short-run, wages are bid up to W 3 In the long run – Movement up the supply curve and down the demand curve – Quantity of labor supplied increases from L 1 to L 2 – Wages settle at W 2 Employment of programmers (work-hours/year) Wage ($/hour) S L1L1 W1W1 D1D1 D2D2 L2L2 W2W2 W3W3

26. Trends in Inequality Market outcomes produce disparities in income Mean Income by Quintile for US (2012 dollars) Quintile19801990200020102012 Lowest 20%17,00916,74618,82915,71515,534 Second 20%37,02639,05943,05238,87138,184 Middle 20%55,39460,15467,66363,35562,464 Fourth 20%77,60186,50999,72196,65995,474 Highest 20%130,656160,773209,225197,055202,559 Top 5%185,739252,260370,751329,487352,338

27. 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

28. 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

29. 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 ©McGraw-Hill Education. All rights reserved. 12-29

30. 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

31. 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

32. 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 Income ($000s) Pre-Tax Income ($000s) No Taxes 101520 10 15 20 NIT 14 16 tax transfer

33. 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

34. Minimum Wage Legislation Minimum wage above equilibrium creates unemployment – Loss in total surplus – L 1 workers earn more – (L 0 – L 1 ) 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 L0L0 L1L1 W min Unemployment Employment Wage ($/hour) S D

35. Minimum Wages and Total Surplus Employer surplus $12.5K L (work-hours/day) W ($/hour) S D 10 5,000 5 0 Worker surplus $12.5K No Minimum Wage L (work-hours/day) S W ($/hour) 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)

36. 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

37. 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

38. 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

39. 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 Poverty threshold