The basic income-leisure choice framework provides a convenient starting point to ana-lyze the work incentive effects of alternative income maintenance schemes. The analysis is restricted to the static, partial equilibrium effects of alternative income maintenance pro-grams. That is, it does not consider dynamic changes that can occur over time, or general equilibrium effects that can occur as the impact of the program works its way through the whole economic system. For example, the withdrawal of a large enough number of work-ers from the work force to take advantage of an income maintenance program may result in higher wages as employers try to compete for a more limited number of workers. Higher wages make work more attractive, which draws back some individuals into the work force and reduces the adverse impact of income maintenance programs on labour supply.
Income support programs affect behaviour by altering the individual’s opportunities (their potential income constraint). To analyze the effect of specific programs on the income con-straint, ask first what is the effect on nonlabour income, and second, what is the effect on the slope of the constraint—that is, what happens as the individual gives up leisure and works more? Throughout this analysis, Y is defined as income after taxes and transfer payments and E as labour market earnings, equal to wages times hours worked.
Demogrant
Perhaps the simplest income maintenance program to analyze is a lump-sum transfer, or demogrant. As the name implies, a demogrant means an income grant to a specific demo-graphic group, such as lone-parent families with children, all persons aged 60 and over, or all family units irrespective of their wealth. There are very few examples of pure demogrants.
The best example in Canada is the Old Age Security (OAS) program, which provides monthly benefits to individuals over the age of 65. The former Family Allowance program was also a pure demogrant, providing monthly payments to families in respect of each child under 18.
Demogrants are characterized by their complete universality: the benefit received does not LO1, 2 , 3
LO1, 2 , 3
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CHAPTER 3: Labour Supply and Public Policy: Work Incentive Effects of Alternative Income Maintenance Schemes 77
depend on income or earnings. The Child Tax Credit, which effectively replaced the Family Allowance program, is not a demogrant since the level of benefit depends on family income.
The OAS is also “clawed back” (gradually reduced as income increases) for high-income seniors. Nevertheless, demogrants are worth analyzing in their abstract form because many income main tenance programs share the features of demogrants.
As illustrated by the dashed line in Figure 3.1 , the demogrant would shift the potential income constraint vertically upward by the amount of the grant. The slope of the new income constraint would be equal to the slope of the original constraint since the relative price of lei-sure has not changed. Thus, there is no substitution effect involved with the demogrant. The new equilibrium, E d , would be above and to the right of the original equilibrium; that is, work incentives would unambiguously be reduced. This occurs because the demogrant involves only a leisure-inducing pure income effect. The increase in actual take-home income is less than the amount of the demogrant because some of the demogrant was used to buy leisure, hence reducing earned income. This can readily be seen in Figure 3.1 ; if the individual did not alter working time, the outcome would be at the point E 1 (yielding income Y 1 ) vertically above the original equilibrium E 0 , whereas income with the demogrant is given by Y d . Welfare
In Canada, welfare or social assistance programs are administered by the provinces but financed partly (approximately 50 percent) by the federal government under the Canada Health and Social Transfer program. This funding arrangement, implemented in 1995, replaced the Canada Assistance Plan (CAP) that had previously been the avenue for federal-provincial cost sharing for social assistance. Benefits vary by province and according to other factors, such as family type (single parent, couple) and employability. Welfare benefits also depend on the needs of the family and the family’s assets and other sources of income. As illustrated in Table 3.2 , the total income (including welfare payments) of single parents with one child tends to be about 82 percent of the poverty-line level of income, with considerable variation by province.
The demogrant generates a parallel shift of the budget constraint. If leisure is a nor-mal good, the new equilib-rium will occur at a point like E d , with lower labour supply than the original E 0 . Income will not rise by the full value of the demogrant. This would occur only if E 1 were the optimal choice, with hours of work unchanged. But this cannot happen if leisure is normal.
FIGURE 3.1 Work Incentive Effects of a Lump-Sum Demogrant Income
0 T Leisure
Demogrant Ud
U0
U1
Y1
Ed
Yd
E0
E1
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For those who are eligible for welfare, their new potential income constraint is given by the dashed line in Figure 3.2 . If they do not work, they are given the welfare payment. Hence, at the point of maximum leisure (zero work), their income constraint shifts vertically upward by the amount of the welfare payment. Under traditional welfare programs, as individuals work and receive labour market earnings they are required to forgo welfare payments by the exact amount of their labour market earnings. In this sense, there is a 100 percent tax on earnings. In fact, the implicit tax may even be greater than 100 percent if, for example, they also lose medical or housing subsidies. Their potential income constraint is thus horizontal at the amount of the welfare payment: as they work and earn income, they forgo a comparable amount in welfare and hence their income does not increase. Every dollar earned results in
Without a welfare program, E 0 is the optimal choice, and the person works. With welfare, the person receives a fixed level of income, irre-spective of hours worked.
From zero hours worked, wage earnings net of reduced welfare benefits are zero, and there are no returns to working (until benefits are exhausted). The optimal choice would thus be E W , and nonparticipation.
TABLE 3.2 Incomea of Welfare Recipients by Province, 2009 (lone parent, one child)
Province Annual Income ($) Income as % of Poverty Lineb
Newfoundland 19,297 102
Prince Edward Island 16,531 88
Nova Scotia 14,992 79
New Brunswick 16,171 85
Quebec 17,583 78
Ontario 17,372 77
Manitoba 14,829 66
Saskatchewan 17,923 95
Alberta 15,749 70
British Columbia 16,899 75
Average (unweighted) 16,735 82
NOTES:
a. Includes basic social assistance (welfare), additional benefits, child tax benefit, provincial tax credits, provincial child benefits, and GST credit.
b. The National Council of Welfare uses Statistics Canada’s low income cut-offs as their measure of the poverty line.
SOURCE: National Council of Welfare. Welfare Incomes 2009 (Ottawa: National Council of Welfare, 2010). Available online, accessed at http://www.ncw.gc.ca/[email protected]?lid5331.
FIGURE 3.2 Work Incentive Effects of a Welfare Benefit with 100 Percent “Clawback”
UW
EW
U0
E0 Welfare
benefit Leisure T
0 Income
•
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CHAPTER 3: Labour Supply and Public Policy: Work Incentive Effects of Alternative Income Maintenance Schemes 79
a dollar reduction in welfare. Of course, once they reach their original labour market wage constraint, then their take-home pay will be indicated by their original wage constraint: at this point their welfare payments have been reduced to zero so they cannot be “taxed” any further by being required to give up welfare.
If the welfare payment is sufficiently high, the individual would have a strong incentive to move to the corner solution at E w where he would not work at all. There is no incentive to work more (move to the left of E w ) due to the 100 percent implicit tax on income from work that arises because the individual has to give up an equivalent amount of welfare for every dol-lar earned. Even though the person’s take-home pay, Y, is lower at E w than E o , he chooses E w because it involves considerably more leisure. Clearly, welfare has extreme potential adverse effects on work incentives. Of course, for many people on welfare, work is not a viable alter-native if they are perhaps disabled or unemployable. Yet for others, work would be a viable alternative if there was not this 100 percent implicit tax on earned income.
This analysis suggests a variety of ways of reducing the number of people on welfare. Tradi-tionally, we think of making eligibility requirements more stringent or reducing the magnitude of welfare for those who are eligible. These changes would, of course, work. In Figure 3.3(a) , for example, if the welfare payment were lowered to an amount lower than the height of U 0 at the point of maximum leisure, there would be no incentive to go on welfare since the individual would be maximizing utility at E 0 . Although successful in reducing the number of people on welfare, these changes may have undesirable side effects, not the least of which are denying wel-fare to those in need and providing inadequate income support to those who are unemployable.
One alternative to these policies would be to increase the market wage rate of those on wel-fare and thereby encourage them to voluntarily leave welwel-fare and earn income. In Figure 3.3(b) ,
Changes can be made to the welfare program depicted in Figure 3.2 to improve work incentives. In (a), the benefit is reduced so that tax is reduced so that the welfare recipient can keep some of her earnings. This increase in the returns to work can lead to participa-tion at E'W In (d), we see the case where sufficient stigma (for example) is attached to being on welfare, so that E 0 is the preferred choice.
FIGURE 3.3 Other Work Incentive Effects of Welfare Programs
Welfare
(c) Reduce the implicit tax
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80 PART 1: Labour Supply
an increase in the market wage rate would pivot the wage constraint upward from T. At some higher wage rate, the individual clearly would be induced to move to a higher indifference curve that would involve more work effort than under welfare (i.e., a new equilibrium to the left of E w , E 1 ). The increased market wage could come about through training, job information, mobility, a government wage subsidy, or institutional pressures such as minimum wages or unionization. Obviously, these policies may be costly or, in the case of minimum wages and unionization, may involve a loss of jobs. However, they could have the benefit of voluntarily reducing the number of people on welfare and, hence, increasing work incentives.
Another way of improving work incentives would be to reduce the 100 percent implicit tax on welfare. In most welfare programs, this is accomplished by requiring welfare recipients to give up only a portion of their welfare if they earn income by working. For example, if recipi-ents are required to give up 50 crecipi-ents in welfare for every dollar earned in the labour market, they would have some incentive to work because the implicit tax rate would be 50 percent. In Figure 3.3(c) , this could be shown by a wage constraint starting at E w , with a negative slope of 50 percent of the slope of the labour market wage constraint reflecting the fact that the recipient takes home 50 percent of every dollar earned by working. The negative income tax, discussed below, is a general scheme designed to ensure that individuals receiving income support face an implicit tax on income from work that is significantly less than 100 percent.
An alternative solution to reducing the number of welfare recipients would be to alter the preferences of welfare recipients away from being on welfare and toward labour market activity. In Figure 3.3(d) , this would imply changing the shape of the indifference curves. If, for example, at all points to the right of E 0 , the indifference curve U 0 were flat, then the indi-vidual would not have opted for the welfare equilibrium E w . The flat indifference curve would indicate a reluctance to accept any cut in income even to get substantial increases in leisure.
Traditionally, preferences have been altered by attaching a social stigma to being on welfare.
Alternatively, preferences could be altered toward income-earning activities, perhaps by mak-ing potential recipients feel more a part of the nonwelfare society, or perhaps by attemptmak-ing to break the intergenerational cycle of welfare.
Recently, welfare reform has also emphasized the distinction between “employables” and
“nonemployables” and has often set a requirement that the employables work or be reg-istered in a training program as a condition of eligibility for the receipt of welfare. Such programs—termed workfare —have often been directed at single-parent families, given their potential to engage in paid employment. One of the problems, of course, is that this can entail expensive daycare requirements that may be added to the welfare expenses. Neverthe-less, it may encourage work incentives as well as the longer-run employability of recipients by providing them with work experience or training.
Negative Income Tax
Negative income tax or guaranteed annual income plans involve an income guarantee, and an implicit tax rate of less than 100 percent applied to labour market earnings. Income after taxes and transfers would be Y 5 G 1 (1 2 t)E, where G is the basic guarantee, t is the implicit tax rate, and Y and E as defined earlier are take-home pay and labour market earnings, respec-tively. Most negative income tax plans differ insofar as they involve different values of the basic guarantee and the tax rate. The term negative income tax is used because recipients will receive more from the guarantee than they will pay out in taxes, even though they do face a positive implicit tax rate. Guaranteed annual income schemes have frequently been proposed by policy analysts from a variety of political perspectives. 2
2In one of the most comprehensive studies of its kind, the 1985 Report of the Royal Commission on the Economic Union and Development Prospects for Canada (the Macdonald Commission) recommended fundamental reform of existing income maintenance programs. The centrepiece of its proposal was the Universal Income Security Pro-gram (UISP), a negative income tax proPro-gram that would supplement the income of families with low incomes.
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Although a comprehensive guaranteed annual income program has never been imple-mented in Canada, some programs that apply to particular groups—for example, the Child Tax Credit, which supplements the income of families with children, and the Guaranteed Income Supplement, which supplements the income of individuals over 65—have the nega-tive income tax design. That is, there is a basic guarantee received by those with income below a certain level; those with higher income receive less income supplementation according to the program’s implicit tax rate, and those whose income exceeds the program’s breakeven point receive no benefits.
A negative income tax plan with a constant rate is illustrated by the dashed line in Figure 3.4 . As with the demogrant and welfare, at the point of maximum leisure, the basic income guar-antee shifts the potential income constraint upward by the amount of the guarguar-antee: even if the individual does not work, she has positive income equal to the amount of the guarantee. Unlike welfare, as the individual works, income assistance is not reduced by the full amount of labour market earnings. However, income support does decline as income from work increases; thus, labour market earnings are subject to a positive implicit tax rate. Take-home pay does not rise as fast as labour market earnings; hence, the income constraint under the negative income tax plan is less steeply sloped than the original labour market income constraint. At the point B, often referred to as the breakeven point, income received from the negative income tax pro-gram has declined to zero. Thus, to the left of this point the original income constraint applies.
Assuming leisure is a normal good, the new equilibrium for recipients of the negative income tax plan will unambiguously lie to the right of the original equilibrium E 0 : work incentives are unambiguously reduced relative to a situation in which there is no other form of income support. This occurs because the income and substitution effects both work in the same direction to reduce work effort. The tax increase on earned income reduces the relative price of leisure, inducing a substitution into leisure and, hence, reducing work effort. The tax increase also has an income effect (working in the opposite direction); however, for recipients this is outweighed by the guarantee, so that on net their new potential income constraint is always above the original constraint—that is why they are defined as recipients. Because the potential income of recipients is increased, they will buy more of all normal goods, includ-ing leisure. Thus, the income effect works in the same direction as the substitution effect to reduce work effort.
A negative income tax is a welfare program with a less than 100 percent tax-back rate. Such a program will reduce work incentives (compared to no program).
The guarantee level, G, shifts out the budget constraint, producing a work-reducing income effect. Leisure is also cheaper, (1 2 t)W as against W, so the substitu-tion effect will lead to fewer hours worked. No benefit is received when income is higher than the breakeven level, B.
FIGURE 3.4 Work Incentive Effects of a Negative Income Tax
B
E0
G EN
U0
UN
Slope = W
Slope = (1 – t)W
T Leisure 0
Income
}
•
• •
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82 PART 1: Labour Supply
The income-leisure choice framework predicts that work incentives will be unambiguously reduced as a result of a negative income tax plan. But this does not negate the viability of such a program. The adverse work incentive effects may be small, or the increased “leisure” may be used productively as in job search, mobility, education, or increased household activities. In addition, the reduction in labour supply may have other desirable side effects, such as raising the wages of low-wage labour since it is now a relatively scarcer factor of production. Perhaps most importantly, the adverse incentive effects were predicted when a negative income tax was imposed in a world without other taxes and transfers. In most circumstances, a nega-tive income tax scheme is intended to replace some welfare programs that have even larger adverse incentive effects. In this sense, work incentives may increase relative to incentives under welfare (as will be discussed in more detail in subsequent sections). While the basic conclusions from the work-leisure model should not be ignored, they must be kept in proper perspective. Empirical information is needed on the magnitude of any adverse work incentive effects and on the form in which leisure is taken. In addition, the effects on work incentives will depend on the programs that the negative income tax scheme is intended to replace.
Wage Subsidy and Earned Income Tax Credit
Since one of the problems with the negative income tax and welfare is that the tax on earnings may discourage work effort, some have suggested that rather than tax additional earnings, the government should subsidize wages in an attempt to encourage work. Although there are
Since one of the problems with the negative income tax and welfare is that the tax on earnings may discourage work effort, some have suggested that rather than tax additional earnings, the government should subsidize wages in an attempt to encourage work. Although there are