Substitution and Income Effects of the Working Tax Credit on Labour Supply

Labour essay: Having considered the implications for the WTC, we can now analyse the effects of the policy on labour supply by determining the substitution and income effects. It’s clear that the effect of the working tax credit on work behaviour depends upon how much a worker is currently working. To analyse these effects we will only look at one type of individual; a lone parent in the labour force. This will simplify our analysis such that we can divide the diagram below into 3 sections and describe the effects separately. draw:frame} Figure 1: Diagram showing how the imposition of the WTC affects the individuals labour supply decision When the lone parent is either not working at all, or working less than 16 hours (Labelled A in the diagram), her current wage rate and therefore income is unaffected by the WTC. This is simply because they have not yet received any tax credit and therefore have no added incentives to work. However, if they work over16 hours, the programme wi ll raise their overall take home wage as they receive a lump sum payment, shown by the first vertical blue line. Therefore, at this low level of work, there is a very small, or 0, income effect, and a positive substitution effect, thus increasing the individual’s labour supply. These effects are the same as would be under an increase in the wage rate, shown diagrammatically in Figure 2. {draw:frame} Figure 2: Diagram showing the effects of a wage increase The movement around the original indifference curve from A to C is the substitution effect; this arises due the change in price of leisure relative to hours of work, holding utility as constant. As the wage rate has increased the opportunity cost of leisure opposed to work has risen. The substitution effect encourages the worker to decrease his hours of leisure. The movement from C to B donates the income effect illustrating the workers response to an increase in real income. Overall, the substitution effect dominates the income effect and therefore increases labour supply from L1 to L2. There is also the possibility that the income effect may overpower the substitution effect resulting in a decrease in the supply of labour. However, this depends on the position of the indifference curves, hence the worker’s preferences for work and leisure. On the other hand, it is unlikely at this low wage rate for the worker to choose leisure over the opportunity to earn a higher wage. Section ‘C’ of our WTC diagram shows the area at which an individual works more than 30 hours. The worker’s net income is now higher at this point, however the worker’s marginal wage is lower which is demonstrated by the gradient of the WTC line being shallower than gradient of the No WTC line. The Substitution and Income effects here are the same as would be with a decrease in wage. Both the Income and substitution effects work together to reduce the amount of labour; shown in Figure 3: {draw:frame} Figure 3: Diagram showing the effects of a wage decrease The substitution effect is shown by the movement around the old indifference curve, from A to C. The income effect is shown by the movement from A to B. Although the substitution effect is stronger, both effects work together to reduce the hours of work from L1 to L3. Lastly, section ‘B’ represents the area at which an individual works between 16 and 30 hours. Here, the effects of the WTC on labour supply are much more complex. Despite the gradient of the WTC line being the same as section C, this time there is the possibility of increasing work to above 30 hours and receiving the additional payment. This therefore results in lone parents bunching around the 16 and 30 hour marks in order to gain the greatest benefit from the WTC payment. Some will therefore substitute leisure for work and work longer hours to gain the additional bonus at 30 hours, whilst others will choose to forgo work for leisure and be content with the benefit of working over 16 hours.