Labor Economics

The Earned Income Tax Credit (EITC) program aims to “make work pay” by supplementing the earnings of low-wage workers, particularly those with children. The credit involves three parts, with the numbers for each part changing with the number of kids and marital status:

Part 1 (the phase-in): For an unmarried worker with 1 dependent child, the EITC gives workers a 34% refundable tax credit on earned income up to $10,540 in 2020.

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Part 2 (the plateau): The worker can continue to receive the full credit (of $3584) until their earned income reaches $19,330, but earnings between $10,540 and $19,330 do not receive the 34% credit.

Part 3 (the phase-out): Once the worker’s earned income exceeds $19,330, the credit of $3584 is gradually reduced until it reaches 0 at an income of $41,576 in 2020. This means there is implicitly an additional marginal tax rate of (about) 16% applied to income between $19,330 and $41,576.

a) Given these numbers, use the labor-leisure model to illustrate the EITC program for an unmarried worker with one child who earns $10 an hour and has no unearned income or other taxes. Maximum annual hours available (T) is 2000. First fill in the blanks below, then on the next page draw the labor-leisure diagram without and with the program. Round to the nearest whole number as necessary. (11 points)

Without the EITC:

Slope of budget constraint: _________Maximum annual earnings: ____________

With the EITC:

Part 1 (phase in):

Slope of budget constraint: _________Hours worked when reach max EITC: ________

Total income when reach max EIC: __________

Part 2 (plateau):

Slope of budget constraint: _________Hours worked when EITC phase-out begins: ________

Total income when EITC phase-out begins: __________

Part 3 (phase-out):

Slope of budget constraint: _________Hours worked when EITC hits 0: ________

Total income when EITC hits 0: __________

b) Using your answers above, draw a carefully labeled diagram in (Leisure, Income) space to show the budget constraint without and with the EITC program. Label the axes and all kink points. (5 points)

c) For a worker who initially is working a positive but low number of hours, would we expect the creation of the EITC program to increase or decrease their hours worked? Explain in terms of income and substitution effects (5 points)

d) Does it make sense for the program to have a phase-out region that slowly reduces the credit as income increases instead of just reducing the tax credit to 0 when earnings hit a certain threshold? Explain, and include a well-labeled diagram with your answer. (5 points)

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