Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin - PowerPoint PPT Presentation

Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 8b: Taxing Lower Income Workers ECON 551: Lecture 8b 1 of 44

Agenda 1. Overview 2. Basic models 3. Saez 2002 4. Evidence on in-work tax credits ECON 551: Lecture 8b 2 of 44

Overview Let’s recall the Mirrlees optimal income tax formula we derived a few weeks ago: 𝑈 ′ 𝜁) (1 − 𝐺(𝑥 0 )) (1 − 𝑈 ′ ) = (1 + 1 𝑥 0 𝑔(𝑥 0 ) For low-ability workers:  Low wage ( 𝑥 0 ), so productivity gain from their work not great.  Lots of workers above them in the distribution, so big revenue gain (1 − 𝐺(𝑥 0 ))  Both these things push to higher marginal tax rates at low ranges. Also:  We want to redistribute toward them.  In presence of fixed transfer, may choose corner solution of no work.  Both these things push to lower marginal tax rates at low ranges. So…it’s complicated. ECON 551: Lecture 8b 3 of 44

How could we tax low earners? In most income taxes, there is basic amount which effectively leaves low earners untaxed or only very lightly taxed.  This suggests the income tax bracket/rate schedule not going to be particularly important. Instead, other features of our tax/transfer system are going to be much more important  Provincial social assistance schemes — how do they handle earnings?  Employment Insurance — how does it handle earnings?  Transfers that reduce with income — e.g. GST tax credit, or full negative income tax.  Earned income supplements — credits that provide multiplicative subsidy for earnings. ECON 551: Lecture 8b 4 of 44

Example of an earned-income supplement: WITB (now CWB)  Working Income Tax Benefit introduced in 2007. o Now changed to Canada Workers Benefit  Supplements earnings over a threshold at 21% rate.  Phased out once income over another threshold at 17%  In 2013 maxed out at $1230 (singles) $1952 (others). Many other countries have similar programs.  Earned Income Tax Credit (EITC) in US.  Working Tax Credit in UK. In Canada, many provinces have their own similar programs as well. ECON 551: Lecture 8b 5 of 44

How WITB is calculated:  Line 8 from Step 1 is a measure of your earned income.  Line 15 from Step 1 is based on couple line 236 net income.  Note starting point of $4,750; pivot at $12,301/$16,579.  Note phase in and phase out rates. ECON 551: Lecture 8b 6 of 44

WITB by earnings: ECON 551: Lecture 8b 7 of 44

WITB vs. EITC: ECON 551: Lecture 8b 8 of 44

Canada Child Benefit: Since 2016  Basic benefit of $6,400/yr (<age 6) and $5,400/yr (>=age 6)  Phased out starting at $30,000.  Everyone under 150,000 (P90) better off. ECON 551: Lecture 8b 9 of 44

All the refundable tax credits: This adds up to $1,181 per month! ECON 551: Lecture 8b 10 of 44

Questions we will try to address: What is sensitivity of work decision to these incentives? Is intensive (hours) or extensive (in/out) decision more important? ECON 551: Lecture 8b 11 of 44

Agenda 1. Overview 2. Basic models 3. Saez 2002 4. Evidence on in-work tax credits ECON 551: Lecture 8b 12 of 44

Review: The static labour supply model After- tax income U 0 Z Slope w 0 A l=24 leisure  Transfer of A.  Wage rate of w 0 . ECON 551: Lecture 8b 13 of 44

Add in a WITB-style credit Phase-out range. Slope w 0 (1-t) After- Receiving max tax benefit; not yet D income phasing out. Slope w 0 E C Phase-in range. Slope w 0 (1+s) Slope w 0 A B l=24 leisure Benefit phase-in rate: s Benefit phase-out rate: t ECON 551: Lecture 8b 14 of 44

What happens to a corner-solution guy? U 1 U 0 After- tax D income E C A B l=24 leisure Moves from corner solution at A to point C with introduction of EITC.  With any convex expansion of budget set, will (weakly) bring more off A and into work. ECON 551: Lecture 8b 15 of 44

What happens to an interior-solution guy? U 0 After- tax D income E C ?? Z A B l=24 leisure Could go anywhere, depending on where Z is, and nature of preferences.  In parallel segment DC there is just income effect — less work.  In BC and DE, there are income and substitution effects; potentially offsetting. ECON 551: Lecture 8b 16 of 44

Agenda 1. Overview 2. Basic models 3. Saez 2002 4. Evidence on in-work tax credits ECON 551: Lecture 8b 17 of 44

Saez (2002): Transfers to low-income earners Question asked by paper: under what conditions should we prefer a Negative Income Tax vs. an Earned Income Tax Credit?  Negative Income Tax: Give an initial transfer to zero earners; tax it back gradually.  EITC: Wage subsidy for lower earners, eventually clawed back as incomes grow. ECON 551: Lecture 8b 18 of 44

Participation vs intensive elasticities Key insight of model:  With fixed cost of work, may be optimal for some to choose corner solution of no work.  But, with right incentives, they may ‘jump’ into workforce.  If things aren’t continuous and smooth in the labour market, we need to augment Mirrlees (1971) to account for these kinds of costs and jumps. Definitions: Participation tax rate:  What is the change in taxes between working at a certain point and not working, divided by the wage.  Not distinct from an ‘average tax rate’. Marginal tax rate:  What you pay on the next dollar of earnings. Participation and intensive margin elasticities follow in the same way. ECON 551: Lecture 8b 19 of 44

Optimal income taxes with participation margin Here’s a stripped down version of what’s in Saez (2002) that captures the essential insight.  Individual has skill z  Tax function 𝑈(𝑨) . After-tax income 𝑨 − 𝑈(𝑨) .  With no work, gets −𝑈(0) .  No savings, so after tax income is consumed.  Fixed cost of work q.  Utility given by 𝑣 = 𝑑 − 𝑟 . (Consumption less cost of work) The work decision rule is very simple: If 𝑨 − 𝑈(𝑨) + 𝑈(0) > 𝑟 then work. If 𝑨 − 𝑈(𝑨) + 𝑈(0) < 𝑟 then don’t work. If q is distributed according to CDF 𝑄(𝑟|𝑨) , then number of individuals who work is 𝑄(𝑨 − 𝑈(𝑨) + 𝑈(0)|𝑨) ECON 551: Lecture 8b 20 of 44

Implementing the perturbation approach: Let’s define an elasticity: how does participation change with net return to work? 𝜃 (𝑨) = 𝑨 − 𝑈(𝑨) + 𝑈(0) ∙ 𝜖𝑄 𝜖𝑟 𝑄 Consider a small increase in taxes at a particular skill level z: 𝑒𝑈 .  This affects only those with skill level z. There are three effects we need to balance for the optimal tax rate to be in equilibrium: 1. Mechanical effect: higher taxes for those at skill z who still work. 2. Welfare effect: we care that those at skill z and working are paying higher taxes. 3. Behavioural effect: some workers at skill z now choose not to work. In equilibrium, all three of these should balance, so that any change nets to zero across these three effects: 𝑒𝑁 + 𝑒𝑋 + 𝑒𝐶 = 0 Let’s walk through these one at a time. ECON 551: Lecture 8b 21 of 44

Mechanical effect We get extra tax revenue from those who still work. 𝑒𝑁 = 𝑄(𝑟|𝑨)𝑒𝑈 We get the change in taxes dT multiplied by the proportion of those at skill z who are working. ECON 551: Lecture 8b 22 of 44

Welfare effect Imagine we value a dollar distributed to workers of skill z according to 𝑕(𝑨) . Welfare goes down because of this tax increase. 𝑒𝑋 = −𝑒𝑁 ∙ 𝑕(𝑨) = −𝑄(𝑟|𝑨)𝑒𝑈𝑕(𝑨) ECON 551: Lecture 8b 23 of 44

Behavioural effect Raising the tax rate at skill level z causes some workers to drop out as they can no longer cover their fixed cost of work. This costs us revenue. To calculate the behavioural effect, we need to multiply the number of workers affected by the fiscal cost for work dissuaded. First, the number of workers. How many drop out? Drop out if dT pushes you over your q. Those between 𝑨 − 𝑈(𝑨) + 𝑈(0) − 𝑒𝑈 and the original 𝑨 − 𝑈(𝑨) + 𝑈(0) drop out. 𝜖𝑄 There are 𝑒𝑈 𝜖𝑟 such workers. Now substitute in using the elasticity definition. 𝑒𝑈 𝜖𝑄 𝑒𝑈𝜃𝑄 𝜖𝑟 = 𝑨 − 𝑈(𝑨) + 𝑈(0) The cost of this is therefore: 𝜃𝑄(𝑟|𝑨)𝑒𝑈 [𝑈(𝑨) − 𝑈(0)] ∙ 𝑨 − 𝑈(𝑨) + 𝑈(0) ECON 551: Lecture 8b 24 of 44

Add up the effects 𝑒𝑁 + 𝑒𝑋 + 𝑒𝐶 = 0 𝜃𝑄(𝑟|𝑨)𝑒𝑈 𝑄(𝑟|𝑨)𝑒𝑈 − 𝑄(𝑟|𝑨)𝑒𝑈𝑕(𝑨) − [𝑈(𝑨) − 𝑈(0)] ∙ 𝑨 − 𝑈(𝑨) + 𝑈(0) = 0 Which reduces to: 𝜃 1 − 𝑕(𝑨) − [𝑈(𝑨) − 𝑈(0)] ∙ 𝑨 − 𝑈(𝑨) + 𝑈(0) = 0 Further reducing: [𝑈(𝑨) − 𝑈(0)] 𝑨 − 𝑈(𝑨) + 𝑈(0) = 1 𝜃 (1 − 𝑕(𝑨)) ECON 551: Lecture 8b 25 of 44

Interpretation Define the participation tax rate as [𝑈(𝑨) − 𝑈(0)] 𝑢(𝑨) = 𝑨 We can now rewrite the tax formula as 𝑢(𝑨) 1 − 𝑢(𝑨) = 1 𝜃 (1 − 𝑕(𝑨)) This comes out as a very simple inverse elasticity rule, multiplied by a term accounting for the social value of workers of type z.  The higher is the participation elasticity, the lower we want the tax rate to be. ECON 551: Lecture 8b 26 of 44