GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given - PowerPoint PPT Presentation

GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture October 3rd: Redistribution — theory GPP501: Lecture Oct 3 1 of 31

Agenda for today: 1. Basic labour supply analysis 2. Minimum wages 3. In-work earnings subsidies 4. Taxing top earners GPP501: Lecture Oct 3 2 of 31

Basic Labour Supply Analysis Why do we work? What does it cost us to work? GPP501: Lecture Oct 3 3 of 31

Basic Labour Supply Analysis  One period static model of labour supply.  Get utility from leisure and consumption.  Wage w , fixed tax rate t .  24 hours in a day; working hours are 24-l.  Get transfer income y 0 even if you don’t work at all.  Let’s denote after tax wage as 𝑥 0 = 𝑥(1 − 𝑢 0 ) . 𝑉(𝑑, 𝑚) 𝑡. 𝑢. 𝑑 = 𝑥 0 (24 − 𝑚) + 𝑧 0 max 𝑚 GPP501: Lecture Oct 3 4 of 31

Basic static labour supply diagram: income U 0 E Slope w 0 A l=24 leisure GPP501: Lecture Oct 3 5 of 31

Basic diagram: The story in this diagram:  Choice is between hours worked and income/consumption.  If work 0 hours, then you get to be at point A.  Find tangency point — in this case E, but could be at point A.  Slope of budget line is the after tax wage w(1-t). Now, what happens if the tax rate t 0 goes up to t 1 > t 0 ? Well, w 0 goes down to w 1 . This makes the slope of the budget constraint flatter: GPP501: Lecture Oct 3 6 of 31

Basic diagram:  Slope is now flatter. income  We pivot at point A because our original nonlabour income y 0 didn’t change. E U 0  We will clearly be Slope w 0 at a lower level of utility. Slope w 1 A  Whether labour supply moves up or down depends on indifference curves l=24 leisure GPP501: Lecture Oct 3 7 of 31

Agenda for today: 1. Basic labour supply analysis 2. Minimum wages 3. In-work earnings subsidies 4. Taxing top earners GPP501: Lecture Oct 3 8 of 31

Minimum wages: How can we use our supply/demand analysis to think about minimum wages? p  What is demand here? What is supply?  What is Q? What is P? Demand Supply p 0 Q Q 0 GPP501: Lecture Oct 3 9 of 31

Minimum wages: Competitive markets analysis of minimum wages wages:  Impose a minimum wa ge… Demand  What happens to hours demanded? Supply w min  What happens to hours supplied? w 0  Where is the equilibrium?  What are interesting features of this equilibrium? Hours H D H 0 H S GPP501: Lecture Oct 3 10 of 31

Refinements to the theory: That’s the basic theoretical analysis…but is that enough? What market assumptions might affect this basic analysis? GPP501: Lecture Oct 3 11 of 31

Refinements to the theory: Monopsonistic competition:  What if there isn’t much competition among firms? Efficiency wages / multiple equilibria:  What if employers would like to invest more in their employees? When business costs increase, where can these costs manifest themselves? GPP501: Lecture Oct 3 12 of 31

Agenda for today: 1. Basic labour supply analysis 2. Minimum wages 3. In-work earnings subsidies 4. Taxing top earners GPP501: Lecture Oct 3 13 of 31

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. GPP501: Lecture Oct 3 14 of 31

Example of an earned-income supplement: WITB  Working Income Tax Benefit introduced in 2007.  Supplements earnings over a threshold at 25% rate.  Phased out once income over another threshold at 15%  In 2016 maxed out: $1028 (singles) $1868 (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. GPP501: Lecture Oct 3 15 of 31

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 $3,000; pivot at $11,675/$16,122.  Note phase in and phase out rates. GPP501: Lecture Oct 3 16 of 31

How WITB is calculated: $1,200 $1,000 WITB Benefit Level $800 $600 $400 $200 $0 $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 $10,000 $11,000 $12,000 $13,000 $14,000 $15,000 $16,000 $17,000 $18,000 $19,000 $20,000 $21,000 $22,000 Earnings levels GPP501: Lecture Oct 3 17 of 31

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? GPP501: Lecture Oct 3 18 of 31

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 . GPP501: Lecture Oct 3 19 of 31

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 GPP501: Lecture Oct 3 20 of 31

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. GPP501: Lecture Oct 3 21 of 31

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. GPP501: Lecture Oct 3 22 of 31

Key distinction: Extensive vs. Intensive Margin Responses Extensive margin:  ‘ in ’ vs ‘ out ’ decision. Do you work at all?  Why would this occur? Intensive margin:  Do you want to work another hour?  How relevant is this for labour market decisions? For whom? GPP501: Lecture Oct 3 23 of 31

Agenda for today: 1. Basic labour supply analysis 2. Minimum wages 3. In-work earnings subsidies 4. Taxing top earners GPP501: Lecture Oct 3 24 of 31

Deriving top tax rates How much can we push taxation at the top? This raises the concept known as the ‘Laffer Curve’… . http://youtu.be/dxPVyieptwA?t=30s GPP501: Lecture Oct 3 25 of 31

The Legend of the Laffer Curve It was traced out on a napkin during a 1974 meal at the “ Two Continents Restaurant ” in Washington. Argued that above some point, higher taxes would lead to lower revenues. At the dinner were:  Arthur Laffer  Jude Wanniski (WSJ) — coined the term.  Donald Rumsfeld  Dick Cheney There are many historical precedents of this notion (Hume, Smith, others…)  Location of Laffer peak is empirical question, but clearly of theoretical importance. GPP501: Lecture Oct 3 26 of 31

Deriving the revenue maximizing tax rate We can derive a formula for the revenue maximizing tax rate. There are two parameters: The elasticity of taxable income e :  How much do incomes change when the tax rate goes up?  Could be a real response (work less) or an accounting response (use tax shelters)  As elasticity rises, higher tax rates become less effective. The Pareto parameter 𝛽 :  How unequal are incomes?  As more income resides in the extremes, higher tax rates will be more effective.  The higher is the Pareto parameter, the less income resides in the extremes. GPP501: Lecture Oct 3 27 of 31

Deriving the revenue maximizing tax rate The revenue maximizing tax rate 𝜐 ∗ is … . 1 𝜐 ∗ = 1 + 𝑓 ∙ 𝛽 (See Milligan 2016 for a full derivation.) What happens when 𝑓 goes up? What happens when 𝛽 goes up? GPP501: Lecture Oct 3 28 of 31

Some values for 𝝊 ∗ alpha 1.4 1.5 1.6 1.7 1.8 1.9 2.0 e 0.10 87.7% 87.0% 86.2% 85.5% 84.7% 84.0% 83.3% 0.25 74.1% 72.7% 71.4% 70.2% 69.0% 67.8% 66.7% 0.50 58.8% 57.1% 55.6% 54.1% 52.6% 51.3% 50.0% 0.75 48.8% 47.1% 45.5% 44.0% 42.6% 41.2% 40.0%  As 𝛽 gets bigger, more equitably distributed — less gain from taxing high incomes.  As 𝑓 gets bigger, larger efficiency cost from taxing high incomes. Saez, Slemrod, and Giertz find e of 0.25 reasonable. Assume 𝛽 = 1.5 for US.  Gives 72.7% revenue maximizing rate. But, in UK Mirrlees review, Brewer, Saez, and Shephard (2011) found e =0.46, 𝛽 = 1.67  Gives 56.6% revenue maximizing rate. For Canada … .  Estimates range from 0.4 up to 0.7 for e . For 𝛽 , around 1.8 is right. GPP501: Lecture Oct 3 29 of 31