Question

Suppose that the Earned Income Tax Credit is set up so that a maximum payment of $3,000 can be earned when a qualified worker earns $10,000. This payment represents a subsidy of 30 cents for each additional dollar earned up to $10,000. Workers earning between $10,000 and $14,000 are eligible for the maximum payment. Once labor market earnings exceed $14,000, additional earnings reduce the subsidy by 45 cents for each dollar earned.

The going wage rate is $10 per hour.

A: Will a person working between 1000 and 1400 hours in the labor market before the policy experience an income effect, a substitution effect, or both as a result of the EITC?

B: What will happen to the labor market hours of a person working 1500 hours in the labor market per year before the policy?

Answer 1

Let's tabulate the information as follows. Since for a person working between 1000 and 1400 hours, there's same EITC, they don't see any substitution effect, only income effect.

A person working for 1500 hours under EITC will see their marginal wage rate go down and hence they will face a substitution effect (their leisure hours are increasingly more precious)

H	A	B	C=A+B	D=C*H	E=Sum of Marginal Earnings	F = E/H
Number of hours	Wage Rate	EITC Effect	Marginal wage rate	Marginal Earnings	Total Earnings	Net Average Wage Rate		Average wage rate prior to EITC
0	10	3	13	0	0			10
500	10	3	13	6500	6500	13.00		10
1000	10	3	13	6500	13000	13.00		10
1100	10	0	10	1000	14000	12.73		10
1200	10	0	10	1000	15000	12.50		10
1300	10	0	10	1000	16000	12.31		10
1400	10	0	10	1000	17000	12.14		10
1500	10	-4.5	5.5	550	17550	11.70		10