Let’s compare the incentives generated by two different types of public programs. The Aid to Families with Dependent Children (AFDC welfare before reform) provides an income subsidy, G, at 0 hours of work, it is taxed away at a rate t when an individual chooses to work. The Earned Income Tax Credit (EITC), on the other hand, consists of a subsidy (at rate s) for individuals working low hours, up to a max credit (C) at a certain level of income, and then is phased out (at a rate t) above a certain income cut off.
a. Draw what an AFDC budget constraint looks like, including a standard budget constraint for comparison.
b. Draw what an EITC budget constraint looks like, including a standard budget constraint for comparison. How does the EITC solve the work disincentive problem created by the AFDC? Refer to income and substitution effects in your answer.
c. The effects of the EITC on labor supply are not positive for all individuals. On a graph, illustrate a case in which the EITC reduces the number of hours worked by an individual. Explain using income and substitution effects.