2.6 Putting the Tools to Work the Effect of Temporary Assistance Programs on the Budget Constraint

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1 Module 2 Lecture 4 Topics 26 Putting the Tools to Work the Effect of Temporary Assistance Programs on the Budget Constraint 27 Budget Constraint 28 The Effect of Temporary Assistance Programs on the Budget Constraint 29 The Effect of Various Policy Changes 210 What Happens to Labor Supply in Response to Such a Policy Change? 211 A Different Preference Function 212 Summary of Labor Supply Effects 26 PUTTING THE TOOLS TO WORK THE EFFECT OF TEMPORARY ASSISTANCE PROGRAMS ON THE BUDGET CONSTRAINT Let s consider Temporary Assistance programs common in many countries It generally distributes money from tax payers to low-income families Example: Progresa (Mexico), TANF (US), NREGA (INDIA) Optimal Choice: Labor vs Consumption 27 BUDGET CONSTRAINT Assume 2 goods in the utility max problem: leisure & food consumption Whatever time is not devoted to leisure is spent working & earning money 1

2 There is a tradeoff so far we considered two goods, both normal Now 1 good & 1 bad The tride is to model leisure instead of labor Assume the person can work up to 2000 hours per year, at a wage rate of 10 per hour, and that temporary assistance is not yet in place By working more hours, she can earn more money for food But there is cost to work More work makes her worse off and more food better Now consider the utility maximization problem of an individual facing a laborleisure choice The budget constraint faced by the individual can be described using the following concepts: Price of food (Assume that this is 1 per unit) price of leisure tradeoff between leisure and food Slope of Budget Constraint By working 1 less hour in a year she will lower her consumption by 10 rupees and increase her leisure time by 1 hour Thus the price or opportunity cost of 1 hour of leisure is the wage rate 10 Thus the price of 1 hr of leisure is 10, the foregone wage she could have earned working Slope of Budget Constraint: -W/P F Figure: 41 illustrates this P Price of leisure = opportunity cost of leisure Slope of budget constraint All work, no leisure rupees income I Figure 41 2

3 28 THE EFFECT OF TEMPORARY ASSISTANCE PROGRAMS ON THE BUDGET CONSTRAINT Let s consider Temporary Assistance programs, a typical welfare program TANF was created in 1996 in the US by restructuring the cash welfare system Distributes cash from taxpayers to low income families A typical TANF program generally has the following features, has two key features Benefit guarantee, G baseline amount that a recipient gets for enrolling in the program Benefit reduction rate rate at which baseline benefit amount is reduced if recipients have other income; an implicit tax rate 100% vs 50% benefit reduction rates 100% benefit reduction rate implies that TANF recipients are entitled to the benefit guarantee if they have no other income or below a specific income, but they lose a rupee of benefit guarantee for each unit of extra income earned 50% benefit reduction rate implies that TANF recipients are entitled to the benefit guarantee if they have no other income, but they lose 050 rupee of benefit guarantee for each unit of other income earned Thus, Benefit guarantee falls as earnings increases A poor single mother spends all the income on food By working more hrs she can earn more money but has less time at home She faces a labor-food choice Convert this to a leisure-food choice & then analyze her trade oft Assume that Benefit Guarantee is 5,000 per year Benefit Reduction rate is 50% The following figure illustrates the effect of TANF on the budget constraint we saw in the previous graph Slope = = 3

4 Benefit Guarantee Benefit Reduction For each additional rupee earned, income If he works 1000 hrs, Figure 42 (A) Can be purchased with no work, no other Remain on initial Budget constraint for income greater than 10,000 Additional hours of work involve an income of 10 hour of additional work Price of leisure Net wage When l Net income = = THE EFFECT OF VARIOUS POLICY CHANGES One possible policy experiment is reducing the benefit guarantee level G What happens when G falls from 5,000 to 3,000, holding all other parameters constant? Figure 43 illustrates this Figure 43 4

5 Now at 1000 hrs of work income = 10,000 Where will net benefit be zero? Leisure hrs, income No net benefit BR > BG => the individual is better off without enrolling into the TANF program Thus she will face the same old Budget Constraint Below rupees of income, wage Net wage How will individuals respond to this policy change, Recall the concepts of income effect (IE) & substitution effect (SE) Suppose she earned < 6000 before the policy change no SE associated with the in BG from 5000 to 3000 there is no change in the relative price of leisure before & after But there is IE income s with in BG leisure If income is between before in BG, then the relative price changes as well Leisure is more expensive SE+IE (Price of leisure charges from 5 to 10 as BG form 5000 to 3000) Leisure more than before Now Earlier 210 WHAT HAPPENS TO LABOR SUPPLY IN RESPONSE TO SUCH A POLICY CHANGE? How large would the labor supply response be? How sizable this response would be is not answered by the model above It depends on where the individual initially was on the budget constraint To explain the different possible magnitudes of response consider 2 different preference functions 5

6 Figure 44 illustrates this Income < 6000 IE > Income > 6000 IE + SE Income > no effect Figure 44 Expected change in labor supply Suppose initial income is less than per yr The policy change involves no change in relative price of leisure / food Relative price of leisure to food is -5 at policy 1 Relative price of leisure to food is -5 at policy 2 Only income effect, since net income at every level of leisure over 1400 Income effects Suppose the individual has the following utility function: She values leisure somewhat more Figure 45 illustrates this 6

7 Figure 45 Initial Income : Earlier relative price of leisure(slope of ) =5 Now relative price of leisure (slope of ) =10 Price of leisure Real Income falls : Earlier at 5000 BG she was eligible for TANF at income levels between But now as, she is not eligible for TANF for income between Income also Income effect amounts to a movement from u 1 to u 2 What happens if when income is greater than 10000? No or Income Effects, not eligible for TANF either ways 211 A DIFFERENT PREFERENCE FUNCTION Economic theory clearly suggests that a benefit reduction will increase labor supply, but does not speak about the magnitude of the response For example, some welfare recipients who were not initially working might continue not to work Consider a specific preference function to illustrate the above point Suppose the utility function is given by A very strong preference for leisure Figure 46 illustrates this Figure 46 When BG was 5000, the optimal choice was not to work at all The person was initially out of the labor force 7

8 She puts a significant weight on leisure A large in consumption is required to compensate for a unit in leisure Optimal choice No labor, all leisure for corresponding to point u 1 (2000,5000) Suppose there is a policy change and the individual continues not to work & just lets consumption Thus the individual, in this case continues to stay out of the lab force even after benefit Reduction 212 SUMMARY OF LABOR SUPPLY EFFECTS The actual magnitude of the labor supply response therefore depends on the preferences of various welfare recipients To the extent the preference is more like the former case, labor supply increases Theory alone cannot say whether this policy change will increase labor supply, or by how much Must analyze available data using empirical methods to figure out the magnitude of labor supply response 8