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 w 0 = w(1 t 0 ). max l U(c, l) s. t. c = w 0 (24 l) + y 0 GPP501: Lecture Oct 3 4 of 31
Basic static labour supply diagram: income Slope w 0 E U 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: income E Slope is now flatter. We pivot at point A because our original nonlabour income y 0 didn t change. Slope w 0 Slope w 1 U 0 A We will clearly be at a lower level of utility. l=24 leisure Whether labour supply moves up or down depends on indifference curves 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: p How can we use our supply/demand analysis to think about minimum wages? What is demand here? What is supply? Demand Supply What is Q? What is P? p 0 Q 0 Q GPP501: Lecture Oct 3 9 of 31
Minimum wages: wages Competitive markets analysis of minimum wages: Demand Supply Impose a minimum wage What happens to hours demanded? w 0 w min What happens to hours supplied? Where is the equilibrium? What are interesting features of this equilibrium? H D H 0 H S Hours 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
$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 WITB Benefit Level How WITB is calculated: $1,200 $1,000 $800 $600 $400 $200 $0 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 Aftertax income Slope w 0 Z U 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 Aftertax income Phase-out range. Slope w 0 (1-t) E D Receiving max benefit; not yet phasing out. Slope w 0 C Phase-in range. Slope w 0 (1+s) Slope w 0 B A 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 Aftertax income E D U 0 C B A 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 Aftertax income E D?? C Z B A 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 α: 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 τ is. τ = 1 1 + e α (See Milligan 2016 for a full derivation.) What happens when e goes up? What happens when α goes up? GPP501: Lecture Oct 3 28 of 31
Some values for τ 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 α gets bigger, more equitably distributed less gain from taxing high incomes. As e gets bigger, larger efficiency cost from taxing high incomes. Saez, Slemrod, and Giertz find e of 0.25 reasonable. Assume α = 1.5 for US. Gives 72.7% revenue maximizing rate. But, in UK Mirrlees review, Brewer, Saez, and Shephard (2011) found e=0.46, α = 1.67 Gives 56.6% revenue maximizing rate. For Canada. Estimates range from 0.4 up to 0.7 for e. For α, around 1.8 is right. GPP501: Lecture Oct 3 29 of 31
Should we aim to push top rate to τ? Diamond and Saez (2011 JEP) argue that we ought to push the top tax rate up until it raises no revenue at the margin the peak of the Laffer curve. Raising the tax rate on the top percentile obviously reduces the utility of high income tax filers. If we denote by g the social marginal value of $1 of consumption for top income earners (measured relative to government revenue), the direct welfare cost is g multiplied by the change in tax revenue collected. Because the government values redistribution, the social marginal value of consumption for top bracket tax filers is small relative to that of the average person in the economy, and so g is small and as a first approximation can be ignored. Feldstein (2012 JEL) reviews the Mirrlees Review, and disagrees. I find the words if society places some positive value on the welfare of those with income in the top tax bracket quite amazing. Who speaks for this society? What kind of nation places no value on the welfare of those with income in the top tax bracket, treating them only as the revenue producing property of the state? What do you think? GPP501: Lecture Oct 3 30 of 31
For next time We will walk through some empirical examples of what happens when taxes and transfers increase. See Jones, Milligan, and Stabile (2015) available online here. GPP501: Lecture Oct 3 31 of 31