Econ 421 Subsidies Problem Set Spring 2015

Econ 421subsidies Problem Set spring 20151 Suppose Low Income People

Suppose low-income people are given vouchers worth 200 dollars per month that they can use only to pay rent on housing. a. Use indifference curve analysis to show how the person could be made as well off with a 200 dollar case transfer. b. Would the consumer's choice of the amount of housing to rent be any different if he receives cash instead of housing vouchers? c. Use indifference curve analysis to show under what circumstance the 200 dollar per month housing voucher would cause the recipient to increase the amount of housing rented compared to what would be rented if the recipient received 200 dollars in cash each month in lieu of the housing vouchers. d. Would this recipient be as well off under the housing voucher scheme as he would be with a cash transfer of equal value? 2. A needy family consisting of a mother and three children currently receives cash benefits that average 12 dollars per day. The mother of this family is allowed to earn an average of 4 dollars per day before her benefits begin to decline. After that, for each dollar earned cash benefits decline by 67 cents. a. Plot the recipients money income-leisure tradeoff (budget) line under these circumstances. b. Assume that she can find work at 4 dollars per hour. How many hours will she have to work per day before her benefits are eliminated? c. Assuming that her indifference curves for work and leisure are convex, show her equilibrium allocation of time between work and leisure per day. Show that it is possible to have more than one most preferred outcome. 3. Go to to obtain the tables for the earned income tax credit (EITC) for the current year. a. Explain how the program increases earnings for low-income workers and affects their incentives. b. Draw a curve for single workers filing jointly, and single parents show how the EITC will vary with earnings. c. Why does the EITC encourage low-income workers to work? Use indifference curve analysis to show the income and substitution effects results from the EITC up to the point at which the maximum credit level of earnings is reached. 4. Explain why the negative income tax plan is likely to be more expensive than the current system of assistance to the poor. What are the advantages of wage rate subsidies?

Paper For Above instruction

Income redistribution policies are crucial tools in addressing poverty and economic inequality. Among these, vouchers, cash transfers, earned income tax credits (EITC), and negative income taxes represent varying mechanisms with different incentives and outcomes. This paper analyzes these policies through the lens of indifference curve analysis and economic incentives, examining their efficiency, impact on behavior, and relative costs.

1. Housing Vouchers versus Cash Transfers: An Indifference Curve Approach

The provision of housing vouchers worth $200 per month, restricted to housing expenditures, can be modeled through indifference curves to understand their impact on a low-income individual’s well-being. If the individual’s initial budget constraint is represented by a budget line tangent to an indifference curve, the voucher effectively shifts this budget line outward parallel to itself, assuming the individual values housing and other goods accordingly.

In the case of a voucher, the individual can allocate the voucher towards housing expenses, potentially allowing the consumer to reach a higher indifference curve, indicating increased satisfaction. If instead, the cash transfer of $200 were given, the consumer could choose how to allocate these resources, which might lead to a different consumption bundle. If the preferences for housing versus other goods are linear or convex, the person might substitute cash for housing differently, potentially renting less or more depending on relative prices and preferences.

Under specific circumstances—particularly when the individual values housing highly and faces a fixed need for housing—the voucher could incentivize more housing rent, as it is earmarked solely for this purpose. Conversely, cash provides flexibility, possibly resulting in less spent on housing if other needs are prioritized.

Finally, whether the recipient is equally well off under either policy depends on their preferences. If they value the actual housing quality and quantity more than other goods, vouchers may better meet their preferences, potentially making them as well off as cash transfers. However, if they seek flexibility or have diversified needs, cash transfers might allow for a higher overall utility.

2. Income-Information Tradeoff and Labor Supply Decision

The family’s daily cash benefits of $12, with a phase-out associated with earnings, create a complex budget constraint. The mother can earn up to $4 daily before benefits begin to decline, and thereafter benefits decline at 67 cents per dollar earned. Plotting this constraint illustrates a kinked budget line, where the initial income (benefits) are constant up to a certain earning threshold, after which the budget line slopes downward, reflecting the benefits reduction.

If she finds work at $4 per hour, her benefits will be eliminated after earning enough to exhaust the threshold, which is at 4 dollars per day—meaning she would need to work approximately one hour per day at this wage to lose her benefits. The convexity of indifference curves for leisure versus work suggests multiple optimal points of allocation, where she is indifferent between working and leisure, leading to potential multiple equilibria.

3. The Earned Income Tax Credit (EITC) and Incentives to Work

The EITC enhances earnings for low-income workers by increasing the after-tax income as earnings rise up to a maximum credit level. The program’s design creates a "step-shaped" EITC schedule, which can be graphically represented with a curve that rises with earnings, peaks, and then declines or plateaus. This structure encourages work by subsidizing additional earnings, especially within certain income ranges.

Indifference curve analysis reveals that the EITC induces both income and substitution effects. As the credit increases with earnings initially, workers are incentivized to work more (substitution effect). Once the maximum credit is reached, further increases in earnings do not translate into higher benefits, and workers may work less or more depending on preferences. The balance between these effects determines overall labor supply responses, with some evidence suggesting the EITC raises overall employment among low-income populations.

4. Negative Income Tax versus Traditional Welfare Systems

The negative income tax (NIT) proposes a direct subsidy to individuals earning below a threshold, effectively providing a guaranteed income that phases out gradually. While economizing on administrative costs and reducing stigma, NIT tends to be more expensive due to its universal scope and the high phase-out rates. It also introduces disincentives for additional work when benefits decline rapidly, potentially leading to higher costs than traditional means-tested programs that limit assistance.

Wage rate subsidies, on the other hand, aim to incentivize employment directly by subsidizing wages rather than income levels. These subsidies can improve work incentives, increase employment, and reduce dependency, offering a more targeted and potentially cost-effective approach to alleviating poverty.

Conclusion

The analysis underscores that welfare policies should carefully consider behavioral incentives and economic efficiency. Vouchers can be effective when targeted at specific needs, while cash transfers offer flexibility. EITC and wage subsidies effectively incentivize work, but their design must balance costs and benefits. Ultimately, a combination of targeted interventions and incentives can most effectively address poverty and promote economic inclusion.

References

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