During the Clinton Administration, the EITC— or Earned Income Tax Credit, was expanded considerably. The program provides a wage subsidy to low income families through the tax code in a way similar to this example: Suppose, as in the previous exercise, that you can earn $5 per hour. Under the EITC, the government supplements your first $20 of daily earnings by 100% and the next $15 in daily earnings by 50%. For any daily income above $35, the government imposes a 20% tax.
A: Suppose you have at most 8 hours of leisure time per day.
(a) Illustrate your budget constraint (with daily leisure on the horizontal and daily consumption on the vertical axis) under this EITC.
(b) Suppose the government ends up paying a total of $25 per day to a particular worker under this program and collects no tax revenue. Identify the point on the budget constraint this worker has chosen. How much is he working per day?
(c) Return to your graph of the same worker’s budget constraint under the AFDC program in exercise 3.18. Suppose that the government paid a total of $25 in daily AFDC benefits to this worker. How much is he working?
(d) Discuss how the difference in trade-offs implicit in the EITC and AFDC programs could cause the same individual to make radically different choices in the labor market.
B: More generally, consider an EITC programin which the first x dollars of income are subsidized at a rate 2s; the next x dollars are subsidized at a rate s; and any earnings above 2x are taxed at a rate t.
(a) Derive the marginal tax rate function m(I ,x, s, t ) where I stands for labor market income.
(b) Derive the average tax rate function a(I ,x, s, t ) where I again stands for labormarket income.
(c) Graph the average and marginal tax functions on a graph with before-tax income on the horizontal axis and tax rates on the vertical. Is the EITC progressive?