Substitution and Income Effects of the Working Tax Credit on Labour Supply

Labour essay: Having considered the implications for the WTC, we can now analyse the effects of the policy on labour supply by determining the substitution and income effects. It’s clear that the effect of the working tax credit on work behaviour depends upon how much a worker is currently working. To analyse these effects we will only look at one type of individual; a lone parent in the labour force. This will simplify our analysis such that we can divide the diagram below into 3 sections and describe the effects separately. {draw:frame} Figure 1: Diagram showing how the imposition of the WTC affects the individuals labour supply decision When the lone parent is either not working at all, or working less than 16 hours (Labelled A in the diagram), her current wage rate and therefore income is unaffected by the WTC. This is simply because they have not yet received any tax credit and therefore have no added incentives to work. However, if they work over16 hours, the programme will raise their overall take home wage as they receive a lump sum payment, shown by the first vertical blue line. Therefore, at this low level of work, there is a very small, or 0, income effect, and a positive substitution effect, thus increasing the individual’s labour supply. These effects are the same as would be under an increase in the wage rate, shown diagrammatically in Figure 2. {draw:frame} Figure 2: Diagram showing the effects of a wage increase The movement around the original indifference curve from A to C is the substitution effect; this arises due the change in price of leisure relative to hours of work, holding utility as constant. As the wage rate has increased the opportunity cost of leisure opposed to work has risen. The substitution effect encourages the worker to decrease his hours of leisure. The movement from C to B donates the income effect illustrating the workers response to an increase in real income. Overall, the substitution effect dominates