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

fag essay Having considered the implications for the twin towers, we can now analyse the orders of the policy on labour egress by determining the substitution and income effects. Its clear that the effect of the pruneing tax credit on rick behaviour depends upon how much a sniper is currently working. To analyse these effects we testament only hold off at one type of undivided 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. drawframe Figure 1 Diagram coering how the imposition of the WTC affects the individuals labour issue decision When the lone parent is either not working at all, or working less(prenominal) than 16 hours (Labelled A in the diagram), her current wage rate and wherefore income is unaffected by the WTC. This is just because they have not yet assembled any tax credit and therefore have no added incentives to work. However, if they work over1 6 hours, the programme will raise their overall take home wage as they receive a lump sum payment, shown by the first vertical blue line. at that placefore, at this low train of work, there is a very small, or 0, income effect, and a positive substitution effect, thus increasing the individuals labour supply. These effects are the alike as would be under an increase in the wage rate, shown diagrammatically in Figure 2. drawframe Figure 2 Diagram showing the effects of a wage increase The front man 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, retention 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 return his hours of leisure. The movement from C to B donates the income effect illustrating the workers chemical reaction to an increase in real income. Overall, the substitution effect dominates the income effect and therefore increases labour supply from L1 to L2. There is also the possibility that the income effect may overpower the substitution effect resulting in a decrease in the supply of labour.However, this depends on the position of the indifference curves, hence the workers preferences for work and leisure. On the other hand, it is unlikely at this low wage rate for the worker to choose leisure over the opportunity to earn a higher wage. Section C of our WTC diagram shows the area at which an individual works more than 30 hours. The workers net income is now higher at this point, however the workers marginal wage is lower which is demonstrated by the gradient of the WTC line being shallower than gradient of the No WTC line.The Substitution and Income effects here are the same as would be with a decrease in wage. Both the Income and substitution effects work unitedly to reduce the amount of labour shown in Figure 3 drawframe Figure 3 Diagram showing the effects of a wage decrease The substitution effect is shown by the movement around the old indifference curve, from A to C. The income effect is shown by the movement from A to B. Although the substitution effect is stronger, both effects work together to reduce the hours of work from L1 to L3. Lastly, section B represents the area at which an individual works between 16 and 30 hours.Here, the effects of the WTC on labour supply are much more complex. Despite the gradient of the WTC line being the same as section C, this time there is the possibility of increasing work to above 30 hours and receiving the additional payment. This therefore results in lone parents bunching around the 16 and 30 hour marks in order to pull ahead the greatest benefit from the WTC payment. Some will therefore substitute leisure for work and work longer hours to gain the additional bonus at 30 hours, whilst others will choose to forgo work for leisure and be content with the benefit o f working over 16 hours.