Problem

Consider an income guarantee program with an income guarantee of $3,000 and a phase out rate of 50%. This means that individuals always have at least $3,000 in disposable income but lose 50 cents of the income guarantee for each $1 that they earn in the market. A person can work up to 2,000 hours per year at $6 per hour. Martin, Alan, Emmanuel, and Joel work for 100, 333.33, 400, and 600 hours, respectively, under this program. The government is considering altering the program to improve work incentives. Its proposal has two pieces. First, it will lower the guarantee to $2,000. Second, it will not reduce benefits for the first $3,000 earned by the workers. After this, it will reduce benefits at a phase out rate of 50%.

a. Draw the budget constraint facing any worker under the original program in a similar leisure-consumption diagram as in slide 7 of the "optimal labor tax" lecture. Assume that leisure is simply 2,000 if the individual does not work and 0 if the individual works 2,000 hours. Also assume that consumption is equal to disposable income.

b. Draw the budget constraint facing any worker under the proposed new program.

c. For each of the four workers, explain the impact of the new program in terms of income and substitution effects. Which of the four workers do you expect to work more under the new program? Who do you expect to work less? Are there any workers for whom you cannot tell if they will work more or less?