1986 and 1987, as compared to only an increase of $976 in Quebec. As a result of the policy shift, the average disability benefit in the rest of Canada increased by $1,666 more than the increase experienced by persons residing in Quebec.
The bottom rows of the table document how this increased generosity affected labor supply. The fraction of men aged 45–59 who did not work fell from 25.6 to 24.6 in Quebec (a decrease of 1.0 percentage point), likely reflecting changes in aggregate economic activ- ity over the period. In contrast, the proportion of comparable men residing outside Quebec who did not work rose from 20.0 to 21.7 percent, an increase of 1.7 percentage points. The difference-in-differences estimator (or 1.7 ⫺ (⫺1.0)) implies that the increased generosity of the disability program increased the proportion of men who did not work by 2.7 percent- age points. It seems, therefore, that generous disability benefits do indeed reduce the labor supply of men nearing retirement age.
flattening out the budget line, and generating segment FG. Finally, if the retiree earns more than $47,000, the retiree forfeits his entire Social Security benefits, and the slope of the budget line reverts back to its original slope. 57 The earnings test thus generates the budget
“line” HGFE in Figure 2-22 .
It is of interest to ask if the elimination of the earnings test would increase the labor sup- ply of older workers. The elimination of the test would allow the retiree to face budget line H ⬘ E, instead of HGFE. As is evident in Figure 2-22 , there are three potential effects of the
Consumption ($)
Hours of Leisure 0
$10,000
T E
$27,000
$47,000 H
G
F R2
R3
P2
P3
P1
H'
Worker 2
Worker 3
Worker 1
FIGURE 2-22 The Impact of the Social Security Earnings Test on Hours of Work
The Social Security earnings test (which taxes retirees when they earn more than $17,000 per year) generates the budget “line” HGFE. The repeal of the earnings test moves retirees to budget line H ⬘ E. The first retiree (worker 1) would not change his hours of work; the second retiree would reduce his hours; and the third retiree might increase or decrease his hours, depending on whether substitution or income effects dominate.
57 The first $17,000 of earnings for this retiree is exempt from the Social Security tax, so that only
$30,000 of wage income is subject to the tax. Because Social Security benefits are reduced by $1 for every $3 of taxable income, the entire Social Security benefit of a worker who earns $47,000 is taxed away. The consumption basket available to this worker is illustrated by point G in Figure 2-22 . He has $47,000 available for consumption (or $10,000 in Social Security benefits ⫹ $47,000 in wage income ⫺ $10,000 in Social Security taxes).
earnings test on work incentives. The first worker (worker 1 in the figure) has indifference curves that place him at point P 1 , where he works very few hours, regardless of whether there is an earnings test. Obviously, this retiree will not be affected by the elimination of the earnings test. The second worker’s indifference curves place him at point P 2 , indicating strong “tastes for work.” This person allocates many hours to the labor market even though it means he has to forfeit his Social Security benefits. Interestingly, removing the earnings test for this worker is equivalent to an increase in the person’s wealth, moving the worker from point P 2 to point R 2 . This income effect induces the retiree to consume more leisure hours, thus reducing work hours.
Finally, the third worker is a retiree who works a “medium” number of hours. This per- son has not entirely forfeited his Social Security benefits and faces a 33 percent tax rate on labor earnings. The repeal of the earnings test moves this worker from point P 3 to point R 3 . In other words, this worker effectively gets a wage increase when the earnings test is repealed. As such, the worker will experience both an income and a substitution effect.
The income effect will motivate the worker to consume more leisure and work fewer hours;
the substitution effect induces the worker to consume fewer leisure hours and work more hours. As drawn, the substitution effect dominates.
Overall, the theory suggests that the elimination of the Social Security earnings test is unlikely to substantially increase labor supply among retirees. A few studies have examined the labor supply consequences of repealing the earnings test. The evidence confirms the theoretical expectation: the labor supply effects of the repeal tended to be small. 58
Summary
• The reservation wage is the wage that makes a person indifferent between working and
not working. A person enters the labor market when the market wage rate exceeds the reservation wage.
• Utility-maximizing workers allocate their time so that the last dollar spent on leisure
activities yields the same utility as the last dollar spent on goods.
• An increase in nonlabor income reduces hours of work of workers.
• An increase in the wage generates both an income and a substitution effect among per-
sons who work. The income effect reduces hours of work; the substitution effect in- creases hours of work. The labor supply curve, therefore, is upward sloping if substitu- tion effects dominate and downward sloping if income effects dominate.
• An increase in nonlabor income reduces the likelihood that a person enters the labor force.
An increase in the wage increases the likelihood that a person enters the labor force.
• The labor supply elasticity is on the order of ⫺0.1 for men and ⫹ 0.2 for women.
• Welfare programs create work disincentives because they provide cash grants to partici-
pants as well as tax those recipients who enter the labor market. In contrast, credits on earned income create work incentives and draw many nonworkers into the labor force.
58 Jae G. Song and Joyce Manchester, “New Evidence on Earnings and Benefit Claims Following Changes in the Retirement Earnings Test in 2000,” Journal of Public Economics 91 (April 2007):
669–700.
added worker effect, 71 budget constraint, 32 budget line, 32 discouraged worker
effect, 71
difference-in-differences estimator, 63
employment rate, 23 fixed effects, 70 hidden unemployed, 23 income effect, 35
Key Concepts
indifference curve, 27 intertemporal substitution
hypothesis, 67 labor force, 22
labor force participation rate, 22
labor supply curve, 42 labor supply elasticity, 44 marginal rate of
substitution (MRS) in consumption, 30
marginal utility, 29 neoclassical model of
labor-leisure choice, 27 opportunity set, 32 reservation wage, 41 Social Security earnings
test, 77
substitution effect, 39 unemployment rate, 23 utility function, 27 1. What happens to the reservation wage if nonlabor income increases, and why?
2. What economic factors determine whether a person participates in the labor force?
3. How does a typical worker decide how many hours to allocate to the labor market?
4. What happens to hours of work when nonlabor income decreases?
5. What happens to hours of work when the wage rate falls? Decompose the change in hours of work into income and substitution effects.
6. What happens to the probability that a particular person works when the wage rises?
Does such a wage increase generate an income effect?
7. Why do welfare programs create work disincentives?
8. Why does the earned income tax credit increase the labor force participation rate of targeted groups?
9. Why have average hours worked per week declined?
10. Why did the labor force participation rate of women increase so much in the past century?
11. Why does a worker allocate his or her time over the life cycle so as to work more hours in those periods when the wage is highest? Why does the worker not experience an income effect during those periods?
12. What is the added worker effect? What is the discouraged worker effect?
13. What factors account for the secular decline in labor force participation rates among older workers in the United States?
Review Questions
2-1. How many hours will a person allocate to leisure activities if her indifference curves between consumption and goods are concave to the origin?
2-2. What is the effect of an increase in the price of market goods on a worker’s reserva- tion wage, probability of entering the labor force, and hours of work?
2-3. Tom earns $15 per hour for up to 40 hours of work each week. He is paid $30 per hour for every hour in excess of 40. Tom faces a 20 percent tax rate and pays $4 per hour in child care expenses for each hour he works. Tom receives $80 in child support pay- ments each week. There are 168 hours in the week. Graph Tom’s weekly budget line.
2-4. Cindy gains utility from consumption C and leisure L. The most leisure she can consume in any given week is 168 hours. Her utility function is U ( C, L ) ⫽ C ⫻ L.
This functional form implies that Cindy’s marginal rate of substitution is C/L. Cindy receives $630 each week from her great-grandmother—regardless of how much Cindy works. What is Cindy’s reservation wage?