Answer to Question #202737 in Macroeconomics for Akhona Klanisi

Question

how public policies such as unemployment benefits and tax incentives can affect the employers, government and the level of unemployment, taking into account the age groups, skills endowments and substitution effects of the various workers in an economy.

Answer 1

Unemployment benefits can also be refered to as unemployment trap. This is what is paid to the unemployed individual and is usually relative to the net income from work. As this provides income security to the unemployed individuals.

Inactivity trap is where the working-age does not receive any unemployment benefits this is because it is believed one in the working age is in a position to look for an income.

Tax incentives

These have different effect on the different categories. For employment-conditions this tend to increase marginal tax at low earnings level due to phasing out in-work benefits

Tax benefit systems may create disincentives for workless households to obtain employment while on the contrary encouraging labour market participation of second earners in one-earner families.

For instance, when taxes are

reduced and the benefits increased, disposable income increases and people may be more likely to be content with their situation, and so less inclined, for example, to seek to

increase their earnings. This is the income effect. On the other hand, the reduction in taxes would increase the price of leisure as people would gain more than before for each hour

worked. This is the substitution effect and it would make individuals want to work more.

Only when the substitution effect dominates the income effect will a reduction in taxes bring about an increase in-work effort. 

The size of the income and substitution effects depends on individuals’ preferences and needs to be estimated empirically based on individuals’ responses to past tax and benefit changes.

Reducing marginal tax rates on wages and salaries, for example, can induce people to work more. Expanding the earned income tax credit can bring more low-skilled workers into the labor force.High marginal tax rates can discourage work, saving, investment, and innovation, while specific tax preferences can affect the allocation of economic resources.

Increase in taxes therefore has a negative effect on the government since there will be low returns in the government.