.

1
The neoclassical labour leisure model proposes that Individuals m a ke choices on how much to wo r k /Labours and

h ow much to
enjoy leisure time based on their preferences rates and their other income sources .
,
wage ,

EITC's Effec ts on Labour Force Participation for Single Workers :

I C individuals Participate force derive

E
utility
T labour from leisure
Without .
.
.
: decide wether to in the by comparing the they

they from the goods and they purchase their earnings. If the too Individuals
With the
utility gain services can
using wage rate is low ,
some

from leisure > This lower than

may choose n ot to wo r k b e cau s e their
utility potential
earnings. s i t u at i on graphically would be a point

(minimum force)
the re s e r va t i o n
wage wage required to attract individual i n to
entering labou r On labour
supply curve .

With El T C : For EITC provides boost This increase potential labour force
.
.

eligible workers
,
an
earnings . in earnings can make

participation more attrac tive ,

especially for the Individuals that
previously we re not
working because of l ow
wage rates . E .
I .
T . C
effectively

lowers reser vation

wage . On a
graph this would be a downward shift in the reservation
wage and rightward shift in the labour

curve .
supply

E
. 1 .
T .
C Effect on Hours Worked : Depends on where Individuals income falls within E .
I . T C
.
struc ture

their hours
·

Phase-in The E L T supplements higher effective rate . This will motivate workers to i n cre a s e
Range :
. .
.
C
earnings at an
increasing r a te ,
creating a
wage

worked to m a x i m i ze both their

earnings and their E .
/ .
TC
. benefit -

Graphically ,
the labour
supply cur ve becomes Steeper .

Plateau Range : Once a worker's the Plateau fixed E I T C amount their effec tive constant
earnings re a c h
range ,
they re c e i ve a . . .

,
w h e re
wage re m a i n s

This will reduce workers incentive increase wo r k this is represented graphically by Labour curve that
flattens.
a to hours ,
a
supply

:
Phase-out
Range In this
range the E I T C
gradually decreasing earnings effectively creating implicit t ax on additional
earnings.
·
is as rise an
,
.
. .
,

This a disincentive to additional hours . Graphically the labour will bend backward how reduce worked
can create wo r k
, supply c u r ve
,
representing wo r ke rs
may hours

due to the
diminishing benefit
.

.
2 The key identifying assumption in this difference-in-difference analysis is the parallel trends assumption. This assumption states that ,
in the absence of the

1986 EITC the labour force participation of the treatment lunmarried low-income children and than school education) and
expansion ,
rates
group with less a
high the

control groups (unmarried women without children and with less than a high school education
,
AND unmarried wo m e n with children and with m o re than a
high

a
high school education) would have followed parallel trends over time .

· This assumption ass e r ts t h at

any
differences in
changes in labour force participation rates between the treatment and control
groups AFTER the E I. .
T C .
expansion can

be attributed to the than other differences Changing

policy change itself ,
rather
pre-existing between the
groups that were also ove r time .

.
3 Suggest a
way to test the
Validity of the assumption

One the Validity of the parallel trends the trends in labour force participation for the treatment and control in
way to test assumption is by examining rates
groups

the years before the 1986 E I T C expansion. If the assumption holds should observe that the labour force participation rates of these groups a similar
. .
.

,
we we re
moving in

direction and similar before the

at a pace policy change.

For example labour force for three (if data) 1982 1983 and 1984 /Prior in
,
we cou ld compare the participation rates the
groups we had the in the years , ,
to
change

1986) and assess wether their data trends appear parallel . This would make it more
likely that the estimated DID effect captures the causal impact of the E .
I T C
. .
expansion.

I
calculating the DID estimate using provided Sorce participation the labor rates :

Control Group 1 : Unmarried women without children : With less than a High School Education

Treatment Group Change

: 0 .
497 (after) -
0 . 479(before) = 0 . 018

Group : (after) 0 784 (before)

C o n t ro l
Change 0 761 = 0 023
-
. . .

DID Estimate : 0 . 018 - (-0 023) . = 0 . 04/

Control Group 2 : Unmarried Women with children and with More Than a High School Education

Treatment Group Change

: 0 .
497 (after) -
0 . 479(before) = 0 . 018

Group :
920 (after) (before) 009
C o n t ro l
Change 0
0 911 = 0
-
.
.
.
 DID Estimate : 0 . 018 -

0 009 = 0 009
. .

Interpretation : The DID estimate suggests that the 198C E I T C expansion increased labour force unmarried low-Income
. . .
participation among

children 9
Women with .

Using Control
I
Group ,
we e st i m a te the I n c re a s e to be 4 1
.

percentage points . The Control Group 2 estimates only increased by 0 .

percentage

points

5 I find study's 1986 labour participation . The of this study the

. the
findings on the E I T C
. .
.
expansion convincing in
showing a positive impact on force
strength les in DID approach

two the However the

Using control
groups ,
which increases
credibility of the results . my concerns with this study is that short two
year period may not
sully capture long-term effects .

Additionally ,
the parallel trends assumption , is difficult to prove definitively . Lastly ,
the
study only looks at the labour Force Participation , missing the

impact on hours worked ,

which would provide a more complete understanding of the E . T C's
.
impact on labour
supply decision .
Especially considering the E I
. .
T Cs
.

I
Struc ture ,
with its Phase-in , plateau ,
and phase-out ranges , could lead to different effects on participation and hours worked . Overall ,
see this
study
as insightful ,
but I believe m o re
long-term research is needed to
fully a ss e ss the E .
I T
.
. C's effects .

and
.
2
Payroll Tax
Subsidies

2 1) When of mandated benefit than worker's shirts the outcome

.
the cost a is lower the valuation ,
the labour m a r ke t
equilibrium ,
but

is
generally m o re favorable than when the cost exceeds the worker's Valuation . As shown on
my graph below :

Dollars S Mandated Benefit : The firm's of

mandated benefit increases the cost
hiring each

Si

.....
i
wo r ke r . This cost increase shifts the labour demand c u r ve downward (D ,

Worker Valuation :
Since wo r ke rs val u e the benefit , they a re willing to accept
-

slightly lower for This

a
wage in
exchange recieving it
. willingness to accept the Wage

i
(5 ,
↓ supply
skifts
w - -
-
-
-
. .
-

" Do
I Di

to Employment

equilibrium shifted labour intersec ts the shifted labour demand

The new o c c u rs w h e re the
supply curve , resulting in a lower

(W ) a
employment level .
Wage .
and
Potentially l owe r

.. No Deadweight loss because w h e re worker's valuation of the benefit exceeds the cost to the firm so there is benefit fo r both Parties .
,

- better off
workers are because the value
they place on benefit is higher than the reduction in their wages .

- Firms
,
while
facing higher costs ,
a re able to hire workers at a l owe r
wage , offsetting some of the costs of providing the benefit

2 Given that the labour

supply in the U S
.. is
relatively inelastic
,
workers are
likely to bear a
larger portion of the burden from an increased
payroll tax
.

less
An Inelastic Labour Supply means workers are less responsive to
changes in
wages. They are
likely to reduce their labour supply significantly

even if their take-home pay decreases due to the tax

The Incidence of tax refers bears the burden . When is and demand elastic burden falls the
a who ultimately labour supply inelastic
,
is more
,
the more
heavily on

factor that is less responsive to

price changes , in this case ,
labour . Even if the tax is
initially levied on firms ,
the
inelasticity of labour supply makes it

difficult for firms to pass the full cost on to workers through lower
wages.

Contrary to what
might seem intuitive , assessing the increased payroll tax solely on the firms or workers would
t effectively shift the

burden. The relative elasticities of and demand the assignment of the tax determines the Incidence.
labour
supply , no legal ,

If of burden , tax firms .

labour supply remains inelastic ,
workers will still bear a larger share the even if the is
legally assigned only to

Firms maintain and being will larger of the

need to lower
wages to
profitability ,
workers ,
less sensitive to
wage changes ,
absorb a portion

tax burden .

.
3 Perfectly Inelastic Labour
Supply :

EFFECT ON EQUILIBRIUM : With a

perfectly inelastic labour supplyCurve ,
workers are
entirely insensitive to wage changes . They will supply the same

of labour regardless of As the tax will the to decrease by full of the

amount the
wage rate . a result
, payroll cause
wage the amount

tax - $2 ,
while employment remains
unchanged .
Firms bear no burden in this case.
 DEADWEIGHT LOSS There
deadweight loss Deadweight When tax distorts decreased
here. loss the market
leading
: is no arises in outcomes to
,

Welfare . While here

,
we maintain the same levels of labour supply and there is no loss in overall welfare.

Perfectly Elastic Labour Supply

EFFECT ON EQUILIBRIUM elastic extremely to changes decrease in the below the

With
perfectly supply Any going
:
rate
a curve
,
workers are sensitive
wage .

Wage

market
wage would result in a decrease in labour supply ,
a drop to zero .
Consequently ,
the payroll tax will lead to a decrease in
employment as

firms due the increased Workers burden in this

reduce
hiring to cost ,
but the wage rate will not
change. no case

DEADWEIGHT LOSS : There will be

Deadweight loss in this case . The decrease in
employment signifies that there are no
longer Mutually

beneficial transactions firms and The tax has created the cost of forFirms and the
taking place between workers. a
wedge between
hiring compensation

received
by workers
, leading to a reduction in overall Welfare. This is represented by the deadweight loss triangle on the graph .

Dollars Dollars
S
S

·
wo - -
-
-

-
-

wo- =----- ↓
Do

D, ! D

Employment ! !
Employment
Eo E , Eo

Inelastic
Supply Elastic
Supply

.
3 Differentials
Compensating
3 i) The
Equilibrium differential between a clean
job and
dirty job is $20 In this Scenario there are 100 workers and
wage a .
,

20 dirty jobs available for 100 Each worker has reservation for taking dirty minimum
only workers . a price a
jop, representing the

to Since 20 20th
wage premium they require accept it
.
only workers can be
employed in
dirty jobs ,
the
equilibrium will be determined by the

workers reservation price , which is $28 , since we have incrementing wage increases from $1 for worker 1 to $100 for worker 100 .

ii) The
equilibrium wage differential ensures that the workers with the lowest reservation prices for the
dirty jobs will be the

Ones who
accept them. Therefore ,
workers 1
through 28 will take the
dirty jobs because they have a reservation
price at

below $20.

4
. Education

Mincer function
Earnings
1. The

In (v) =
Bo +
B ,
S +
BeExp +
ByExp2 + 4

Y represents
earnings
S represents of education
years

Exp represents the number of since the completion of formal schooling (work experience (
years

T represents the er ror term ,

which accounts for unobserved factors
influencing earnings.

The Coefficient B, represents the rate of return to an additional year of education .

2 The
equation effect of education of
.
estimates from the mincer
may not
accurately represent the causal on earnings because
ability
Bias education
bras .

Ability is a situation where the positive correlation between and

earnings may be
exaggerated due to

unobserved factors like innate ability

. Higher-ability Individuals are more
likely to pursue additional education and may also earn more ,
regardless of

their educational attainment. Therefore , differences than education drive differences to

ability ,
rather alone
, might observed in
earnings ,
leading an overestimate

of the true effect of education on

causal
earnings.

3 a . Assumptions for Quarter of Birth as a valid IV :

To address Bias
Angrist and Quarter of Birth for
issues like
ability , Kruegar Use as an instrumental Variable education .

For birth instrument two must hold .

quarter to be a valid ,
key assumptions

:
Quarter of be correlated educational Angrist found that first
First birth attainment. and
Kruegar students born
·
the
Stage must with in

tend less education

quarter to receive , meeting this assumption

·
Exclusion Restriction : Quarter of birth must be uncorrelated with other determinants of earnings (other than through education) , such as ability.
 This assumption verify. The idea that birth , determined
by random event should not linked to factors like
is a
challenging to is
quarter of a
,
be

that could independently affect

ability earnings.

b Potential threat of Older Age school :

at
entry

Yes
,
the
findings that older
age at school entry may positively affect academic performance represents a potential threat to Angrist and

If affects performance of
Kruegar's methodology . older
age at school entry positively academic ,
then
quarter birth
may be related to
earnings

through channels other than educational attainment. This would violate the exclusion restriction for valid instrumental variable their
requirement a
, making

estimate biased .

C .
In Wi = d +
BEj +
Ei

calculation of the IV estimate of B =

(Difference in
average log weekly wage) (Difference in
average years of education

Difference in
any log weekly wage
: 5 .
16 -5 15 .
= 0 01.

& ifference in years of Education : 11 53 -11 40 = 0 13

any
. . .

: the IV estimate of B is 0 01 .
= 0 077
.

0 . 13

. The IV of 07 that additional of by for of Individuals

schooling
6 estimate 0 7 7 %
.
suggests an
year increases
weekly earnings
.
the
group

whose schooling decisions are effected by changes in compulsory attendance laws . Since this estimate is similar to the OLS estimates of the return to

schooling ability bias here .

, is not a major concer n

.
e Local
Average Treatment Effect (LATE) of the IV Estimate

The IV estimate of 0 07 7 a 7 7 % increase for additional of this represents

.
,
which suggests . in
weekly wages each year
schooling ,

the local treatment effect (LATE) of Individuals "compliers "

"

average .
This LATE
specifically applies to group that are known as whose

educational decisions influenced laws In this

study individuals have dropped of school
are by compulsory schooling .
,
the compliers are who would out

earlier had it been for the laws them to longer

not
requiring stay .

"Always-takers" : The IV estimate does not capture the effect of education on

earnings for Individuals who always planned

to complete a certain level of education regardless of the law .

Never-takers" :
The IV those would have dropped regardless of the
estimate does not capture who out
compulsory schooling
laws .

: IV estimate derived from variation it only reflects to education for the specific
is in
schooling , the return group

behavior
Who's was
changed by these
compulsory schooling laws .

f Angrist Kruegar's to additional of

.
I would not use and
study
estimate the economic returns to an year college education .

Their
study mainly Focus's on
compulsory schooling laws on
earnings ,
which
mainly affect primary and
secondary education , not

university or
college education. Additionally ,
the LATE applies specifically toIndividuals whose educational attainment was
directly affected

by the
compulsory schooling laws (compliers) ·
It doesn't reflect the
average returns to education for the entire population ,
such as

those who would have attended University regardless of laws ("always-takers") or those who wouldn't have attended regardless (" never

takers") .

: The government's decision to adjust university tuition fees should be based on studies that specifically focus on the returns to higher

education ,
and estimates the average return to
college education for all potential students ,
(estimates of the average treatment

effect) not just specific subgroups .

Brianna Henderson 20296656

Econ 360 Labour Economics

Problem Set -
November 1 ,
2024
Professor Sitian Liu
Email: [Link]@[Link]

Econ 360 Labour Economics

Problem Set

Due: November 1, 2024

1 EITC and Labor Supply (31 points)

The Earned Income Tex Credit (EITC) is the largest cash-benefit entitlement program in the United
States, designed to provide assistance to low-income workers with children. In this problem, you
will analyze how the EITC may a↵ect workers’ labor supply decisions.

1. Using the standard labor supply model (i.e., the neoclassical model of labor-leisure choice),
explain how the introduction of the EITC may a↵ect single workers’ decision to participate
in the labor force and their choice of hours worked. You may use graphs to illustrate your
discussion (5 points).

The study by Eissa and Liebman (1996) examines the impact of the 1986 EITC expansion on
labor force participation and hours worked for unmarried low-income women with children. They
use data from the Current Population Survey (CPS) for the tax years 1984–1986 and 1988–1990.
The tax year 1987 is excluded to allow time for labor supply adjustment. The authors employ a
di↵erence-in-di↵erences (DID) approach, using two di↵erent control groups:
• Control Group 1: Unmarried women without children and with less than high school educa-
tion. This control group is more similar to the treatment group in terms of education, but
they do not qualify for EITC as they do not have children.

• Control Group 2: Unmarried women with children and with more than high school education
(their predicted income beyond the EITC range). This control group is more similar to the
treatment group in terms of family status (having children), but less similar in terms of
education.
The following table provides the labor force participation rates for the treatment group (unmarried
women with children and with less than high school education) and control groups before and after
the 1986 EITC expansion:
Note: The reference is presented at the end of this problem set. You may refer to the original
paper when working on the questions below.

1
 Participation Rate Participation Rate
Before 1986 Reform After 1986 Reform
Treatment Group 0.479 0.497
Control Group 1 0.784 0.761
Control Group 2 0.911 0.920

2. What is the key identifying assumption of the DID approach in this study? In other words,
under what assumption, can the DID estimator be interpreted as the causal e↵ect of the 1986
EITC expansion on labor force participation for unmarried low-income women with children?
(5 points)
3. Suggest a way to test the validity of the assumption. (5 points)
4. Calculate the DID estimate using each of the two control groups. Show your work when
calculating the estimate, and do not just present the final number. How would you interpret
the DID estimates in the context of this study? (8 points)
5. Share your thoughts on the results. (8 points)
For example:

• Are you convinced by the findings? Why or why not?

• Do you have concerns about the results?
• What do you think are the strengths or weaknesses of the study?

2 Payroll Taxes and Subsidies (24 points)

1. We have discussed in class how a labor market equilibrium changes when the government man-
dates an employee benefit for which the cost exceeds the worker’s valuation and for which the
cost equals the worker’s valuation. Use a graph to illustrate how the labor market equilibrium
changes when the cost of the mandated benefit is lower than the worker’s valuation. Is there
deadweight loss associated with the mandated benefit in this case? (8 points)
2. In the United States, labor supply tends to be inelastic relative to labor demand, and accord-
ing to law, payroll taxes are essentially assessed evenly between workers and firms. Given
the above situation, are workers or firms more likely to bear the additional burden of an
increased payroll tax in the United States? Could this burden be shifted to the firms by
assessing the increase in payroll taxes on just firms or workers rather than having firms and
workers continue to be assessed payroll taxes equally? (8 points)
3. Consider the impact of a $2 payroll tax imposed on firms—i.e., the firm will pay a tax of $2
for every employee-hour it hires. (8 points)

• If the labor supply curve is perfectly inelastic, what will be the e↵ect of this payroll tax
on the equilibrium wage and employment? Will there be any deadweight loss from the

2
 payroll tax in this case?
• If the labor supply curve is perfectly elastic, what will be the e↵ect of the payroll tax
on the equilibrium wage and employment? Will there be any deadweight loss in this
scenario?

3 Compensating Di↵erentials (10 points)

Suppose there are 100 workers in the economy. The workers have to choose between a clean job
and a dirty job. Worker 1’s reservation price for taking the dirty job is $1; worker 2’s reservation
price is $2, etc. Because of government restrictions, there are only 20 dirty jobs.
1. What is the equilibrium wage di↵erential between a clean job and a dirty job? Explain your
answer. (5 points)

2. Which workers (among workers 1, 2,..., 100) will be employed at the dirty jobs? (5 points)

4 Education (35 points)

1. Write down the human capital earnings function (i.e., the Mincer equation). Make sure to
clearly specify the meaning of each variable. (3 points)

2. Why the estimates from the Mincer equation may not be interpreted as the causal e↵ect of
education on earnings? (5 points)

3. Angrist and Krueger (1991) establish a relationship between the quarter of birth and ed-
ucational attainment because of school start age policy and compulsory school attendance
laws.

(a) Under what assumptions is the quarter of birth (i.e., a dummy variable for being born
in January-March of a year) a legitimate instrumental variable (IV) for education in an
earnings equation? (6 points)
(b) Some research shows that older age at school entry may positively a↵ect academic per-
formance. Does this finding indicate a potential threat to Angrist and Krueger (1991)’s
methodology? Please explain your answer. (5 points)
(c) More specifically, they estimate the following regression using a IV approach:

ln Wi = ↵ + Ei + ✏i (1)

where Wi is individual i’s weekly wage, Ei is the years of education, and ✏i is the error
term. A dummy variable for being born in January-March of a year is used as an IV for
Ei . We discussed in class that when the IV is a dummy variable, the IV estimator is
also called the Wald estimator, which can be easily obtained using sample means. The

3
 following table reports the average log weekly wage and the average years of education
for individuals who were born in the 1st quarter of a year (column 1) and those who were
born in the 2nd, 3rd, or 4th quarter of a year (column 2). Based on the information,
calculate the IV estimate of . Show your work when calculating the estimate, and do
not just present the final number. (3 points)

(1) (2) (3)

Born in Born in 2nd, Di↵erences
1st quarter 3rd, or 4th (1)-(2)
of year quarter of year xx
ln(weekly wage) 5.15 5.16
Years of education 11.40 11.53
Wald estimate
OLS estimate 0.08

(d) How do you interpret the IV estimate? (3 points)

(e) What does the IV estimate represent in this context (in terms of local average treat-
ment e↵ect)? (5 points)
(f) Suppose the government is considering adjusting university tuition fees according to the
economic returns to education. You are asked to review studies in economics literature
and come up with a reasonable estimate of the economic returns to an additional year
of college education. Will you use Angrist and Krueger (1991) for this task and why?
(5 points)

References
Eissa, Nada and Je↵rey B Liebman (1996), “Labor supply response to the earned income tax
credit.” The Quarterly Journal of Economics, 111, 605–637.

4
 • If the labor supply curve is perfectly elastic, what will be the e↵ect of the payroll tax
on the equilibrium wage and employment? Will there be any deadweight loss in this
scenario?

References
Eissa, Nada and Je↵rey B Liebman (1996), “Labor supply response to the earned income tax
credit.” The Quarterly Journal of Economics, 111, 605–637.