1 Introduction
The aim of paper is to discuss some of the complexities involved in modelling the incentive effects of taxes and transfers, using only basic diagrammatic methods of analysis. Tax and transfer systems in most countries are highly complex, consisting of a wide range of benefit payments, each with its own set of withdrawal rates and thresholds. Often the different components are not well integrated, so that unplanned effects can arise, especially where piecemeal adjustments to benefit levels and income thresholds are made over a period of time. Policy reforms are typically concerned with balancing the aims of providing income support with the desire to avoid excessive disincentive effects of taxes. In designing reforms, it is useful to have in mind a number of relationships which can conveniently be discussed in diagrammatic terms.
This paper therefore explores a range of diagrams which are helpful in thinking about the design of tax and transfer systems and their potential effects on labour supply behaviour. Emphasis is given to the role of nonlinear budget constraints and the resulting wide range of labour supply responses. The analysis of labour supply in the presence of nonlinear budget constraints rapidly becomes complicated; the aim here is to steer a path between oversimplified text book treatments and highly technical research papers.[1]
The use of diagrams relating gross and net incomes, for specified groups, is described in Section 2. Section 3 introduces budget constraints and utility maximisation in a very simple labour supply framework. The general implications of piecewise linear budget constraints are discussed in Section 4. The effect of a non-recoverable cost of applying for benefits and its joint effect on take-up and labour supply are briefly examined in Section 5. Brief conclusions are in Section 6.
Notes
- [1]For more technical treatments and further references see, for example, Creedy (1996, 2001).
