The Optimal Earned Income Tax Credit Under Decreasing Long-Run Labour Aversion

According to Saez (2002) the existence of an optimal EITC system depends on the extensive‐margin elasticity, which measures the reaction of working poor's labour market participation to wages. In this paper we add to Saez's analysis two components: i) Heterogeneous tastes for leisure that allow explaining the nature of the extensive‐margin elasticity; ii) an analysis of the optimal EITC for the case in which persistent participation of the working poor in the labour market causes a reduction in his labour aversion, which is one of the explicit long‐run goals of policy makers. We find that the interaction between the evolution of tastes toward a reduction in labour aversion, the extensive and intensive‐margin elasticities and the government budget constraint, produces a variety of optimal long‐run EITC schedules. The simulations show two main scenarios: i) when the initial proportion of the working poor is high relatively to the unemployed, the reduction of labour aversion yields a decreasing optimal EITC; ii) when the proportion of the working poor is initially low relatively to the unemployed, the reduction of labour aversion yields an increasing optimal EITC.