Question

A tax on wages will: a. have an unpredictable impact on labor supply since there are both substitution and income effects. b. raise labor supply since income is reduced. c. reduce labor supply since leisure becomes cheaper. d. have a predictable impact since economists know substitution effects will dominate

Answer 1

Tax refers to the compulsory charge imposed by the government on households for using public
services. Households pay taxes as a proportion of their income, which they get by serving as a labor in
the market. If the government imposes a tax on the income of the people, there would be two effects of the
income tax that are substitution effect and income effect.
The substitution effect refers to the effect that describes the change in the consumption of one good due to change in the price of another good. Here, the imposition of tax makes the leisure cheaper as wages tend to decrease due to taxes. On the other hand, the imposition of tax will decrease the people's real wages, due to which, people try to work more to get the same level of wages earlier.
Empirically, economist knows that substitution effect outweighs income effect because people will prefer
more leisure as if, a person works more than earlier still he gets proportionally lower wages as per hour
wage decreases due to taxes. Therefore, labor will empirically prefer leisure as it has a higher opportunity
cost than to work.
Therefore, option d, that is, have a predictable impact since economists know substitution effects will Dominate, is the correct option.