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Q.1)) Many countries impose payroll taxes on employers and employees to fund the social security system. a) Assume that a country wants to impose a payroll tax of 1$ on employers for every employee-hour hired. What is the effect on both wages and employment in competitive labor markets? Both explain in your own words and illustrate your reasoning graphically. Clearly mark all the important points in your graph.

b) Would it be better to tax workers instead? Why or why not? What determines how much of the payroll tax is shifted to the workers? Only give a short explanation here, a graph is not needed.

Answer 1

a) Payroll taxes are the mandatory contributions by employers to finance the provision of social security system. Now, we are given the fact that labor market is perfectly competitive (Assuming elasticity of supply of labor is greater than zero) and country imposed a payroll tax of $1 on employers.

The impact of such taxation on both wages and employment is as follows:

• The demand curve D is based on the gross wage, WG, that employers must pay to attract any given number of labor hours per year. Assuming a perfectly competitive labor market, this equilibrium wage is equal to the marginal revenue product of labor, MRPL. The pretax equilibrium is at point E. At that point, the wage is WG, and Q1 hours per year are supplied.The introduction of the payroll tax reduces the demand for labor and shift the demand curve downwards to WN. Consequently, the new equilirium is established at point E'. The tax reduces the net wage for any number of hours worked per year from WG to WN' where the net wage is WN=WG (1- t). Also, As a result of the tax, hours worked per year decline from Q1 to Q2. This is because the employer’s part of the tax is subtracted from MRPL at any point. Employers make their hiring decisions on the basis of MRPL minus the tax t per hour of work they must pay. A worker’s contribution to a firm’s revenues now is less at any point, because the employer’s portion of the tax must be deducted from the revenues generated by workers as more are hired. The decrease in the demand for labor by employers caused by the tax decreases the equilibrium market wage received by employees from the initial level, WG, to WN'.

(b) If you tax workers, their net wages will also decline causing decline in hour worked due to the substitution effects. However, market or gross wages will rise due to reduced supply of labor. Here, workers can shift some tax to employers reducing their profitability.

The shifting of payroll on the workers depends upon elasticity of the supply of labor curve. When supply curve is inelastic, entire tax is shifted and borne by workers.