In: Economics
In 2012, presidential candidate Mitt Rommey proposed extending the cut in marginal income tax rates passed during the Bush administration. Explain why theory alone cannot predict how labor supply would be affected if this proposal were implemented. If there were no political or legal impediments to doing so, how could you design an experimental study to estimate the impact of lower marginal tax rates on labor supply?( Says theoretical approach, what the process and the consequences are, and premise)
A change in the marginal tax rate changes the individual's net wage. This generates both an income effect and a substitution effect. As long as leisure is a normal good, these effects work in opposite directions. Hence, one cannot tell a priori whether labor supply increases or decreases. If there were no political or legal impediments, an experimental study could be conducted in which a control group confronts the status quo, and an experimental group faces the new tax regime. Other things that affect work effort would impact both the control group and the experimental group, so any difference in work effort between the two groups could be attributed to the change in marginal tax rates.
Primarily through the supply side. High marginal tax rates can discourage work, saving, investment, and innovation, while specific tax preferences can affect the allocation of economic resources. But tax cuts can also slow long-run economic growth by increasing deficits. The long-run effects of tax policies thus depend not only on their incentive effects but also their deficit effects.