Question

Question 2 (6 credits):

A government considers a proposal to add a tax on employees’ salaries. Assume that
the labor market is perfectly competitive (free entry market). You can ignore long- run effects and externality on other markets.

a)   Suppose that each employee pays a certain percentage of the employee's wages in tax. Using relevant demand-supply analysis AND graph, explain the effect of the tax on the market wage (the wage that employers pay to employees before employees pay the tax) and total employment level. In particular, would such a tax increase or decrease the market wage and the employment level? No need to provide
justifications.


Market wage will (Circle one): Increase   Decrease   No Change   Uncertain Employment level will (Circle one): Increase   Decrease   No Change   Uncertain



b)   Now suppose that both employers and employees pay a tax equal to the same percentage of employee's wages. Using relevant demand-supply analysis AND graph, explain the effect of the tax on the market wage (the wage that employers pay to employees before employees pay their tax) and total employment level. In particular, would such a tax increase or decrease the market wage and the employment level? No
need to provide justifications.

Market wage will (Circle one): Increase   Decrease   No change   Uncertain Employment level will (Circle one): Increase   Decrease       No Change       Uncertain

Answer 1

A government considers a proposal to add a tax on employees’ salaries. Assume that the labor market is perfectly competitive (free entry market).

a) Suppose that each employee pays a certain percentage of the employee's wages in tax.

b)  Suppose that both employers and employees pay a tax equal to the same percentage of employee's wages.

The graphs can be drawn as -

a) In part a of the figure, when the tax is imposed only on the employee, the rax will decrease the after rax income of the emploee and hence will decrease their willingness to work. So some of them may exit from the market and hence the supply of labour will decreasd and hence the supply curve will shift left from S to S1. Thus at new equilibrium e' : Market wage will increase and Employment level will Decrease as shown in the figure.

b) In the second part of the figure, when tax is imposed both on employee and employer of equal amount than the supply will decrease and demand will also decrease by the same amount as shown where supply curve shifts bach from S to S1 and the demand curve from D to D1. So at new equilibrium e': Market wage will not change and Employment level will decrease as shown in figure