Question

Suppose that workers are able to adjust the number of hours they work however they wish. If a tax is levied on wages and a worker does not change the number of hours she works, then which of the following statements is TRUE? The substitution effect exceeds the income effect OR the income effect exceeds the substitution effect? Will the income effect be equal to the substitution effect or we might not see any income effect?

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Answer 1

If a tax is imposed on labor, the worker will perceive this tax as a reduction in his or her wage. For every hour worked, the individual worker receives a lower return on his or her labor. Faced with this change in prices, the worker may decide to increase the number of hours worker in order to achieve a certain income level (income effect) or may choose to work fewer hours, substituting leisure for labor in response to a lower return to labor (substitution effect). Determining whether a tax will result in more or less hours worked depends on whether the substitution or income effect is stronger.  Determining whether a tax will result in more or less hours worked depends on whether the substitution or income effect is stronger. Figure 2 shows the effect that a tax will have on labor market decisions, with both the income effect dominating (part A) and the substitution effect dominating (part B). As shown, the final effect depends on the shape of an individual’s indifference curves—that is, his or her preferred trade-off of labor and leisure given different prices and income levels. Figure 2: Labor Supply Model with the Imposition of a Tax.