Question

Suppose that the lump-sum and the proportional tax systems coexist in the economy. Consider the following fiscal policy changes: the government increases the labor income tax rate and gives the money back to the consumer through a decrease in lump-sum tax in a way that an increase in consumer’s labor income tax amount and a decrease in lumpsum tax amount offset each other. Are consumer’s optimal choices affected by these fiscal policy changes? Explain why or why not. (Note: There are opposing effects working in this example. For full credit, you should explain how each effect works on the changes in optimal c and l, followed by the total effect.)

Answer 1

Lump sum tax and prportional tax system coexist in the economy. The government increases the labor income tax rate and gives the money back to the consumer through a decrease in lumpsum tax amount offset each other.
Yes consumer's optimal choices affected by these fiscal policy changes.
Lump-sum tax is tax based on fixed amount regardless of circumstances. According to Ricardian equivalence, lump -sum taxes have zero effect on consumption, investment and output. So even lump-sum tax decreased or increased, it will not make any effects consumption, investment and output.
Therefore people would consider only the changes in income tax for consumption and investment. Thus increase in labor income tax reduces disposable income of labors and people even lump -sum tax decreased.
Fall in disposable income reduces consumption and investment level in the economy. As consumption and investment falls, production and ouput will decrease