Question

Before we get to the responses, we can put a theoretical framework around the idea of taxing capital incomes (whether income from assets or capital gains). The main targets for raising tax revenue are labour income, capital income, and consumption. These taxes are all imposed on households, but we should expect that they will elicit different behavioural responses. From the perspective of the household, taxes influence the decision about how much to work and how much to save. To keep the model simple, we will assume that the labour income is fixed (and so people will not work less if we increase taxes on labour income).

The model is as follows: People live for two periods. In the first period they earn labour income and consume . In the second period they consume , which is the amount saved in period 1 plus the return on capital, . We can write the household problem as:

Which is to say that households maximise their utility by choosing their consumption in period 1 and period 2, subject to the constraint that they not consume more than they earn (earnings include returns on savings).

1. Draw a system of axes and label the vertical axis consumption in period 2 and the horizontal axis consumption in period 1. Draw the budget constraint and a set of indifference curves. Show optimal consumption in each period and the amount of savings in period 1. Then:
   1. Show the effect of a tax on labour income only. The tax is a constant percentage of income, so that after-tax income is now .
   2. Explain why taxing consumption is equivalent to taxing labour income.
   3. Show the effect of a tax on capital income. The capital tax is imposed on the returns, so that the after-tax consumption in period 2 is .
   4. Explain the income and substitution effects of the tax on capital, and why the net effect of a tax on savings is ambiguous.

Answer 1

(A) the effect of taxes on the labour income -

The tax hike lowers the disposable income of the labour and this may shift the worker into different range of income leisure trade off. Specifically the worker mein value income more highly as compared to leisure when his or her income falls.

As the tax rate increases on the labour income it will lead to to less work time in the legal Market sector, more time working in the household sector a larger underground economy and small shares of national output and employment in industries that rely heavily on low wage low skilled labour inputs .

( B) taxing consumption is equivalent to taxing labour force , it is rightly said because when the tax increases the purchasing power that is the disposable income of the labour will decrease.

On the other side when the indirect taxes like value added tax will increase the commodities in the market will become expensive as the cost of production will be increased for the producers and ultimately the product will be reaching the consumers at a higher price. therefore if commodities or consumer goods are are taxed by the government it will be equal to to reducing the disposable income of the people as the purchasing power will be reduced.

Hence this is correct that if in the consumption , taxing is done the labour income will be automatically decreased.

(C) capital income tax rate if reduced, it shows decrease in public savings.

Capital gains taxes to be reduced are often proposed as a policy that will increase the savings and investments and will provide short term economic stimulus and boost long term economic growth.

( D) when the government cuts a marginal tax rate, it has two effects in the opposite directions which may be called as substitution effect and an income effect.

Substitution effect means to make leisure more expensive.

When the price of the normal goods rises you buy less of it. So people work harder to achieve it.

On the contrary income effect means to make you buy more leisure.

The cut down in the marginal tax rates increases the real income of the person and therefore they demand more leisure.

This means a cut in the tax rate will tends to increase income.