Question

The Ministry of Labour in Cambonesia wants to make workers better-off without incurring additional expenditure by the government. To this end, the Minister proposes to increase the wage tax paid by employers (or, firms) in order to finance a wage subsidy to workers. Would this policy achieve the Ministry’s objective? Discuss your analysis and illustrate with an appropriate diagram.

(Hint: It is not necessary to discuss welfare implications involving consumer surplus or producer surplus.)

Answer 1

Increasing tax on employers to pay for wage subsidy will increase cost of production for these companies. Economic theories propose that any increase in cost of production results in leftward shift of supply curve, as supply decreases and production decreases, unemployment will increase and government will have to pay more unemployment benefits hence government expenditure will increase and this move may be derogatory for producers, employees and government also. Unemployment also has social costs like increasing crime and social unrest.

refer diagram below in which supply shifts left, price goes up from o1 to p2 and quantity reduces from Q1 to Q2.

However, this move has the potential to generate more revenue and it will decrease fiscal burden o government and it will be able to spend on more merit goods like health and education which will enhance supply side skills and productivity will go up in the long run. If demand is inelastic then producers can pass this additional tax burden on consumers.