Question

Suppose the individuals view their loss of income from income taxes as offset by the benefits of public services purchased with revenues. How are their labor supply decisions affected?

(a) Draw the optimal choice of a representative individual in leisure-consumption space before tax imposition.

(b) Describe the change of budget constraint when the income tax is imposed and all the revenue from income tax is returned as the individual’s consumption through public service provision.

(c) Show the change of optimal choice of the representative individual.

Answer 1

If a person is taxed and they get their income reduced in the form of reduced tax. Labour supply can be affected in two ways, when income increases there are two effects simultaneously. First effect is income effect is income effect which happens in part B of the curve where as income rises, people tend to work more. Another effect is substitution effect, when income rises further people tends towards leisure and wants some rest from work and reduces their level of labour and supply curve from their on shifts backwards which show the portion C.(a) Optimal level of budget constraint is given as AB where horizontal line shows labour and leisure. If we move towards right from origin, leisure increases and move towards origin, labour increases. This is the reason point A shows zero level of income where leisure is at its full level and labour is zero. Optimal level of consumption-leisure is at point D.

Diagram 1.1(B) Refer to the diagram 1.1, When there is change in income due to tax imposed, budget constraint shifts downward as income rises and new budget constraint becomes AC.

(c) Refer to the diagram 1.1, Optimal level of consumption leisure can be two points, it totally depends on the individual. If one has less income and more expenditure of their home, they can try to increase their labour hour and reduce leisure hours and improve their income level. If they do not wants to reduce leisure hour, they can work those hour which they were initially working.