Question

Imagine that instead of a subsidy rate, s, the government imposes income tax at rate t. Display the new budget constraint on the same picture. In the new optiμm, is the consumption of goods and leisure higher or lower? Explain the answer in terms of wealth and substitution effects, and label the change produced by each effect in your diagram.

a) Higher; Wealth effect
b) Higher; Substitution effect
c) Lower; Wealth effect
d) Lower; Substitution effect

Answer 1

The new budget constraint line is steeper due to the higher income tax rate. The change in consumption is a result of the wealth effect and the substitution effect.

Step-by-step explanation:

The new budget constraint line will be steeper than the original one, reflecting the higher income tax rate. The new optimal point will show higher consumption of goods and lower leisure.

This change is caused by both the wealth effect and the substitution effect. The wealth effect occurs because the income tax reduces Petunia's wealth and her ability to consume goods and leisure. The substitution effect occurs because the higher tax rate makes leisure relatively more expensive compared to goods, causing Petunia to choose a higher consumption of goods and lower leisure.

The change produced by the wealth effect is labeled as a reduction in wealth, while the change produced by the substitution effect is labeled as an increase in income.