Question

When a tax is applied to labor​ income, what happens to the​ full-employment quantity of labor and potential​ GDP?

Option 1: Both the full-employment quantity of labor and potential GDP increase.
Option 2: The full-employment quantity of labor decreases, but potential GDP increases.
Option 3: The full-employment quantity of labor increases, but potential GDP decreases.
Option 4: Both the full-employment quantity of labor and potential GDP decrease.

Answer 1

When a tax is applied to labor income, it generally creates a disincentive for individuals to work. Therefore, the correct answer is Option 2: The full-employment quantity of labor decreases, but potential GDP increases.

Step-by-step explanation:

When a tax is applied to labor income, it typically creates a disincentive for individuals to work, leading to a decrease in the full-employment quantity of labor. This is because individuals may reduce their labor supply in response to the decreased after-tax income.

However, potential GDP, which represents the maximum sustainable output an economy can produce, may still increase. This is because potential GDP is determined by factors such as technology, capital accumulation, and efficiency, which can continue to improve even if the quantity of labor decreases due to taxation.

Therefore, the correct answer is Option 2: The full-employment quantity of labor decreases, but potential GDP increases.