Question

Suppose that in the country of Tributia a worker's supply of labor is given by H=140 W, and a firm's demand for labor by H=2000−2W, where W is wage per hour, and H is quantity of hours worked.

a. Suppose that the government of Tributia decides to impose an income tax. Calculate the deadweight loss that would be expected if the government imposes a proportional tax of 25% on all of the worker's earnings.
b. Suppose that the government of Tributia tries an experiment in which workers are randomly assigned to two groups. In Group A, the proportional tax is withheld from each paycheck, and in Group B, no tax is immediately withheld from paychecks, but instead the proportional tax is implemented by asking the worker to file and pay taxes on all wages earned at the end of each year.
In each group, the proportional tax is the same, 25% of total earnings. The government finds that the equilibrium labor supply of Group A is reduced according to projections in part (a), while the equilibrium labor supply of Group B is 1,715 hours. What might explain this result?

Answer 1

The deadweight loss due to a 25% income tax is calculated by finding the pre- and post-tax equilibriums and comparing labor quantities. The behavior of Group B suggests that deferred tax payments affect labor supply decisions less than immediate withholdings, demonstrating the impact of tax policy perception on labor markets.

Step-by-step explanation:

To calculate the deadweight loss from a 25% income tax in Tributia, we need to find the equilibrium wage and quantity of labor before the tax and then after the tax. The labor supply and demand equations provided are H = 140W (supply) and H = 2000 - 2W (demand). Setting them equal to each other (140W = 2000 - 2W) allows us to find the pre-tax equilibrium wage and quantity of labor.

After imposing the tax, the worker gets to keep only 75% of the wage, so the supply equation becomes H = 140(0.75W). The new equilibrium needs to be determined with the adjusted supply equation. The difference in the quantity of labor supplied pre- and post-tax at the initial equilibrium wage rate will give us the initial deadweight loss.

As per the experiment with Group A and Group B, the equilibrium labor supply for Group A decreased as expected when the tax was withheld from each paycheck, whereas for Group B, the supply did not decrease as much due to taxes being paid at year's end. This suggests that workers' perception of their after-tax wage influences their labor supply decisions. Immediate tax withholding might make the reduction in after-tax wage more salient, reducing labor supply more than when the tax payment is deferred.

The behavioral response to wage changes influenced by timing of tax payments is a possible explanation for Group B's higher labor supply in comparison to Group A, even when the overall tax burden is identical. This highlights the importance of how tax policy is implemented and perceived by taxpayers when evaluating the effects of taxation on labor markets.