Question

The following questions are about how taxing wage income affects the supply of labor.

(a) What does the empirical evidence tell us about the effect that taxing wage income has on the labor supply of primary earners? Cite evidence from either Gruber or Slemrod-Bakija on estimates of the labor supply elasticity.

(b) Whether the tax on wage income increases or reduces the labor supply depends on the income and substitution effects of the tax. According to your answer to (a), which effect is larger? Explain your answer.

(c) Because the income and substitution effects change the supply of labor in opposite directions, we cannot say anything about their sizes if we know only the labor supply elasticity discussed in part (a). Slemrod and Bakija discuss studies that distinguish the income effect from the substitution effect. How is this done empirically, and what do these studies conclude about the sizes of the income and substitution effects for primary earners.

(d) In a labor-leisure diagram, use budget lines and indifference curves to show that it is possible for a tax on wage income to increase the supply of labor. On your horizontal axis, identify the income and substitution effects of the tax on labor supply, and identify the total effect. Your diagram should contain three budget lines: pre-tax, post-tax, and the budget line used to show the income effect. It should also contain two indifference curves.

Answer 1

Taxing wage income has a moderate effect on the labor supply of primary earners, with the income effect likely to dominate the substitution effect. Empirical studies show that higher taxes on wage income reduce labor supply. In a labor-leisure diagram, a tax on wage income can increase the supply of labor by considering the combination of income and substitution effects.

Step-by-step explanation:

The empirical evidence suggests that taxing wage income has a moderate effect on the labor supply of primary earners. According to Gruber and Slemrod-Bakija, the labor supply elasticity is estimated to be relatively low, indicating that the response of labor supply to changes in wage income tax rates is small. For example, if the labor supply elasticity is 0.2, a 10% increase in wage income tax rates would result in a 2% decrease in labor supply.The larger effect between the income and substitution effects depends on the labor supply elasticity. If the labor supply elasticity is low, the income effect is likely to be larger, suggesting that higher taxes on wage income reduce labor supply. On the other hand, if the labor supply elasticity is high, the substitution effect is likely to be larger, indicating that higher taxes on wage income may increase labor supply.

To empirically distinguish the income effect from the substitution effect, studies conducted by Slemrod and Bakija compare labor supply responses to changes in wage income tax rates across different income groups. These studies find that for primary earners, the income effect tends to dominate the substitution effect, indicating that higher taxes on wage income decrease labor supply.Using a labor-leisure diagram, we can illustrate how a tax on wage income can increase the supply of labor. The budget line representing post-tax wage income will be steeper than the pre-tax budget line, representing the substitution effect. However, the income effect is represented by a separate budget line, which is downward sloping. The total effect of the tax is the combination of the income and substitution effects.