The income effect dominates the substitution effect when there is an increase in wage rates because it increases the purchasing power of workers. For a tax imposed on labor income, the same effect occurs, but in reverse. The government takes a portion of the workers' wages, decreasing their income, and thus reducing their purchasing power. Consequently, workers will tend to work more to compensate for the loss of income.Graphical Analysis:Here is a graph depicting the impact of taxation on labor supply where the income effect dominates the substitution effect:
Figure 1: The Impact of Taxation on Labor SupplyIn Figure 1, the vertical axis represents leisure hours (L), while the horizontal axis represents the wage rate (W). Initially, the wage rate is W_0, and the worker chooses to work L_0 hours of leisure. The wage rate is then increased to W_1, causing the worker to work more hours of leisure to take advantage of the increased wage rate. The substitution effect causes the worker to work more, as the wage rate has increased while leisure hours have stayed the same. As a result, the income effect of the tax is such that the worker's income has decreased, reducing his or her purchasing power. Therefore, to regain some of the lost purchasing power, the worker works more hours of leisure to earn more income.