Question

If the tax elasticity of labor supply is 0.20, by what percentage will the quantity of labor supplied increase in response to

 

Instructions: In part b, enter your response as a percentage rounded to one decimal place.

 

a. A $500 per person income tax rebate check?

• A 2% increase

• A 1.5% increase

• No increase

• A 4.5% increase

b. A 6 percent reduction in marginal tax rates?

 

      %

Answer 1

(a) Tax rebates act as one-time extra income for the consumers. Tax rebates have no impact on the marginal tax rates. It is the change in marginal tax rates that impacts the aggregate supply. As tax rebates do not affect marginal tax rates, they have no impact on aggregate supply. In fact, tax rebates work on the aggregate demand side. By creating one time increase in the disposable income of households, it fuels an increase in consumption thereby leading to an increase in aggregate demand. Tax rebates do not increase the incentive to work and thereby do not impact aggregate supply.

So, a \(\$ 500\) per person income tax will not affect the incentive to work and the quantity of labor supplied will remain the same.

Thus, the quantity of labor supplied will increase by zero percentage in response to a \(\$ 500\) per person income tax rebate.

(b) Tax elasticity of supply \(=0.20\)

Decrease in marginal tax rates \(=4\) percent

Tax rate and labor supply have an inverse relationship. An increase in marginal tax rates decreases labor supply and vice-versa.

Tax elasticity of supply \(=\frac{\% \text { change in labor supply }}{\% \text { change in tax }}\) \(0.20=\frac{\% \text { change in labor supply }}{6}\) \(\%\) change in labor supply \(=1.20 \%\)

Labor supply and marginal tax rates have an inverse relationship. The marginal tax rate has decreased, so this \(\%\) change in labor supply is in fact the \(\%\) increase in labor supply.

Thus, the quantity of labor supplied will increase by \(1.20 \%\) in response to a \(6 \%\) reduction in marginal tax rates.