Question

Explain what happens to an individual supply curve of labor when:

1- a lump sum tax is applied

2- a % wage increase in tax is applied

3- a person has non-wage income

*use graphs as much as possible

Answer 1

1. When a lump sum tax is applied, the amount of tax paid remains the same no matter what the wage is. So, the disposable income of the individual decreases by the same amount at all wage rates due to the tax. In a indifference curve framework, the budget line shifts parallely downwards to the extent of the tax and the individual has to work more to earn the same income as before. So, the individual has lower leisure at all wage levels.

2. When a proportional tax on wages is applied, more tax is to be paid as the wage rate increases. The amount of labour, however depends on how strong are the income and substitution effect. The income effect makes the individual work more to maintain the same lifestyle. The substitution effect makes the individual work less (or prefer more leisure) ad wages increases as the opportunity cost of leisure decreases with increasing wage. Depending on these two factors, the Labour supply may increase or decrease. The proportional tax causes the budget line pivot along the initial budget line and the amount of labour supplied depends on the indifference curve.

3. In the presence of non wage income, the individual will not change his labour supply upto a particular wage but beyond a point the indifference curve will pivot. So, depending on the wage rate and the income and substitution effect the Labour supply changes.