Consider a standard consumption-leisure choice model where the worker supplies l
ID: 1209036 • Letter: C
Question
Consider a standard consumption-leisure choice model where the worker supplies labor by reducing leisure in order to buy consumption goods. If employed income consists only of labor earnings. If unemployed, the worker receives unemployment benefits. There is a simple proportional tax on labor income. Suppose the tax rate on labor income is increased. Framing the discussion in terms of income and substitution effects, discuss the labor supply response in the following two cases,
1. A worker who prior to the tax rate change is supplying a strictly positive amount of labor.
2. A worker who prior to the tax rate change is unemployed.
Explanation / Answer
The tendency to work more or less at high income level has a direct relation with income effect and substitution effect. While the income effect induces a typical worker to enjoy more leisure at high income level, the substitution effect refrains the worker from enjoying ‘more expensive leisure’. The two effects always work in tandem.
1) If an employed worker observes that the tax rate on income has increased, his disposable labor income is reduced and thus the opportunity cost of leisure falls. Substitution effect will force him to increase leisure and reduce working. Income effect will force him to reduce both. Ultimately. leisure is increased.
2) When worker is unemployed, and he receives unemployment benefits. Since a rise in the tax rate has nothing to do with unemployment benefits, there is no substitution effect or income effect.