Effect of Personal Income Taxes on Labor Supply Anderson: Incentive Effects of Taxation.

Effect of Personal Income

Taxes on Labor SupplyAnderson: Incentive Effects of Taxation

2Copyright © by Houghton Mifflin Company. All rights reserved.

Introduction

• The existence of taxes brings with it incentives to change behavior. • In this chapter we examine how taxes provide incentives to change

behavior in three specific ways:• Labor supply• Savings• Tax evasion

Five Principles

1. Raising Adequate Revenue2. Neutrality3. Fairness4. Ease of Administration and Compliance5. Accountability

4Copyright © by Houghton Mifflin Company. All rights reserved.

Taxation and Labor Supply

• Labor-leisure choice problem.

• People value both income and leisure.

• In order to earn income, one must work.

• The problem is to allocate time, a scarce resource, to labor and leisure.

5Copyright © by Houghton Mifflin Company. All rights reserved.

Labor-Leisure Choice• Time endowment T.

• Allocate time to leisure activity l or work activity T - l.

• Work pays wage of w per hour.

• Wage income is y = w x (T - l).

• Optimal combination of labor and leisure is that where the MRS between income and leisure equals the wage.

6Copyright © by Houghton Mifflin Company. All rights reserved.

Figure 11.1: Labor/Leisure Choice

7Copyright © by Houghton Mifflin Company. All rights reserved.

Figure 11.2: Labor Supply Effects of a Wage Reduction

8Copyright © by Houghton Mifflin Company. All rights reserved.

9Copyright © by Houghton Mifflin Company. All rights reserved.

Figure 11.3: Substitution and Income Effects of a Wage Reduction

10Copyright © by Houghton Mifflin Company. All rights reserved.

Figure 11.4: Effects of a Wage Reduction When the Income Effect Dominates

11Copyright © by Houghton Mifflin Company. All rights reserved.

Figure 11.5: The Laffer Curve

12Copyright © by Houghton Mifflin Company. All rights reserved.

13Copyright © by Houghton Mifflin Company. All rights reserved.