Question

Why must the substitution effect be separated from the income effect of tax-induced wage reductions to measure the excess burden of a comprehensive tax on labor income?

Answer 1

Because they work in opposite direction. When labor income is taxed, employer has to pay a higher after tax wage overall so demand curve for labor shifts left. Workers experience a decline in the wage rate which registers two different effects: substitution effect calls for reducing the number of working hours and increasing leisure hours. Income effect calls for reducing leisure hours which implies an increase in working hours. Thus, while one argues to raise leisure and reduce work effort the other advocates to reduce leisure and increase work effort. Hence a segregation must be posed between substitution and income effect of a comprehensive tax on labor income.