Question

Principles of Microeconomics please answer all questions 2. Suppose that an individual owed no taxes on the first $10,000 she earned and 15 percent of any income she earned over $10,000. Now suppose that Congress is considering two ways to reduce the tax burden: a reduction in the tax rate and an increase in the amount on which no tax is owed. b. What effect would an increase in the amount on which no tax is owed have on the individual's labor supply? Say if it would increase hours worked, decrease hours worked, no effect of hours worked or not enough information. a. What would be the income effect of this policy? b. What would be the substitution effect of this policy? c. What would be the total effect of this policy?

Answer 1

An increase in amount of no tax owed means lower marginal tax rate and hence higher disposable incomes.

By this the income effects will induce that the demand for quantity of goods will rise as purchasing power rises. As demand rises the prices also rise. Also since income rises the incentive to work more reduces and hence labor supply reduces. Also since incomes or wages rise work becomes more profitable than leisure and hence people work more to earn more and substitute leisure by work.

Now since the prices rise, due to substitutions effect people will switch to alternatives with lower prices as substitute.

Thus, net effect is sum total of income and substitutions effect and hence labor supply fairly remains constant.