Question

Suppose that you can earn $16 per hour before taxes and can work up to 80 hours per week.
Consider two income tax rates, 10% and 20%.

a. On the same diagram, draw the two weekly consumption-leisure budget constraints
reflecting the two different tax rates.

b. Draw a set of representative indifference curves such that the income effect of the tax
increase outweighs the substitution effect.

c. Draw a set of representative indifference curves such that the substitution effect of the
tax increase outweighs the income effect.

Answer 1

If the price of a good increases, then there will be two different effects – known as the income and substitution effect.

If a good increases in price

1. The good is relatively more expensive than alternative goods, and therefore people will switch to other goods which are now relatively cheaper. (substitution effect) –
2. The increase in price reduces disposable income and this lower income may reduce demand. (income effect)

• Giffen Goods – where higher price leads to higher demand because of the income effect of price rise, outweighs substitution effect.

The substitution effect is to make leisure more expensive.The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less. Empirically, the substitution effect tends to outweigh the income effects slightly for men and strongly for married women.