Question

Assume that workers and firms behave as in the standard model we described in class. The government announces the following policy reform: (i) the labor income tax increases immediately; (ii) all proceeds will be invested in a much required infrastructure project that will permanently raise Total Factor Productivity (A) starting next period; (iii) the tax increase is calculated in a way that will keep workers’ PVLR unchanged (i.e the tax reform does not imply an income effect on labor supply).

1. What is the effect on the labor market in the short run? Explain whether or not the labor supply and labor demand curves shift, in which direction etc.

2. What is the effect on firms’ optimal future capital decision? what does it imply with regards to current investment? (you may assume that the effects of Af on MPKf dominate the effects of Nf on MPKf )

3. Describe the short run equilibrium in the goods market. Does the S curve shift? the I curve? what is the new level of r, what happens to consumption?

4. Describe the new equilibrium in the labor market in the long run. (You may assume that the demand effects dominate the supply effects).

Answer 1

Answer (1): In the short run, there will be very minimal or almost no impact on the labor market, because the short run labor market is directly and majorly impacted by the income level of the labor force, and since the rise in the income tax levels will keep the PVLR unchanged for the common labor force, hence the level of labor force in the market will remain the same and therefore will have no impact in the short run. Therefore, the demand curve will not shift or change its direction in the short run.

Answer (2): The optimal future capital decision of the firms would have a huge impact as the impact of the income tax imposed on labor would have to be born by the firms and in the long run their optimal investment of the firms would greatly reduce. The current investment of the firms would also see a shift as there will be gradual decrease in the level of investment by the firms in the short run.

Answer (3): The short run equilibrium in the goods market would be also have an impact because due to the rise in the taxes, the firms will immediately feel a drop in the availability of funds and therefore the supply of goods int the market would also be impacted., and hence the negative shift in the supply curve would be seen. The consumption, however, would not see any big impact because the availability of funds in the hands of the common man would not be impacted.

Answer (4): In the long run, the market equilibrium will be a new state wherein, the market would evolve after initial changes in the longer run to attain a state of equilibrium wherein the reduced rate of supply and the demand by the consumers would meet each other and form the equilibrium for the market.