You graduate from college and take a job at a consulting firm with a wage of $25

Question

You graduate from college and take a job at a consulting firm with a wage of $25/hour. Your job is extremely flexible: you can choose to work any number of hours from 0 to 2,000 per year.

a. Suppose there is an income tax of the following form: Income up to $10,000: no tax Income from $10,000 to $30,000: 20% tax rate Income from $30,000 up: 30% tax rate Draw your budget constraint with the tax and under a policy of no taxes. With the tax system in place, are there any points that you are particularly unlikely to choose? Why or why not?

b. Say that you choose to work 1,500 hours per year. What is your marginal tax rate? What is your average tax rate? Do these rates differ? Why or why not?

c. Suppose that the two tax rates are increased to 25% and 50%. What is the likely effect on the labor supply of the primary earner? What is the likely effect on secondary earners? Explain how the responses might differ between these groups, both in terms of underlying economic effects and in terms of the empirical evidence on labor supply responses.

Explanation / Answer

a) Draw non-linear BC with slope of –25 from 0 to 400 hours, slope of -.8*25 from 400 to 1200 hours, and slope of -.7*25 from 1200 to 2000 hours (intercept at income = $40,000). Non-taxed BC is line with slope of –25 and intercept at income of $50,000.

b) Marginal tax rate = 30%. Average tax rate = (0%*10,000) + (20%*(30,000-10,000)) + (30%*(37,500-30,000) / 37,500 = 16.67%. Average is less than marginal because most of your income is taxed at a lower rate than your marginal rate.

c) Two theoretical effects, net effect is ambiguous.

Substitution effect: higher taxes mean leisure is relatively cheaper, choose more leisure.

Income effect: higher taxes mean you are poorer, choose less leisure.

For men, the empirical research shows that taxes have little net effect; the two effects offset.

Empirical research shows that women are much more likely to decrease labor supply because there’s a large substitution effect (presumably, women have more outside options). Key is that non-market labor, which women are more likely to engage in, is not taxed, so women are more likely choose to work at home.

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