Answer to Question #315602 in Macroeconomics for anu

Question

The government is considering raising the tax rate on labor income and asks you to report on the supply-side effects of such an action.

Use appropriate graphs and report directions of change, not exact magnitudes. What will happen to:

1. The supply of labor
2. The demand for labor and why?
3. Equilibrium employment and why?
4. The equilibrium before-tax wage rate and why?
5. The equilibrium after-tax wage and why?
6. Potential GDP?

Answer 1

1. The supply of labor and why? The supply of labor will decrease. As shown in figure below, the supply of labor curve shifts leftward from LS₀ to LS₁. The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the after-tax wage rate received by workers. 

2. The demand for labor and why? The demand for labor will remain the same so in figure above the demand for labor curve remains LD. The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income.

3. The equilibrium level of employment and why? The figure above shows, the equilibrium level of employment decreases. In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year.

4. The equilibrium before-tax wage rate and why? The figure above shows, the equilibrium before-tax wage rate increases from $29 per hour to $30 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve. 

5. The equilibrium after-tax wage rate and why? The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per hour, so the after-tax wage rate falls from $29 per hour to $28 per hour. The increase in the tax rate on labor income increases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate decreases.

6. Potential GDP? Potential GDP decreases. The equilibrium level of employment is full employment. So as full employment decreases, potential GDP decreases along the aggregate production function. The figure below shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $12.2 trillion, to point B, with 300 billion hours of employment and potential GDP $12.1 trillion.