The following questions are about how taxing wage income affects the supply of labor.
What does the empirical evidence tell us about the effect that taxing wage income has on the labor supply of prime-age males? Cite evidence from either Rosen-Gayer or Slemrod-Bakija on estimates of the labor supply elasticity. Is there any major disagreement between these two sets of authors?
Whether the tax on wage income increases or reduces the labor supply depends on the income and substitution effects of the tax. According to your answer to (a), which effect is larger? Explain your answer.
Because the income and substitution effects change the supply of labor in opposite directions, we cannot say anything about their sizes if we know only the uncompensated labor supply elasticity discussed in part (a). Slemrod and Bakija discuss studies that distinguish the income effect from the substitution effect. How is this done empirically, and what do these studies conclude about the sizes of the income and substitution effects for prime-age males.
In a labor-leisure diagram, use budget lines and indifference curves to show that it is possible for a tax on wage income to increase the supply of labor. On your horizontal axis, identify the income and substitution effects of the tax on labor supply, and identify the total effect. Your diagram should contain three budget lines: pre-tax, post-tax, and the budget line used to show the income effect. It should also contain two indifference curves.
In a new diagram or your diagram for (d) (if it is not too cluttered), identify the tax payments and equivalent variation of the tax on wage income, and then identify the excess burden (EB).
The following questions are about the earned income tax credit (EITC). Recall from class that the EITC has a phasein range, a “plateau” (or “flat”) range, and a phaseout range. For the following questions, assume that the individual has some fixed positive amount of nonlabor income (such as a lump-sum subsidy). As a result, the individual can buy consumption goods without working.
Assume that the individual chooses not to work in the absence of an EITC. In a labor-leisure diagram, use budget lines and indifference curves to show that an EITC can cause this non-working individual to choose to work. On your horizontal axis, label the amount of labor that the individual chooses to provide. Your diagram should include two indifference curves and two budget lines, one for no EITC and one with the EITC.
Suppose instead that the individual works in the absence of the EITC, but the EITC causes the individual to earn enough income to place him or her in the phaseout range of the EITC. Redraw your budget lines, and use two new indifference curves to show this worker’s change in hours worked. Does the EITC cause the worker to increase or reduce his or her hours of work? Label the change on your horizontal axis. Explain your answer in terms of income and substitution effects, including why they have the same sign or different signs.
In response to a tax, individuals adjust their labor supplies along the “extensive margin” and the “intensive margin”. Define these two terms. Which margins have you illustrated in parts (a) and (b)?
What does the empirical evidence tell us about the importance of labor supply responses to the EITC along the extensive margin, compared to responses along the intensive margin? Use the readings from Chapter 13 of Rosen and Gayer.
For the following questions, use the two-period model of savings presented in class and Rosen-Gayer.
In a diagram, use two budget lines and two indifference curves to show that it is possible for a tax on income from saving to increase saving. (This tax is called an interest income tax in Rosen-Gayer). Identify the change in saving on your horizontal axis.
Explain your answer to (a) by identifying the income and substitution effects of the tax. For the income effect, you will need to draw another budget line. Identify how these two effects change saving on your horizontal axis.
What does the empirical evidence presented in the readings tell us about how taxing the return on saving affects how much people save? Is there any important conflict between the answers given in the Rosen-Gayer and Slemrod-Bakija readings?
Again use the two-period model of saving from class and Rosen-Gayer.
The Rosen-Gayer text does not show how a genuine income tax would shift the budget line in the two-period model, because it considers only a tax on income from saving, not a tax on all income. (Footnote 2 in Rosen-Gayer mentions also taxing wage income.) In one diagram, show how the budget line would shift if a genuine income tax were imposed. Then show how the budget line would shift if a consumption tax were imposed, at a rate that lowers utility the same amount as the genuine income tax; i.e., both taxes move the individual to the same indifference curve. (Assume both taxes are levied at a flat rate.)
Which tax raises more revenue? Use your diagram to explain. Note that you can use the “vertical distance rule for tax revenue.”
The two taxes in have the same equivalent variation, since they lower utility the same amount. But one raises more tax revenue. Define excess burden, and explain which tax has the highest excess burden. (Note that this model does not consider tax distortions to labor supplies, which could change the answer.)