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Effect of Personal Income
Taxes on Labor SupplyAnderson: Incentive Effects of Taxation
2Copyright © by Houghton Mifflin Company. All rights reserved.
Introduction
• The existence of taxes brings with it incentives to change behavior. • In this chapter we examine how taxes provide incentives to change
behavior in three specific ways:• Labor supply• Savings• Tax evasion
Five Principles
1. Raising Adequate Revenue2. Neutrality3. Fairness4. Ease of Administration and Compliance5. Accountability
4Copyright © by Houghton Mifflin Company. All rights reserved.
Taxation and Labor Supply
• Labor-leisure choice problem.
• People value both income and leisure.
• In order to earn income, one must work.
• The problem is to allocate time, a scarce resource, to labor and leisure.
5Copyright © by Houghton Mifflin Company. All rights reserved.
Labor-Leisure Choice• Time endowment T.
• Allocate time to leisure activity l or work activity T - l.
• Work pays wage of w per hour.
• Wage income is y = w x (T - l).
• Optimal combination of labor and leisure is that where the MRS between income and leisure equals the wage.
6Copyright © by Houghton Mifflin Company. All rights reserved.
Figure 11.1: Labor/Leisure Choice
7Copyright © by Houghton Mifflin Company. All rights reserved.
Figure 11.2: Labor Supply Effects of a Wage Reduction
8Copyright © by Houghton Mifflin Company. All rights reserved.
9Copyright © by Houghton Mifflin Company. All rights reserved.
Figure 11.3: Substitution and Income Effects of a Wage Reduction
10Copyright © by Houghton Mifflin Company. All rights reserved.
Figure 11.4: Effects of a Wage Reduction When the Income Effect Dominates
11Copyright © by Houghton Mifflin Company. All rights reserved.
Figure 11.5: The Laffer Curve
12Copyright © by Houghton Mifflin Company. All rights reserved.
13Copyright © by Houghton Mifflin Company. All rights reserved.