Question

You are the governor's economic policy adviser. The governor wants to put in place policies that encourage employed people to work more hours at their jobs and that encourage unemployed people to find and take jobs. Assess each of the following policies in terms of reaching that goal. Explain your reasoning in terms of income and substitution effects, and indicate when the impact of the policy may be ambiguous. a. The state income tax rate is lowered, which has the effect of increasing workers' after-tax wage rate. b. The state income tax rate is increased, which has the effect of decreasing workers' after-tax wage rate. c. The state property tax rate is increased, which reduces workers' after-tax income.

Short answer

Question: Analyze the impact of each of the following policies proposed by the governor and determine whether they will encourage employed people to work more hours and unemployed people to find jobs: A) Lowering State Income Tax Rate, B) Increasing State Income Tax Rate, C) Increasing State Property Tax Rate. Answer: A) Lowering State Income Tax Rate would have an ambiguous impact on labor supply, as it depends on the balance between the positive substitution effect and negative income effect. B) Increasing State Income Tax Rate also has an ambiguous impact, depending on whether the substitution or income effect dominates. C) Increasing State Property Tax Rate is more likely to encourage individuals to work more hours and find jobs, as both income and substitution effects seem to encourage working in this case.

Step-by-step solution

Policy A: Lowering State Income Tax Rate

Lowering the state income tax rate would effectively increase workers' after-tax wage rate. This can lead to two effects: 1. Substitution effect: The higher after-tax wage rate increases the opportunity cost of leisure, which should encourage individuals to work more hours and increase labor supply. 2. Income effect: Since workers earn a higher after-tax wage rate, they may feel wealthier and could choose to work fewer hours to afford the same level of consumption while enjoying more leisure time. The ambiguity of policy A's impact on labor supply lies in the balance between the substitution and income effects. If the substitution effect dominates, then individuals are more likely to work more hours and find jobs. If the income effect dominates, the opposite may occur.

Policy B: Increasing State Income Tax Rate

Increasing the state income tax rate would effectively decrease workers' after-tax wage rate. This can lead to two effects: 1. Substitution effect: The lower after-tax wage rate reduces the opportunity cost of leisure, which could discourage individuals from working more hours and decrease labor supply. 2. Income effect: Since workers earn a lower after-tax wage rate, they may feel poorer and could decide to work more hours to compensate for the decrease in their after-tax income to maintain their previous level of consumption. Similar to policy A, the ambiguity of policy B's impact on labor supply depends on the balance between the substitution and income effects. If the substitution effect dominates, then individuals are less likely to work more hours and find jobs. If the income effect dominates, the opposite may happen.

Policy C: Increasing State Property Tax Rate

Increasing the state property tax rate reduces workers' after-tax income because they would need to pay more in taxes on their properties. This can lead to two effects: 1. Substitution effect: At first glance, property taxes might not have a direct impact on the opportunity cost of leisure. However, if we consider that the higher taxes reduce disposable income, individuals might perceive working as relatively more attractive and be encouraged to work more hours to compensate for the decreased after-tax income. 2. Income effect: As the higher property tax rate decreases workers' after-tax income, individuals may feel poorer and could decide to work more hours to compensate for the decrease in their after-tax income to maintain their previous level of consumption. In this case, both income and substitution effects seem to encourage individuals to work more hours and find jobs, reducing the ambiguity of the policy's impact on labor supply.