Microsoft Word - Solution-Chapter-13

Microsoft Word - Solution-Chapter-13 - Chapter 30 1. The...

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C h a p t e r 3 0 1. The government is proposing to increase the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions using appropriate diagrams. You are being asked about directions of change, not exact magnitudes. a. What will happen to the supply of labor and why? The supply of labor will decrease. As shown in Figure 13.1, the supply of labor curve shifts leftward from LS 0 to LS 1 . 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. b. What will happen to the demand for labor and why? The demand for labor will remain the same so in Figure 13.1 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. c. How will the equilibrium level of employment change and why? As Figure 13.1 shows, the equilibrium level of employment decreases. In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year. d. How will the equilibrium before-tax wage rate change and why? As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $29 per hour to $31 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to movement up along the demand for labor curve.
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e. How will the equilibrium after-tax wage rate change 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. f. What will happen to 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. Figure 13.2 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. g. How would your answers to the above questions change if at the same time as raising the tax rate on labor income, the government cut the rate of sales tax to keep the amount of tax collected constant? There are two effects at play in the question and they run counter to each other. If the hike in the labor income tax rate were offset by a cut in the sales tax, it would be equivalent to no change in the real wage rate received by workers. So the supply of labor would not change. With no change in the supply of labor or the demand for labor, equilibrium employment would remain the same and equilibrium before-tax and after-tax wage rates would remain the same. Potential GDP would remain unchanged.
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h. What evidence would you present to the government to support
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Microsoft Word - Solution-Chapter-13 - Chapter 30 1. The...

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