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Question:Let w denote the wage rate, let V denote weekly non-labour income, and let T be the number of hours in the week. In addition, assume that wages are taxed at rate t, so that the after-tax wage rate is w(1-t).
a. Sketch the budget constraint. Label the x-axis, the y-axis, the x-intercept, the y-intercept, the slope and the endowment point.
b. On the same graph as above, show how an increase in t will affect a worker’s budget constraint.
c. Suppose that when the tax rate goes up, people’s labour supply decreases. Use your graph to illustrate the income effect, the substitution effect and the total effect.
d. Which effect dominates?
e. Suppose that the government plans to increase tax rates in order to increase tax revenues. Is an increase in the tax rate guaranteed to increase tax revenues?
Explain. Your answer should include a discussion of the substitution effect and the income effect. Note: the tax revenues generated by a worker who works h hours are given by: Revenue = t×h×w.
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