Question

Question 3. Consumer problem with progressive tax. In the standard one-period consumer model, it is assumed that wage income is subject to progressive taxation. The consumer's income is taxed at the rate 0 <t <1, beyond a wage income threshold, x Thus, the total amount of taxes paid by the consumer is T = 0 if the wage income is less than x and T = t (wN-x) if the wage income is higher aw is the real wage andN is the number of hours worked by the consumer. It is assumed that wage income constitutes all of the consumer's income. 1. Graph the consumer's budget constraint. 2. Analyze the effect of an increase in real wages, w: graphically represent the effect on the budget constraint and analyze the effect on the quantity of labor offered by the consumer.

Answer 1

1.

2. Increase in real wage will shift the budget line upwards to A'B'C and move the optimum point of labor supplied from point E1 to point E2. AT this new optimum point, the amount of labor supplied has increased from L1 to L2 and amount of lesire has decreased. This is because increase in real wage rate will increase the amount of labor supplied in the economy.