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Consider the labor-leisure choice model. Assume that the labor supply elasticity with respect to after tax...

Consider the labor-leisure choice model. Assume that the labor supply elasticity with respect to after tax wages is 0.15. Assume that individuals currently pay a 70% marginal tax rate on wage income. The government plans to increase the marginal tax rate in order to increase tax revenue. Will this work? Explain.

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Answer #1

A tax elasticity of labour supply of 0.15 indicates that a 1% increase in tax rate will reduce labour supply by 0.15%. The total tax collected is the product of the total labour force and the tax rate. Now the tax rate increases by 1%, but the labour force only decreases by 0.15%, so the total tax actually increases due increase in tax rate. Therefore, the tax increase will help in increasing tax revenue.

Suppose the labour supply is L and tax rate is 70%. The tax collected is 0.7L.

Now tax increases to 71% and labour supply decreases to L - 0.0015 L = 0.9985 L. The new tax collected is 0.7089L, which is greater than 0.7L.

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