Question

Explain the paradox that the income tax generates excess burden even if the labor supply curve is perfectly inelastic. In explaining your answer, highlight the difference between the regular (perfectly inelastic) supply curve and the compensated labor supply curve.

Answer 1

If the labor supply curve is perfectly inelastic, imposition of high level of income tax does not bring about any change in the labor supply. Thus as the income tax increases, the burden falls more on the labors and they would be left with less disposal income for their consumption as there wont be any change in the labor supply.

In perfectly inelastic supply curve,there would not be any changes in the labor supply even if the income tax increases. On the other hand, in case of compensated labor supply labor's interest depends on leisure and work.If there would higher income, workers spend more in working and less for leisure. But if there is less disposal income, the working hours are replaced by leisure.