Question

1. Suppose that you can earn $16 per hour before taxes and can work up to 80 hours per week. Consider two income tax rates, 10% and 20%
   1. Suppose the government just changedd the tax to 20% from 10%. If the income effect outweighs the substitution effect, where on your new budget will you reoptimize?

Answer 1

It is given that there is an increase in the tax rate from 10% to 20%. The income effect of an increase in the tax rate is to reduce the real income of the consumer. This would force the consumer to reduce leisure in order to make up for the lost income. The substitution effect would encourage consumer to enjoy more leisure and work less.

It that appears that if income effect outweighs the substitution effect, then the consumer will actually increase the number of working hours and reduce the leisure hours compared to the situation in which substitution effect is greater than the income effect.

However compared to a tax rate of 10%, the consumer will actually reduce number of leisure hours and will increase the number of working hours.