Question

During 2010, Congress debated retaining some or all of the tax cuts signed into law by former President George W. Bush in 2001 and 2003 which was set to expire at the end of 2010. By reducing tax rates across the board, take-home pay for all taxpaying workers would increase. The purpose, in part, was to encourage work and increase the supply of labor. Households would respond the way the president hoped, but only if income effects were stronger than substitution effects. Do you agree or disagree? Explain.

Answer 1

Reduction in tax rates has resulted in an increase in income(take home pay) of households.

The purpose of this increase in income of households induced by the tax rate cut was to encourage work and increase the supply of labor.

However, increase in income leads to increase in supply of labor only when substitution effect is stronger than the income effect.

If income effect is stronger than the substitution effect then in that case increase in income leads to decrease in supply of labor.

So,

We do not agree that if income effects were stronger than substitution effects then households will increase the supply of labor as hoped by the President.