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What is the consequence of an increase in the income tax (that is paid out of...

What is the consequence of an increase in the income tax (that is paid out of wages) in the classical model? How would you expect such a change to affect output, employment, and the real wage?

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Answer #1

The classical model assumes that Income Tax increase will reduce the after tax real wages. This will result in a decrease in the labour supply. The labour supply curve will shift to the left and it will reduce the level of employment in the nation. The aggregate supply curve shifts to the left and there is a reduction in the level of output and an increase in the level of prices.

Therefore output will fall employment will fall and real wage will also fall when income tax is increased.

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