Question

Suppose that the government imposes a lump-sum tax on goods produced by a firm. Determine the effect of this tax on the firm’s demand for labor?

Answer 1

If the government imposes a lump- sum tax on goods produced by a firm, then there will be an income effect on the labor supply and there will be no substitution effect. There will be no substitution effect because the real wage is not changing.

So, an increase in lump sum tax reduces a worker's wealth and labor supply increases. And when labor supply increases firms will have enough choice with them to hire labourers. So to avoid the effect of lump sum tax, the firm will reduce there demand for labor.